Advanced Capital Budgeting Decisions
What the exam tests
Advanced capital budgeting examines incremental cash-flow estimation, replacement and expansion decisions, capital rationing, inflation, risk-adjusted discount rates, APV, real options, sensitivity and scenario analysis. Numerical questions are common.
Core rules
- Use incremental after-tax cash flows; exclude sunk costs; include opportunity costs, working-capital changes and tax salvage.
- Match nominal cash flows with nominal discount rates, and real with real.
- APV = base-case NPV at unlevered cost + PV(financing side effects), including tax shields and flotation costs.
- Under capital rationing, rank divisible projects by profitability index; for indivisible projects use trial combinations or integer programming.
- Real options add value by allowing deferral, expansion or abandonment; value them with decision trees or option pricing.
Worked example
Project outlay ₹500 crore, annual free cash flow ₹120 crore for six years, unlevered cost 12%, debt ₹200 crore, tax 30%, flotation cost 2% of debt. Annuity factor at 12% for six years = 4.1114. Base NPV = 120 × 4.1114 − 500 = −₹6.63 crore. PV tax shield = 0.30 × 200 = ₹60 crore. Flotation cost = 0.02 × 200 = ₹4 crore. APV = −6.63 + 60 − 4 = ₹49.37 crore. The project is acceptable only after financing side effects.
Traps
Deducting interest in cash flows and again in APV; using accounting depreciation instead of tax depreciation; ignoring working-capital release; ranking by IRR when projects differ in scale or life; applying a single WACC to a risk-different project.