FI21 · Firm Valuation

Chapter 8

Fundamentals of Capital Budgeting

Theory Notes — based on lecture slides & course notes

Topics: Capital Budgeting · Relevant Cash Flows · Cash Flow from Operations Net Working Capital ·
Project Free Cash Flow · NPV · Terminal Value Break-Even · Sensitivity · Scenario Analysis

1 · Introduction to Capital Budgeting

1.1 Key Definitions

Capital Budgeting is the process of analysing investment opportunities and deciding which ones to accept. It
answers the central question: does a proposed real investment create value for the firm?

Capital Budget is a list of all projects that a company plans to undertake during the next period. It is the output of
the capital budgeting process.

1.2 The Core Framework

Capital budgeting has two fundamental tasks:

• Identifying and correctly measuring the cash flows that are properly attributable to the proposed project (Chapter
8).
• Discounting those cash flows at the appropriate required return to compute NPV (Ch.7 decision rules).

This chapter is entirely about task (1). The NPV formula is well-known:

NPV = –I(0) + C(1)/(1+r(1)) + C(2)/(1+r(2))^2 + ... + C(t)/(1+r(t))^t

where: I(0) = initial investment

C(t) = project free cash flow in period t

r(t) = discount rate applicable to period t

The challenge is not the formula — it is getting C(t) right. The rest of Chapter 8 explains how.

2 · Relevant Cash Flows

2.1 The Principle: Incremental Cash Flows

The foundational principle of capital budgeting is to use incremental cash flows — the extra cash flows that the
project produces. Formally:

Incremental CF = CF(firm with project) – CF(firm without project)

This principle immediately implies six practical rules for what to include and exclude.

2.2 Rule 1 — Discount Cash Flows, Not Profits

We discount cash flows, not accounting profits. The two differ because:

• Depreciation reduces accounting profit but is a non-cash charge — no money leaves the firm.
• Capital expenditure (CapEx) is a real cash outflow but does not appear on the income statement in the year of
payment.
• Interest payments reflect financing decisions, not operating performance — they are excluded from FCF and
captured in the discount rate instead.

2.3 Rule 2 — Include All Indirect Effects (Cannibalization)

A new project can affect the cash flows of existing projects. These indirect effects must be included. The most
important indirect effect is cannibalization: cash flows of a new project that come at the expense of a firm's
existing products.

The correct approach is to count all incremental changes across the entire firm, not just the revenue from the new
product alone.

Example — New Feet Company (slides)

The firm adds sandals (price $24, expected 4,500 units) to its line. But dress shoe sales fall 800 units ($59
each) and athletic shoe sales rise 600 units ($89 each).

Incremental sales = +4,500×$24 – 800×$59 + 600×$89

= +$108,000 – $47,200 + $53,400 = +$114,200

Only counting sandal revenue ($108k) would overstate the benefit by almost 6%. The indirect effects are
material.

2.4 Rule 3 — Forget Sunk Costs

A sunk cost is a cost that has already been paid, or whose liability has already been incurred, before the
investment decision is made. Because the firm must pay this cost regardless of whether it proceeds with the
project, it has no bearing on the decision.

Classic examples: market research fees, feasibility studies, prior R&D; spending. These are gone — including
them would lead to bad decisions by making projects appear less attractive than they truly are going forward.

Watch out

A cost is sunk if it was incurred BEFORE the current investment decision and cannot be recovered. Its size is
irrelevant — even a very large sunk cost must be ignored.

Do not confuse sunk costs with future committed costs. If a contract signed today obligates the firm to future
payments conditional on the project proceeding, those future payments ARE incremental.

2.5 Rule 4 — Include Opportunity Costs

An opportunity cost is the most valuable alternative that is given up if a particular investment is undertaken. Even
if no cash changes hands with a third party, the foregone value is a real cost of the project.
Opportunity costs are always measured on an after-tax basis, because if the firm had taken the alternative, it
would have received the after-tax proceeds.

