Capital Budgeting for Valuations

Class 9: Capital Budgeting

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Week 9 Overview: Capital Budgeting

The Big Picture

Capital budgeting is the process of deciding which investments/projects create value, by (1) projecting incremental after-tax cash flows, (2) choosing the right discount rate, and (3) applying a decision rule (with NPV as the workhorse).

πŸ’΅

Free Cash Flow (FCF)

The cash available after operating expenses and capital investments. Key formula: FCF = EBIT(1βˆ’t) + Depreciation βˆ’ CAPEX βˆ’ Ξ”NWC

πŸ“Š

Net Present Value (NPV)

Sum of all discounted future cash flows minus initial investment. Decision rule: Invest if NPV > 0

∞

Terminal Value

Value at the end of forecast period. Either liquidation (sell assets) or perpetuity (continue forever at growth rate g).

🎯 Key Learning Objectives
1
Identify Relevant Cash Flows Only incremental, after-tax cash flows matter
2
Include/Exclude Correctly Opportunity costs YES, sunk costs NO, interest NO
3
Handle Depreciation Tax Shield Depreciation saves taxes but isn't a cash outflow
4
Account for Terminal Value Liquidate or continue as perpetuity?
5
Apply Decision Rule NPV > 0 means the project creates value
⚠️ Common Exam Pitfalls
❌ Including Interest Expense

Interest is already in the discount rate (WACC). Including it in cash flows = double counting!

❌ Including Sunk Costs

Past R&D or expenses already incurred don't affect future decisions.

❌ Wrong NWC Sign

Increase in NWC = cash OUTFLOW (subtract). Decrease = inflow (add).

❌ Tax on Full Salvage Value

Tax is on capital GAIN (SV βˆ’ BV), not the full sale price!

βœ… INCLUDE in FCF
  • Incremental revenues and costs
  • Opportunity costs (foregone alternatives)
  • Externalities (cannibalization, synergies)
  • Depreciation (for tax shield calculation)
  • CAPEX (capital expenditures)
  • Changes in Net Working Capital
  • Terminal/Salvage value
❌ EXCLUDE from FCF
  • Sunk costs (already spent)
  • Interest expense (in WACC already)
  • Overhead unaffected by project
  • Financing cash flows
  • Allocated costs not incremental
πŸ“ Key Formulas at a Glance
FCF = (1 βˆ’ Ο„) Γ— (Revenue βˆ’ Costs βˆ’ Depreciation) + Depreciation βˆ’ CAPEX βˆ’ Ξ”NWC
NPV = βˆ’Initial Investment + Ξ£ [FCFβ‚œ / (1+r)α΅—] + TV / (1+r)ⁿ
Terminal Value (Perpetuity) = FCFβ‚… / (r βˆ’ g)
After-tax Salvage = SV βˆ’ Ο„(SV βˆ’ BV) = SV(1βˆ’Ο„) + τ×BV
πŸ’‘ Inflation Consistency (Testable!)

Discount nominal cash flows at nominal discount rates. Be careful: some items like depreciation have NO inflation even if sales/costs do. This mismatch is a common exam trap!

πŸ“š Formula Reference Sheet

Free Cash Flow (FCF)

FCF = (1 βˆ’ Ο„) Γ— (Revenue βˆ’ Costs βˆ’ Depreciation)
+ Depreciation
βˆ’ CAPEX
βˆ’ Ξ”NWC
Or equivalently: FCF = EBIT(1βˆ’t) + Depreciation βˆ’ CAPEX βˆ’ Ξ”NWC

Net Present Value (NPV)

NPV = βˆ’Initial Investment + Ξ£ [FCFβ‚œ / (1+r)α΅—] + TV / (1+r)ⁿ
Decision Rule: Invest if NPV > 0

Terminal Value

Growing Perpetuity:
TV = FCFβ‚… / (r βˆ’ g)
Liquidation:
TV = SV(1βˆ’Ο„) + τ×BV + NWC
βœ… INCLUDE:
  • Incremental revenues/costs
  • Opportunity costs
  • Externalities
  • Depreciation (for tax shield)
  • CAPEX
  • Changes in NWC
  • Terminal value
❌ EXCLUDE:
  • Sunk costs
  • Interest expense (in WACC!)
  • Unaffected overhead
  • Financing cash flows
Corporate Finance Week 9 Study Tool β€’ Capital Budgeting for Valuations