Capital Budgeting
Capital Budgeting
The exam tests estimating incremental project cash flows and applying the decision rules: NPV, IRR, payback, discounted payback, and profitability index.
Core rules
- Relevant cash flows are incremental, after-tax, and actual cash-never accounting income.
- Operating cash flow = (Sales − Costs)(1 − T) + Depreciation × T, equivalently net income + depreciation.
- Include initial capex and installation, working capital investment, salvage value (taxed on the gain over book value), and recovery of working capital at project end.
- Exclude sunk costs; include opportunity costs and any cannibalization of existing sales.
- NPV = Σ CFt/(1+r)^t − initial outlay; accept when NPV > 0. It is the preferred rule because it measures value added in dollars.
- IRR is the rate making NPV = 0; accept when IRR > required return.
- Payback ignores time value and all cash flows after the cutoff; discounted payback fixes the time-value flaw only.
- Profitability index = PV of inflows/initial outlay; accept when PI > 1.
Worked example
A machine costs $100,000, runs 5 years, and generates $30,000 operating cash flow annually; the required return is 10%. The 5-year annuity factor is 3.7908, so PV of inflows = $113,724 and NPV = $113,724 − $100,000 = $13,724. PI = 113,724/100,000 = 1.137. IRR solves 30,000 × factor = 100,000, so factor = 3.3333, giving IRR ≈ 15.2%. NPV, PI, and IRR all accept the project.
Traps
- Double-counting depreciation after starting from net income, or omitting the depreciation tax shield.
- Forgetting working capital at the start and its recovery at the end.
- Treating allocated overhead or prior research spending as incremental.
- Ranking mutually exclusive projects by IRR when scale differs-NPV is the correct ranker.
- Alternating cash flow signs can produce multiple IRRs; fall back on NPV or MIRR.