Opportunity cost of using an owned resource = After-tax value of best

alternative use

= Market value × (1 – tax rate)

Example — HomeNet project (slides)

HomeNet's new lab uses office space the firm would otherwise rent out for $200,000/year. Tax rate = 20%.

The opportunity cost reduces incremental earnings by $200,000 × (1 – 20%) = $160,000 per year.

Intuition: if the firm had rented the space, it would have received $160k after tax. Using it for the project costs
exactly that amount in foregone income.

2.6 Rule 5 — Beware of Allocated Overhead Costs

Firms routinely allocate shared overhead costs (IT, HR, facilities, management time) across divisions and projects.
For NPV purposes, only the extra overhead costs caused by the project should be included.

If the firm would incur the same overhead expenditure regardless of whether the project proceeds, that overhead is
not incremental and must be excluded. Including non-incremental overhead understates NPV and biases the
decision against valuable projects.

2.7 Rule 6 — Ignore How the Project Is Financed

Interest expenses and other financing charges are excluded from project cash flows. The cost of debt (and the
decision about how much debt to use) is captured in the discount rate — typically the Weighted Average Cost of
Capital (WACC). Including interest in the cash flows AND using WACC as the discount rate would double-count
the cost of debt.

Key concept

Summary: compute Free Cash Flows as if the project is 100% equity financed (hence 'unlevered net income' in
the FCF formula). Any debt tax shields appear through WACC, not through FCF.

3 · Project Free Cash Flow

3.1 Definition
Project Free Cash Flow (FCF) is the cash generated by the project that is free to be distributed to all capital
providers — both creditors and shareholders — after funding all operating activities and investment needs.

A project FCF includes three components:

• Cash flow from operations (CFO) — the operating performance of the project
• Cash flow from capital investments — CapEx, plus salvage value at project end
• Cash flow from changes in working capital — ∆NWC, plus recovery at project end

Project FCF = Cash Flow from Operations – Capital Investments – ∆NWC

3.2 The Master FCF Formula

Expanding the three components, the master formula takes two equivalent forms:
 FORM 1 (starting from EBIT):

FCF = (Revenues – Costs – Depreciation) × (1 – t) + Depreciation – CapEx – ∆NWC

[■■■■■■■■■■■■■■■■■■■ EBIT ■■■■■■■■■■■■■■■■■■]

[■■■■■■■■ Unlevered Net Income ■■■■■■■■■■■■■]

FORM 2 (starting from Cash Flow from Operations):

FCF = (EBIT + Depreciation – Taxes) – CapEx – ∆NWC

[■■■■■■ Cash Flow from Operations ■■■■■■■■■]

Key concept

Both forms are algebraically identical. Use Form 1 when you want to see the tax shield on depreciation
explicitly. Use Form 2 when you have already computed CFO from an income statement.

t (tau) is the marginal corporate tax rate. Taxes = EBIT × t. If EBIT is negative, taxes are negative — this
represents a tax saving (cash inflow from reduced tax on other firm income).

4 · Cash Flow from Operations (CFO)

4.1 Definition and Formula

Cash Flow from Operations is the net cash produced by the project's operating activities, after taxes but before
capital investment and working capital adjustments.

CFO = EBIT + Depreciation – Taxes

= Unlevered Net Income + Depreciation

where: EBIT = Revenues – Costs – Depreciation

Taxes = EBIT × t (the actual tax cash payment)

Unlevered Net Income = EBIT × (1 – t) [also called NOPAT]

4.2 Why Depreciation Is Treated This Way

Depreciation plays a dual role that causes it to appear twice in the income statement→CFO journey:

Role Where Effect

Subtracted from revenues Income statement (→ EBIT) Reduces taxable income → lower tax bill

Added back to net income Cash flow reconciliation It is non-cash: no money left the firm

