FNCE20005 · Corporate Financial Decision Making
Capital Budgeting
Capital budgeting is the heart of corporate investment: deciding whether a project adds value. The dominant rule is NPV — accept if positive, because it measures dollars of value created, which is exactly what shareholders want. Three other rules compress a project into a number with their own thresholds: IRR (the rate where NPV = 0; accept if IRR > the required return, but it suffers scale, timing and multiple-IRR pitfalls), payback (a crude liquidity screen that ignores the time value of money), and the profitability index (value per dollar invested, useful under capital rationing). The part the subject leans on hardest is getting the cash flows right: use incremental after-tax free cash flows — drop sunk costs, include opportunity costs and the change in net working capital, capture depreciation only through its tax shield, and exclude financing costs (they live in the discount rate). After an explicit forecast horizon, capture the rest with a terminal value, a growing perpetuity computed at year T and then discounted back. The recurring warning is to match the discount rate to the risk of the cash flow.
What this chapter covers
- 012.1 The four decision rules — NPV, IRR, payback, profitability index
- 022.2 NPV-vs-IRR conflict and the IRR pitfalls (scale, timing, multiple IRR)
- 032.3 Estimating cash flows — the five inclusion/exclusion rules
- 042.4 Free cash flow to the firm and the depreciation tax shield
- 052.5 Terminal value as a growing perpetuity
- 062.6 A full NPV worked example, every cash-flow rule in one problem
- 072.7 The traps that cost the most marks
Worked example: NPV with the depreciation tax shield and working-capital recovery
- +1Operating cash flow each year: EBIT = 50,000 − 30,000 depreciation = 20,000; after tax = 20,000 × 0.70 = 14,000; add back depreciation 30,000 → $44,000 FCF in years 1–3.
- +1Year-0 outflow: CapEx 90,000 + working capital 10,000 = −$100,000.
- +1Year-3 extra: recover working capital +$10,000 (machine sells for $0, no salvage), so year 3 = 44,000 + 10,000 = $54,000.
- +2Discount at 12%: 44,000/1.12 = 39,286; 44,000/1.12² = 35,077; 54,000/1.12³ = 38,438. PV(inflows) = $112,801.
- +1NPV: 112,801 − 100,000 = +$12,801 → NPV > 0, accept.
Key terms
- Net present value (NPV)
- The sum of a project's expected cash flows discounted at the required return, minus the initial outlay. Accept if NPV > 0. It measures dollars of value added and is the rule to trust when the decision rules conflict.
- Internal rate of return (IRR)
- The discount rate at which a project's NPV equals zero; accept if IRR exceeds the required return. It is intuitive but suffers from scale, timing and multiple/no-IRR pitfalls, so on mutually exclusive projects follow NPV.
- Free cash flow (FCF)
- The after-tax cash a project generates for all capital providers before financing: FCF = EBIT(1 − tc) + depreciation − ΔNWC − CapEx. It is discounted at WACC in capital budgeting and takeover valuation.
- Depreciation tax shield
- Depreciation is non-cash but lowers taxable profit, saving tc × depreciation in tax. Only that tax saving is a cash flow; depreciation itself is never subtracted as a cash payment.
- Terminal value
- The value of all cash flows beyond an explicit forecast horizon, usually a growing perpetuity TVT = FCFT(1 + g)/(WACC − g). It is computed at year T and must still be discounted back T periods, and needs WACC > g.
Capital Budgeting FAQ
Which decision rule should I trust when they disagree?
NPV. It measures dollars of value created, which is directly what shareholders want. On mutually exclusive projects the exam loves a setup where Project A has the higher IRR but Project B has the higher NPV (B is bigger, or its cash arrives later); the wealth-maximising choice is the higher NPV. IRR ranks by percentage and ignores scale and timing; payback ignores the time value of money entirely. Never let payback or accounting return override a positive NPV.
Which cash flows belong in a capital-budgeting analysis?
Only incremental after-tax cash flows — the ones that change because the project goes ahead. Exclude sunk costs (already spent), include opportunity costs (the next-best use of a resource you already own), include the change in net working capital (an outflow when it rises, recovered at project end), include capital expenditure and after-tax asset sales, and capture depreciation only through its tax shield. Exclude financing costs (interest, dividends) — they are captured in the discount rate, so counting them in the cash flows double-counts.
How do I handle the depreciation tax shield?
Two equivalent ways. Either compute EBIT(1 − tc) + depreciation, or compute after-tax operating cash flow and add tc × depreciation separately as the tax shield. They give the same number. The key point is that depreciation is non-cash — it enters only because it reduces tax, never as a cash outflow.
What are the two classic terminal-value mistakes?
First, the terminal value is computed at year T, so you must still discount it back T years; adding it un-discounted massively overstates value. Second, the growing-perpetuity formula needs WACC > g — a perpetual growth rate above the discount rate is impossible and gives a negative or absurd value.
Exam move
Treat a capital-budgeting question as the subject's signature multi-part problem and practise it as a fixed routine: build the incremental after-tax free cash flows, discount at the right rate, apply NPV, then cross-check with IRR or PI. Drill the five cash-flow rules until they are automatic — sunk out, opportunity in, ΔNWC in and recovered, CapEx and after-tax salvage in, depreciation only via its tax shield, financing out. Keep the terminal-value discipline in front of you (compute at year T, discount back T years, need WACC > g). The marks live in getting the cash flows and the discount rate right; the rest is arithmetic. The exam earns its marks by changing one input so the rules disagree, so always know why NPV wins.
