FNCE90060 Chap.4 Capital Budgeting
Capital Budgeting
Week 4 builds the project cash flows that decision rules require. The model includes only incremental effects caused by undertaking the project. Sunk costs are excluded because they cannot be changed; opportunity costs enter because using a resource sacrifices its best alternative; side effects such as cannibalisation enter when the project changes other cash flows.
Accounting earnings become free cash flow by applying tax to EBIT, adding depreciation back, subtracting capital expenditure and subtracting increases in net working capital. Depreciation is not cash, but it creates a tax shield. Working capital commonly leaves at the start or during growth and returns when the project closes. Terminal cash flow may also include after-tax salvage proceeds or continuation value.
Each dated free cash flow is then discounted to calculate NPV.
What this chapter covers
- 01
Incremental earnings and side effects
- 02
Sunk costs and opportunity costs
- 03
Depreciation and the tax shield
- 04
Capital expenditure
- 05
Net working capital changes
- 06
Terminal cash flow and project NPV
Worked example · free
Build annual free cash flow
- 1After-tax EBIT equals $50,000 times 0.70, or $35,000.
- 1Add back non-cash depreciation of $20,000.
- 1Subtract capital expenditure of $8,000 and the $5,000 working-capital increase.
- 1Free cash flow equals $42,000.
Key terms
- Incremental Cash Flow
- Cash flow that changes because the project is accepted.
- Sunk Cost
- A past cost that cannot be changed by the current decision.
- Opportunity Cost
- The value sacrificed by using a resource in the project.
- Depreciation Tax Shield
- Tax saved because depreciation reduces taxable operating income.
- Net Working Capital
- Operating current assets less operating current liabilities supporting the project.
- Continuation Value
- The value at a terminal date of cash flows occurring after the explicit forecast.
Capital Budgeting FAQ
Why is interest usually excluded from project cash flow?
Financing is reflected in the discount rate used to value unlevered project cash flow. Subtracting interest in the cash flow and then using a financing-sensitive rate would count the financing effect twice.
Why is depreciation added back?
Depreciation lowers taxable income but does not itself require a cash payment in the period. It is deducted when EBIT is calculated, tax is applied, and then it is added back to reach cash flow.
How should working capital be treated?
An increase ties cash up in receivables or inventory net of payables and is therefore subtracted. When the project ends and working capital is released, the recovery becomes a terminal inflow.
What belongs in after-tax salvage value?
Start with sale proceeds, compare sale price with book value, calculate tax on the gain or benefit on the loss, and include the resulting after-tax cash amount at the sale date.
How do I test whether an input is incremental?
Ask how the firm's total cash flow changes if the project is accepted rather than rejected. Include extra revenue, cash costs, tax, opportunity costs and side effects caused by that decision. Exclude a past payment that cannot change and an allocated overhead amount when the firm's actual cash spending remains the same.
Where does a working-capital recovery belong?
An increase in net working capital is a cash outflow when operating resources become tied up. If those resources are released when the project closes, record the recovery as a terminal inflow. Do not add the initial outflow back automatically when part of the investment is expected to remain permanently committed.
How should a continuation value be dated?
A continuation value sits at the end of the explicit forecast and represents cash flows after that point. First calculate it using the next cash flow required by its formula, then discount the resulting terminal-date value back to today. Adding it directly to current NPV without discounting mixes valuation dates.
Why should the terminal year be rebuilt separately?
The last operating year can contain normal operating cash flow plus working-capital recovery, after-tax asset sale proceeds or continuation value. Copying an ordinary middle-year column can omit those closing items. Recompute book value, tax, recovery and timing explicitly before discounting the final total.
Exam move
Build a classification ledger before a spreadsheet: incremental, sunk, opportunity cost, side effect or financing. Lay out initial, operating and terminal dates in separate columns. Reconcile EBIT to free cash flow with the same sequence every time. Give the terminal year a separate audit for working-capital recovery, salvage and continuation value. Only after the cash-flow model is complete should discounting begin.
Finish by stating NPV and the stand-alone or ranking decision it supports. Reconcile the depreciation tax shield independently and rebuild the closing-year column instead of copying an ordinary year. For every excluded input, write the causal reason, such as already paid, unchanged total cash spending or financing already reflected in the discount rate.
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