The net result is a depreciation tax shield: the project saves taxes equal to Depreciation × tax rate, and this
saving is a real cash benefit.
 Depreciation tax shield = Depreciation × t

Cash effect in CFO: –Depreciation enters EBIT (lowers tax), then

+Depreciation added back

Net cash impact of depreciation = Depreciation × t (tax saving only)

4.3 Building the Income Statement to Reach CFO

The standard procedure is to build a project income statement first, then adjust to cash:

Revenues (incremental sales)

– Variable Costs

– Fixed Costs

– Depreciation

= EBIT

– Taxes (= EBIT × t)

= Unlevered Net Income (= Net Operating Profit After Tax)

+ Depreciation [add back: non-cash]

= Cash Flow from Operations (CFO)

Watch out

Never put the accounting net income (which includes interest expense) into the FCF formula. Always use
UNLEVERED net income — computed as if the project were 100% equity financed (no interest deduction).

Tax payments can be negative ('tax savings') when the project generates a loss. This reduces the firm's total
tax bill and is a real positive cash flow to the project.

4.4 Worked Illustration (from slides)

Example — Mike's project

Annual sales = $119,000 | Variable costs = $59,300 | Fixed costs = $23,800

Equipment = $90,000 depreciated straight-line over 3 years → Depreciation = $30,000/yr

Tax rate = 34%

Line Item Amount ($)

Sales 119,000

– Variable Costs (59,300)

– Fixed Costs (23,800)

– Depreciation (30,000)

= EBIT 5,900
 – Taxes (34% × 5,900) (2,006)

= Unlevered Net Income 3,894

+ Depreciation (add back) +30,000

= Cash Flow from Operations 33,894

Reading the result: Even though accounting profit is only $3,894, the project generates $33,894 in operating cash
flow. The $30,000 depreciation charge shields taxes but is itself non-cash, so it is fully recovered in CFO. The tax
bill is modest ($2,006) because the large depreciation deduction keeps taxable income low.

5 · Net Working Capital (NWC)

5.1 What is NWC?

Net Working Capital (NWC) = Current Assets – Current Liabilities. It represents the short-term financial resources
the firm has tied up in its operations.

For capital budgeting, we focus on Operating Working Capital (also called BFR — Besoin en Fonds de
Roulement — in French accounting):

Operating Working Capital (OWC / BFR)

= Accounts Receivable + Inventory – Accounts Payable

The three components:

• Accounts Receivable (AR) — customers' unpaid bills. The firm has sold goods but not yet collected cash. This
is money owed TO the firm; it is a current asset and an investment the firm must fund.
• Inventory — raw materials and finished goods held. Cash has been spent to create inventory but not yet
recovered through sales. Also a current asset requiring funding.
• Accounts Payable (AP) — bills the firm has not yet paid to suppliers. Suppliers are effectively lending money to
the firm. This is a current liability and offsets the investment in AR and inventory.

5.2 Why NWC is a Cash Investment

Investments in working capital, just like investments in plant and equipment, result in cash outflows. When a
project starts:

• The firm must purchase inventory before selling → cash out

• The firm sells on credit → cash receipt is delayed (AR builds up)
• Suppliers allow some delay → AP partially offsets the above
• Net result: the firm has 'lent' OWC to the operating cycle and cannot use that cash elsewhere
Critically, working capital is recovered at the end of the project when AR is collected, inventory is liquidated, and
AP is paid off. This recovery is a positive cash inflow in the terminal year.

5.3 ∆NWC in the FCF Formula

What matters for cash flows each year is the change in NWC (∆NWC), not its level:

∆NWC(t) = NWC(t) – NWC(t–1)

In the FCF formula, we SUBTRACT ∆NWC:

 If NWC increases → ∆NWC > 0 → cash OUTFLOW (subtract from FCF)

If NWC decreases → ∆NWC < 0 → cash INFLOW (negative subtraction =

addition to FCF)

At project end: NWC returns to 0 → large positive cash inflow (full

recovery)

Watch out

Subtract the CHANGE in NWC from FCF each period, not the total NWC level. In Year 1, the outflow is the
increase from Year 0 to Year 1; in Year 2, it is the increase from Year 1 to Year 2, and so on.

