FNCE90065 Chap.9 NPV and Project Cash Flow
NPV and Project Cash Flow
Capital budgeting asks whether incremental project cash flows create value after the required return. This chapter builds operating cash flow after tax, adds capital expenditure and working-capital commitments, includes terminal recovery and disposal effects, and discounts the full timeline to net present value. It separates sunk costs from opportunity costs and compares NPV with IRR, payback and profitability index.
The central discipline is deciding which cash flows change because the project is accepted.
What this chapter covers
- 01
NPV sums the present values of all incremental project cash flows
- 02
Sunk costs are excluded while opportunity costs are included
- 03
Depreciation affects cash through tax and is added back after tax calculation
- 04
Working-capital increases are outflows and may be recovered at project end
- 05
After-tax disposal proceeds belong in terminal cash flow
- 06
NPV measures dollar value and is preferred for mutually exclusive project ranking
Worked example · free
Evaluate a short equipment project
- 1Record the $95,000 time-zero outflow without discounting it.
- 2Value the three $38,000 inflows as an annuity at 9 percent.
- 1The operating-inflow present value is approximately $96,202.
- 1Discount the $8,000 disposal value to approximately $6,178.
- 1NPV is approximately $7,380, so accept under the stated forecasts.
Key terms
- Incremental cash flow
- Incremental cash flow is the change in cash caused by accepting a project.
- Sunk cost
- A sunk cost is a past cost that cannot be changed by the current decision.
- Opportunity cost
- Opportunity cost is the cash value sacrificed by using a resource in the project.
- Depreciation tax shield
- A depreciation tax shield is the tax saving created when depreciation reduces taxable income.
- Internal rate of return
- Internal rate of return is the discount rate that makes project NPV equal zero.
NPV and Project Cash Flow FAQ
Which cash flows belong in project NPV?
Include cash flows changed by accepting the project: operating inflows and costs, tax effects, capital expenditure, opportunity costs, side effects, working capital and terminal proceeds. Exclude sunk costs. Financing cash flows are normally excluded when financing cost is already reflected in the discount rate.
Why is depreciation included if it is non-cash?
Depreciation reduces taxable income and therefore changes tax paid. Operating cash flow can be written as after-tax operating profit plus depreciation. The expense is added back because it is non-cash, while its tax shield remains a real project benefit under the assumed tax treatment.
Why can NPV and IRR rank projects differently?
IRR is a percentage rate, while NPV measures total dollar value at the required return. Projects can differ in scale, timing and cash-flow pattern, so the highest IRR need not create the most value. For mutually exclusive choices, the higher positive NPV is the primary ranking criterion.
Exam move
Create a project cash-flow template with rows for revenue, cash costs, depreciation, tax, operating cash flow, capital expenditure, working capital and terminal items. Classify every number before calculating: incremental, sunk, opportunity, financing or terminal. Rebuild the timeline so time-zero outlays are not discounted and terminal recovery is not treated as recurring revenue.
Compare NPV with IRR, payback and profitability index by stating what each measure retains or ignores. After finding base-case NPV, change the most uncertain driver and explain whether the investment decision survives. Start each case with a relevance screen.
Mark past expenditures as sunk, owned resources as opportunity costs, side effects on existing products as incremental spillovers and interest payments as financing flows excluded when the discount rate already reflects financing. Build operating cash flow from revenue less cash costs and tax, showing depreciation's tax effect without treating depreciation itself as a cash outflow.
Put capital expenditure and working-capital investment on dated lines, and reverse recoverable working capital only at the project end. For asset disposal, calculate any tax consequence from sale value relative to book value rather than adding the sale proceeds alone. Once the cash-flow timeline is complete, discount each date and sum to NPV. Use a sign convention that makes acceptance at positive NPV immediate.
Rework one project with unequal lives or mutually exclusive scale and explain why a larger NPV can be preferred even when its IRR is lower. Create a non-conventional cash-flow example to show why multiple sign changes can make IRR ambiguous. For sensitivity analysis, vary price, volume, cost and discount rate separately; do not call a one-variable test a probability forecast.
Calculate a break-even driver where practical and interpret its distance from the base case. Finish by writing a recommendation that separates the numerical decision rule from assumptions requiring managerial verification, especially forecast horizon, terminal value and working-capital recovery.
Add a post-completion review design: identify which actual revenues, costs and working-capital balances would be compared with forecasts. This keeps appraisal assumptions testable and distinguishes learning from hindsight-based blame.
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