BFC2140 · Corporate Finance
Capital Budgeting II: Cash Flow Analysis
Once you can apply the decision rules, the real work is estimating the right cash flows to put into them. This chapter covers the incremental after-tax free cash flow (FCF) of a project — the initial investment, the operating cash flows and the terminal cash flow — built up from EBIT, and the rules for what to include: ignore sunk costs, include opportunity costs and net working capital (recovered at the end), add back depreciation, and exclude interest. It is examined as Section C written-response questions that ask you to construct an FCF table and compute the project's NPV, plus conceptual parts on why each rule applies.
What this chapter covers
- 01Relevant cash flow = incremental after-tax free cash flow (the three components)
- 02The FCF build: Revenue − COGS − SG&A − Depreciation = EBIT; less tax; plus depreciation; less CapEx; less ΔNWC
- 03Initial investment: CapEx plus the initial increase in net working capital at t = 0
- 04Operating cash flow each year, including the depreciation tax shield (Dep × tax rate)
- 05Terminal cash flow: net salvage (after tax on disposal) plus recovery of net working capital
- 06Sunk costs (ignore), opportunity costs (include) and allocated overheads (use incremental only)
- 07Why interest is excluded from project cash flows (it is captured in the discount rate)
- 08Replacement decisions and the after-tax treatment of salvage value
Incremental free-cash-flow table and project NPV
- 1 markCompute EBIT: 50 − 22 − 5 − 10 = $13m. Note interest is not deducted here — financing is handled through the discount rate, not the cash flows.
- 1 markTax the EBIT: tax = 30% × 13 = $3.9m, giving unlevered net income = 13 − 3.9 = $9.1m.
- 1 markAdd back depreciation (a non-cash expense) to get operating FCF: 9.1 + 10 = $19.1m per year for years 1-4.
- 1 markBuild the initial cash flow at t = 0: −CapEx − initial ΔNWC = −40 − 4 = −$44m.
- 1 markBuild the terminal cash flow at t = 4: operating FCF plus NWC recovery = 19.1 + 4 = $23.1m (the asset is depreciated to zero with no salvage, so no salvage term).
- 1 markLay out the cash-flow timeline: t = 0: −44; t = 1, 2, 3: +19.1 each; t = 4: +23.1.
- 1 markDiscount each cash flow at 11%: −44 + 19.1/1.11 + 19.1/1.11² + 19.1/1.11³ + 23.1/1.11⁴ = −44 + 17.207 + 15.502 + 13.965 + 15.218.
- 1 markSum to the NPV: NPV = $17.89m > 0, so accept the project.
Key terms
- Incremental cash flow
- The change in the firm's total cash flow caused by accepting the project — what is different with the project versus without it. Only incremental, after-tax cash flows are relevant to NPV; everything else (sunk costs, unaffected overheads) is excluded.
- Free cash flow (FCF)
- The project's after-tax operating cash flow available to all investors: EBIT × (1 − T) + Depreciation − CapEx − ΔNWC. It strips out non-cash items and financing, so it is the cash the project actually generates.
- Sunk cost
- Money already spent that cannot be recovered regardless of the decision (e.g. completed feasibility studies). Sunk costs are never incremental, so they are excluded from project cash flows — a frequent exam trap.
- Opportunity cost
- The cash flow forgone by using a resource the firm already owns in this project rather than its next-best use (e.g. the rent forgone on a building used for the project). It is a real incremental cost and must be included.
- Net working capital (NWC)
- Current assets minus current liabilities tied up by the project. An increase in NWC is a cash outflow when it occurs and is recovered as a cash inflow at the end of the project's life; both must appear in the cash-flow table.
- Depreciation tax shield
- The tax saving created by deducting depreciation: Depreciation × tax rate. Depreciation is non-cash, so it is added back in the FCF build, but it reduces taxable income and therefore lowers the tax paid — a genuine cash benefit.
Capital Budgeting II: Cash Flow Analysis FAQ
Why is interest excluded from a project's cash flows?
Because the cost of financing the project is already captured in the discount rate (the required return or WACC). If you both deducted interest in the cash flows and discounted at a financing-inclusive rate, you would double-count the cost of capital. Project FCF is deliberately 'unlevered' — it measures the cash the project generates for all investors, and the discount rate then accounts for how that cash is split between debt and equity holders.
How do I treat depreciation if it isn't a cash flow?
Depreciation matters indirectly through tax. In the FCF build you subtract it to get EBIT (so it lowers taxable income and the tax bill), then add it straight back because it is a non-cash expense. The net effect is the depreciation tax shield: Depreciation × tax rate of extra cash each year. So depreciation reduces tax but is not itself a cash outflow — getting this two-step right is essential to a correct FCF table.
What's the difference between sunk costs, opportunity costs and overheads?
Sunk costs are already incurred and unrecoverable, so they are irrelevant and excluded — accepting or rejecting the project will not change them. Opportunity costs are the value of resources the firm already owns but would have to give up another use for, so they are real incremental costs and must be included. Allocated overheads are tricky: include only the incremental overhead the project actually causes, not a share of fixed corporate overhead that would exist anyway.
How is net working capital handled in the cash-flow table?
An increase in NWC (more inventory and receivables, net of payables, to support the project) is a cash outflow at the time it is needed — usually largely at t = 0. At the end of the project's life that NWC is recovered (inventory sold, receivables collected) and appears as a cash inflow, typically in the terminal year. Forgetting the terminal recovery is one of the most common errors and understates the NPV.
How is cash-flow analysis examined in BFC2140?
It is one of the unit's signature Section C skills. Expect a written-response question giving project assumptions (sales, costs, depreciation, NWC, tax, discount rate) and asking you to build the incremental FCF table and compute the NPV, often with conceptual parts on why a particular item (a sunk cost, an opportunity cost, interest) is included or excluded. Incremental FCF tables are explicitly listed as a high-yield recurring exam skill, and Section C may require an Excel download/upload.
Exam move
Drill the FCF build until you can reproduce it from memory: Revenue − COGS − SG&A − Depreciation = EBIT, less tax, plus depreciation, less CapEx, less change in NWC = FCF. Always lay your answer out as a labelled table with a clear t = 0 row, the operating years, and a terminal row, because organised work both earns method marks and prevents the classic slips. Internalise the inclusion rules as a checklist — ignore sunk costs, include opportunity costs, use only incremental overheads, add and recover NWC, and never deduct interest — and be ready to justify each in one sentence for the conceptual parts. Treat depreciation in two moves (subtract for tax, add back as non-cash) and remember the depreciation tax shield. Practise full FCF-to-NPV problems end to end and recompute the discounting carefully, since Section C rewards a clean, complete cash-flow statement as much as the final NPV.