Do NOT forget the NWC recovery in the final year. All working capital returns to zero when the project ends,
generating a cash inflow equal to the terminal NWC balance.

Accounts Payable is a LIABILITY — an increase in AP REDUCES the OWC investment (more free supplier
financing). Get the sign right: OWC = AR + Inv – AP.

5.4 Computing OWC from Days Outstanding

In practice, OWC items are estimated using activity ratios that express each component as a number of 'days' of a
reference flow:

Accounts Receivable = Sales × (Collection Period in days / 365)

Inventory = COGS × (Inventory Days / 365)

[approximation: use Sales if COGS not given]

Accounts Payable = COGS × (Payable Period in days / 365)

[approximation: use Sales if COGS not given]

Note: 365 days can sometimes be replaced by 360 days — use what the problem
specifies.

Interpreting each ratio:

• Collection period = average number of days customers take to pay. A 60-day collection period means AR ≈
(60/365) × annual sales.
• Inventory days = average number of days goods are held before being sold. Longer inventory days → higher
inventory balance → larger cash investment.
• Payable period = average number of days the firm takes to pay its own suppliers. Longer payable period →
higher AP → lower net OWC investment.

6 · Capital Investments and Salvage Value

6.1 Capital Expenditure (CapEx)

Capital Expenditure is the initial investment in fixed assets (equipment, plant, property) required to undertake the
project. It is a cash outflow at the time of purchase, typically at Year 0.

CapEx is distinct from the operating costs in the income statement. It is capitalised on the balance sheet and
gradually expensed through depreciation. In the FCF formula, we deduct the actual cash payment (CapEx) — not
the annual depreciation — as the capital investment component.

6.2 Salvage Value (After-Tax Proceeds)

At the end of the project, fixed assets are often sold. The after-tax salvage value is the cash received from the
sale after paying any taxes on the gain (or claiming a tax saving on any loss).

After-tax Salvage Value = Sale Price – t × (Sale Price – Book Value)

where: Sale Price = market price received for the asset

Book Value = undepreciated value remaining on the balance sheet

t = corporate tax rate

If the asset is fully depreciated (Book Value = 0):

After-tax Salvage Value = Sale Price × (1 – t)

Three cases arise:

Condition Tax Treatment After-Tax Salvage

Sale Price > Book Value Taxable gain: t × (SP – BV) SP – t × (SP – BV) < SP

Sale Price = Book Value No gain or loss, no tax SP (full proceeds kept)

Sale Price < Book Value Tax-deductible loss: saving = t × (BV – SP) SP + t × (BV – SP) > SP

Key concept

The formula SP – t × (SP – BV) works in all three cases — when BV > SP, (SP – BV) is negative, so the tax
term becomes positive, increasing the after-tax proceeds above the sale price. This correctly represents the tax
refund on a loss.

Do NOT forget salvage value — the slides explicitly highlight it as a common omission ('don't forget salvage
value!!'). It can materially affect project NPV.

7 · Putting It Together: NPV of the Project

7.1 Timeline of Cash Flows

Once all three FCF components are computed (CFO, capital investment, ∆NWC), they are mapped on a
year-by-year timeline. A typical project timeline has this structure:

Year CapEx / Salvage ∆NWC CFO Total FCF

0 (start) –CapEx –Initial NWC 0 –CapEx – Initial NWC

1 … T–1 0 –∆NWC(t) +CFO(t) CFO(t) – ∆NWC(t)

T (end) +Salvage +NWC Recovery +CFO(T) CFO(T) + Salvage + NWC Recovery

NPV is then computed by discounting each year's FCF at the cost of capital r:

NPV = –FCF(0) + FCF(1)/(1+r) + FCF(2)/(1+r)^2 + ... + FCF(T)/(1+r)^T

Decision rule: NPV > 0 → Accept | NPV < 0 → Reject | NPV = 0 → Break-even

Economic interpretation of NPV: A positive NPV means the project generates more cash than investors require
given its risk. The NPV figure is the immediate increase in firm (and shareholder) wealth from accepting the project
— it is the economic profit in today's money, above and beyond the opportunity cost of capital.

