Strategic Financial Management and Capital Budgeting
Capital budgeting questions test whether you can build incremental after-tax cash flows and choose between projects when capital is scarce or risk differs.
Core rules
- Use free cash flow: incremental, after tax, excluding financing flows and sunk costs; include opportunity cost, working-capital investment and release, and tax on salvage.
- Depreciation is not a cash flow, but the depreciation tax shield is: tax rate × depreciation.
- NPV = present value of cash inflows − initial outlay. IRR is the discount rate at which NPV = 0; use NPV for mutually exclusive projects because IRR can mislead on scale and timing.
- Profitability index = present value of inflows / initial outlay; rank by PI under capital rationing.
- Money and real rates must be consistent: discount nominal cash flows at a nominal rate, real cash flows at a real rate.
- WACC uses market-value weights and after-tax cost of debt; CAPM: Ke = Rf + β(Rm − Rf).
Worked example
Outlay ₹100 lakh; EBITDA ₹40 lakh a year for 5 years; depreciation ₹20 lakh straight line; tax 30%; cost of capital 12%; no salvage. Annual cash flow = (40 − 20) × (1 − 0.30) + 20 = ₹34 lakh. The annuity factor at 12% for 5 years is 3.6048, so PV = ₹122.56 lakh and NPV = ₹22.56 lakh. Accept, subject to qualitative fit and risk.
Traps
- Discounting accounting profit instead of cash flow.
- Forgetting working-capital release in the final year.
- Using the coupon rate as the cost of debt rather than the yield, and ignoring the tax shield.
- Comparing projects with unequal lives without equivalent annual annuity.
- Using historical book weights in WACC.