BFF5520 Chap.6 Capital Budgeting I
Capital Budgeting I
Capital budgeting values incremental after-tax project cash flows at a risk-matched opportunity cost. NPV includes initial investment, working capital, operating cash, tax effects, opportunity costs, side effects and terminal recovery, while excluding sunk costs and financing flows already reflected in the discount rate. Positive NPV creates value.
Payback can omit time value and later cash flows, while IRR can fail with sign changes or mis-rank projects that differ in scale and timing. Sensitivity, scenario and break-even analysis reveal where forecasts are fragile without creating unsupported probabilities.
What this chapter covers
- 01
Incremental cash flow
- 02
NPV decision rule
- 03
Payback limitations
- 04
IRR definition
- 05
Multiple IRRs
- 06
Working capital
- 07
Discount-rate matching
- 08
Sensitivity and break-even analysis
Worked example · free
Value a project with a terminal cash flow
- +1Set C0 = -$90,000 and years one through three at $31,000.
- +1Build year-four cash flow as $31,000 + $8,000 = $39,000.
- +1Discount year one: $31,000/1.08 = $28,703.70.
- +2Discount later cash flows and sum present value to $107,694.60.
- +1NPV = $107,694.60 - $90,000 = $17,694.60, so accept.
Key terms
- Net present value
- Net present value is discounted incremental cash flow less initial outlay and measures value created today.
- Incremental cash flow
- Incremental cash flow is the after-tax cash difference caused by accepting the project.
- Sunk cost
- A sunk cost is an amount already incurred that cannot change with the current decision.
- Opportunity cost
- An opportunity cost is the cash value of the best alternative use sacrificed by the project.
- Internal rate of return
- Internal rate of return is a discount rate at which project NPV equals zero.
- Break-even input
- A break-even input is the value of a forecast variable that makes project NPV exactly zero.
Capital Budgeting I FAQ
Why is NPV the main investment rule?
NPV includes every incremental dated cash flow, discounts at the opportunity cost and reports value added in present dollars. It is additive across projects and directly aligns the acceptance rule with owner wealth.
What is wrong with the payback rule?
Payback ignores cash after the cutoff and usually ignores time value within the cutoff. It can prefer a quick-recovery project that destroys value or reject a slower project with substantial later benefits.
When can IRR be misleading?
IRR can produce multiple values after repeated sign changes, reverse its usual rule for financing-type cash flows, and mis-rank mutually exclusive projects that differ in scale or timing. NPV at the relevant opportunity cost resolves those conflicts.
How does working capital enter project cash flow?
Working capital is normally an outflow when committed and an inflow when recovered. Omitting the initial commitment or the terminal recovery misstates value. Only the incremental amount caused by the project belongs in the model.
What does sensitivity analysis prove?
Sensitivity analysis shows how NPV responds when one assumption changes. It identifies influential inputs but does not supply a probability of failure unless probabilities are estimated separately. Scenario analysis changes coherent groups of assumptions together.
Exam move
Draw every project on a dated timeline and label cash flows before calculating. Practise classification: incremental versus sunk, cash flow versus accounting profit, operating versus financing, and nominal versus real. Recompute one example with working capital and one with disposal value. Then create ranking conflicts by changing scale, timing or cash-flow signs and explain why NPV controls.
Finish with sensitivity language that states what changes and what remains fixed. A good capital-budgeting answer contains the numerical NPV, the decision rule and a sentence naming the forecast or discount-rate condition that could reverse it. Maintain a cash-flow taxonomy beside the timeline.
Include opportunity costs, erosion of existing sales, tax effects, working-capital investment and recovery, capital expenditure and after-tax disposal proceeds; exclude sunk research and financing flows when the discount rate already prices financing. Reconcile operating profit to cash flow explicitly so depreciation is added back only after its tax effect has been recognised.
Build one nominal forecast with inflation and one real forecast without it, then discount each using its matching rate. For IRR, count sign changes before trusting a root and use NPV directly when projects are mutually exclusive or differ in scale. Test sensitivity one input at a time before constructing scenarios in which several inputs move together.
Convert break-even output into an operational statement about units, price or cost rather than leaving it as a spreadsheet number. Finally, check whether the required return reflects the project exposure. The current corporate average is not automatically appropriate for a project in a different market, currency or operating-risk class.
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