7.2 Blooper Industries — Full FCF Table (from slides)

Example — Blooper Industries

Mining project. CapEx = $10,000k at Year 0. 5-year life. Equipment sold for $2,000k in Year 6 (after 5-yr SL
depreciation → BV = 0 → after-tax SV = $2,000k × (1–0.35) = $1,300k).

Year 1 revenues = $15,000k, growing 5%/yr. Expenses = $10,000k growing 5%/yr. Depreciation = $2,000k/yr.
Tax rate = 35%.

($000s) Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6

CF from Operations — 3,950 4,113 4,283 4,462 4,651 —

∆ Working Capital (1,500) (2,575) (204) (214) (225) 1,678 3,039

Capital Investment (10,000) — — — — — —

Salvage Value (AT) — — — — — — 1,300

Project FCF (11,500) 1,375 3,909 4,069 4,237 6,329 4,339

NPV @ 12% = $4,222,350 → Accept the project.

Reading the table: Year 0 is dominated by the CapEx and initial NWC investment. Years 1–5 generate growing
operating cash flows partially offset by NWC investment as the business grows. Year 5–6 sees NWC recovery as
the project winds down, and Year 6 adds the after-tax salvage proceeds from equipment sale.

8 · Terminal (Continuation) Value

8.1 Definition and Purpose

The Terminal Value (or Continuation Value) represents the present value, measured at the end of the explicit
forecast horizon T, of all project free cash flows beyond year T.

In practice, we cannot forecast cash flows indefinitely year by year. After some horizon, we assume the project's
cash flows enter a steady state where they grow at a constant long-run rate g. The infinite tail of growing cash
flows is then compressed into a single number — the continuation value — using the growing perpetuity formula.

8.2 Formula
Continuation Value at Year T = FCF(T+1) / (r – g)

= FCF(T) × (1 + g) / (r – g)
 where: FCF(T+1) = first post-horizon cash flow = FCF(T) × (1+g)

r = cost of capital (discount rate)

g = long-run perpetual growth rate of FCF

r > g must hold for the formula to be valid

Present value of Continuation Value (at Year 0):

PV(CV) = CV / (1+r)^T

Intuition: This is the same growing perpetuity formula from Chapter 4, applied to FCF rather than dividends. The
continuation value is computed at Year T (the last explicit forecast year), using the Year T+1 cash flow — because
the perpetuity formula gives value one period before the first payment.

Under constant growth, the continuation value can also be expressed as a multiple of the final year's FCF:

CV at Year T = FCF(T) × (1+g) / (r–g) = FCF(T) × multiple

where multiple = (1+g)/(r–g) e.g. with g=5%, r=10%: multiple = 1.05/0.05 =

21

Watch out

The perpetuity formula gives value ONE period BEFORE the first cash flow. CV at Year T captures FCF starting
from Year T+1. So FCF(T+1) = FCF(T) × (1+g) — do not forget to apply the growth factor.

r must be strictly greater than g. If g ≥ r the formula gives a negative or infinite result, which is economically
meaningless.

Continuation value is NOT the same as salvage value. Salvage = proceeds from selling physical assets. CV =
value of future operating cash flows. A project can have both.

8.3 How to Use Continuation Value in an NPV Calculation

The standard approach has three steps:

• Step 1: Forecast FCF explicitly for years 1 through T.

• Step 2: Compute CV at Year T = FCF(T) × (1+g) / (r–g). Add this to FCF(T) to get the total cash flow in Year T.
• Step 3: Discount all cash flows (including the augmented Year T cash flow) back to Year 0 to get NPV.

