Corporate Finance Week 9 — Capital Budgeting

Week 9 in one sentence (lecturer framing)

Capital budgeting decides which 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).

Key take-away logic you must internalise

1) “Count all, incremental, after-tax cash flows…”

Foundation: count all incremental, after-tax cash flows, allowing for reasonable inflation.

2) Inflation consistency (very testable)

Discount nominal cash flows at nominal discount rates.
Some items may not inflate (e.g., depreciation rules) even if sales/costs do.

Free Cash Flow (FCF): what you will repeatedly compute

General FCF formula (memorise the structure)

FCF = (1 − τc) · (Revenues − Costs − Depreciation) + Depreciation − CAPEX − ΔNWC

Equivalent framing: discount only cash flows; use after-tax operating profits, add back depreciation, subtract CAPEX and ΔNWC.

Five skills Week 9 expects you to demonstrate

Identify relevant cash flows for capital budgeting.
Explain why opportunity costs and externalities must be included, while sunk costs and interest expense must not.
Handle depreciation tax shield, CAPEX, and NWC adjustments.
Account for salvage values and terminal values.
Calculate project FCFs.

Capital Budgeting inclusion/exclusion checklist (marking-scheme logic)

Include (YES)

Revenues, COGS, SG&A — incremental only.
R&D — yes, but identify what is sunk vs incremental.
Depreciation — yes (because it affects taxes).
Opportunity costs and externalities (if real and identifiable).
Income tax (to get unlevered net income).
Add back depreciation; subtract CAPEX; subtract increases in NWC / add decreases.
Salvage value and terminal value (when relevant).

Exclude (NO)

Sunk costs (already incurred; not incremental).
Overhead costs unaffected by the project.
Interest expense / interest payments (handled by the discount rate).

The interest-expense trap (classic pitfall)

Rule: ignore interest payments in project cash flows.

Interest is already reflected via the discount rate (often WACC).
Subtracting interest in cash flows is double counting.
Build unlevered project cash flows, then discount appropriately.

Net Working Capital (NWC): how it appears and how to compute it

The sign rule

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

“Days” mechanics (exam-like logic)

Example logic: if suppliers are paid 55 days late and costs are evenly distributed, average payables are:

55/365 ≈ 15% of annual COGS

For full credit, show steps: identify the driver (AR, Inventory, AP) and convert days into a fraction of annual flow.

Terminal value: “and then what?” (liquidation vs perpetuity)

Two terminal value types

Liquidation (shut down and extract salvage).
Perpetuity (flat/growing/declining steady-stage cash flows).

Liquidation terminal value: what goes into it

After-tax salvage value of assets
Recovery of net working capital at project end (if applicable)

After-tax salvage value mechanics (high-yield)

Salvage value: SV = liquidation price − liquidation costs
Tax is paid on the capital gain: (SV − BV)

After-tax proceeds = SV · (1 − t) + t · BV

Interpretation: tax applies to (sale price − book value), not the gross sale price.

Perpetuity terminal value (course expression)

Terminal value = FCF5 / (r − g)

Be explicit about timing: which year is the first steady-state cash flow (FCF6 vs FCF5) and discount terminal value back correctly.

Risk diagnostics: break-even, sensitivity, scenario

Break-even analysis

Studies the relationship between sales volume and profitability.
Question: under what conditions does the project break even?

Sensitivity analysis

Change one variable and observe the effect on NPV.
Focus on variables with the largest NPV impact.
High NPV sensitivity implies high forecasting risk for that variable.

Scenario analysis

Change several variables together (best/base/worst).
Produces a range of outcomes; maps plausible states of the world.

Exam-grade workflow (use for every capital budgeting question)

Set up incremental operating forecast (sales, costs, depreciation → EBIT).
Compute unlevered after-tax operating profit: EBIT · (1 − τc).
Add back depreciation (non-cash).
Subtract CAPEX (include correct timing: year 0 vs later follow-on).
Subtract ΔNWC (subtract increases / add decreases).
Add terminal value (liquidation or perpetuity) if required by “and then what?”
Discount at the appropriate rate and apply decision rule: invest if NPV > 0.

Most common ways students lose marks (Week 9-specific)

Treating accounting profit as cash flow (forgetting CAPEX and ΔNWC).
Including interest expense in cash flows (double counting).
Mishandling ΔNWC signs (increases are outflows).
Forgetting after-tax salvage value logic (tax on SV − BV).
Ignoring opportunity costs/externalities or incorrectly including sunk costs.