Key concept

In practice, continuation value often accounts for the majority of a project's (or firm's) total NPV. This makes the
choice of g and r particularly important — small changes in g can dramatically affect the continuation value.

9 · Analysing the Project

Once a base-case NPV has been computed, the analyst should test the robustness of the investment decision
using three complementary tools.

9.1 Break-Even Analysis

Definition: The break-even level of an input is the value at which the NPV of the investment equals exactly zero —
the minimum performance required for the project to be worthwhile.

How to use it: For a key variable (e.g. sales volume, selling price, unit cost), find the threshold value X* such that
NPV(X*) = 0. Compare X* to the base-case forecast and to the range of plausible outcomes.

Interpretation: If the break-even sales volume is far below the expected sales volume, the project has a
comfortable margin of safety. If break-even is close to the expected value, the project is risky — small errors in
forecasting could flip the NPV from positive to negative.

Key concept

NPV break-even (where NPV = 0) is distinct from accounting break-even (where net income = 0). NPV
break-even is the more economically meaningful threshold because it incorporates the time value of money and
the required return on investment.

9.2 Sensitivity Analysis

Definition: Sensitivity analysis shows how the NPV changes when one assumption is changed, holding all other
assumptions constant at their base-case values.

Purpose: To identify which assumptions drive project value most. A variable to which NPV is highly sensitive
deserves more careful forecasting effort. A variable to which NPV is insensitive can be treated as less critical.

Typical presentation: A table or chart showing NPV as a function of one variable (e.g. price or market share), with
all others held constant. The steeper the slope of NPV vs. the variable, the more sensitive the project is to that
variable.

9.3 Scenario Analysis

Definition: Scenario analysis considers the effect on NPV of simultaneously changing multiple assumptions to
reflect a coherent, internally consistent scenario.

Purpose: Real-world outcomes are correlated — a recession reduces both prices and volumes simultaneously.
Sensitivity analysis, which changes one variable at a time, cannot capture this. Scenario analysis constructs
realistic joint outcomes (e.g. optimistic, base, pessimistic) and evaluates the NPV under each.

Tool Variables Changed What It Tests Limitation

Only a single threshold; no

Break-even analysis ONE (solve for threshold) Minimum viable performance probability

ONE at a time (others Ignores correlations between

Sensitivity analysis fixed) Which variables matter most variables

MULTIPLE Scenarios are somewhat

Scenario analysis simultaneously Realistic joint outcomes arbitrary

10 · Formula Summary

■■ Income Statement ■■

EBIT = Revenues – Costs – Depreciation

Taxes = EBIT × t

Unlevered Net Income = EBIT × (1 – t) = EBIT – Taxes

■■ Cash Flow from Operations ■■

CFO = EBIT + Depreciation – Taxes

= Unlevered Net Income + Depreciation

■■ Operating Working Capital ■■

OWC = AR + Inventory – AP

AR = Sales × Collection period / 365

Inv = COGS × Inventory days / 365 (or Sales if COGS not given)

AP = COGS × Payable period / 365 (or Sales if COGS not given)

■■ Capital Investment ■■

After-tax Salvage Value = SP – t × (SP – BV)

If BV = 0: = SP × (1 – t)

■■ Project Free Cash Flow ■■

FCF = (Revenues – Costs – Dep) × (1–t) + Dep – CapEx – ∆NWC

= CFO – CapEx – ∆NWC

■■ Terminal Value ■■

CV at Year T = FCF(T) × (1+g) / (r – g)

PV(CV) = CV / (1+r)^T

■■ NPV ■■

NPV = –I(0) + FCF(1)/(1+r) + ... + FCF(T)/(1+r)^T

Accept if NPV > 0 | Reject if NPV < 0

FI21 · Chapter 8 Theory Notes · Based on ESCP lecture slides and course notes