Capital Budgeting
Long-lived projects require cash before their benefits are known. An appraisal therefore needs to account for when cash moves, the risks involved, whether the decision can be reversed, and what happens at the end of the project.
Build cash flow, not accounting profit
Include:
- equipment, installation and initial working capital;
- incremental after-tax operating cash flows;
- cannibalisation and opportunity costs;
- later capital expenditure;
- terminal disposal cash flow, tax and working-capital recovery.
Exclude:
- sunk feasibility studies;
- financing interest when the discount rate already reflects financing;
- allocated costs that do not change.
Depreciation is non-cash, but it can affect tax cash flows. Northstar’s example supplies after-tax cash flows, so no separate tax shield is added.
Put every cash flow on a timeline
Time 0 means now, before operations begin. Time 1 means the end of year 1 in this example, not its beginning. At 10%, £100 now and £110 in one year's time have the same modelled value: discounting reverses that growth. A year-t receipt has present value CFt / (1 + r)^t; later receipts have smaller present values for the same positive discount rate.
Match the discount rate to the cash-flow period; an annual rate cannot simply be applied once to each monthly receipt. Also state whether the cash flows include inflation and tax, and choose a rate on the same basis. More decimal places will not compensate for inconsistent assumptions.
Northstar automation case
- equipment and installation now: £240,000;
- working capital now: £20,000;
- after-tax operating cash inflow: £75,000 at each year-end for four years;
- year-4 after-tax salvage proceeds: £20,000;
- year-4 working-capital recovery: £20,000;
- discount rate: 10%.
| Time | Cash flow | Present value at 10% | Explanation |
|---|---|---|---|
| 0 | −£260,000 | −£260,000.00 | Equipment plus working capital |
| 1 | +£75,000 | £68,181.82 | Operating |
| 2 | +£75,000 | £61,983.47 | Operating |
| 3 | +£75,000 | £56,348.61 | Operating |
| 4 | +£115,000 | £78,546.55 | Operating + salvage + working-capital recovery |
At the 10% discount rate, the base case supports the project by a narrow margin. Its approximate IRR is 10.84%, so even small forecast errors could reverse the decision.
The £20,000 working-capital outflow is cash tied up for operations; its assumed release at the end is not revenue. Year 4 already includes that recovery and the after-tax disposal proceeds. Do not add them a second time. A positive NPV means value above the required return under the model's assumptions, not guaranteed accounting profit or sufficient funding today.
Reproduce and stress-test
Northstar NPV, IRR and rate sensitivity
Try reducing annual operating inflow by 5% or delaying the year 1 receipt. Use the results to identify which assumption leaves the least room for error, and explain that vulnerability in your recommendation.
Keep the terminal £40,000 unchanged when testing a 5% cut in operating inflows: use £71,250 in years 1–3 and £111,250 in year 4. NPV becomes approximately −£6,827, reversing the base-case result. A delay must move the affected receipt to its later date; merely reducing its amount answers a different question.
The IRR cell is deliberately limited to an initial outflow followed by non-negative receipts, with a root inside the stated search interval. It rejects unsupported cash-flow patterns or an interval that does not contain a root. For alternating inflows and outflows, inspect the NPV profile rather than treating this simple solver as a general IRR calculator.
NPV, IRR and payback answer different questions
| Method | Useful for | Main limitation |
|---|---|---|
| NPV | Absolute value created at the chosen discount rate | Depends on cash-flow and rate estimates |
| IRR | Percentage-return communication | Can mis-rank mutually exclusive projects or produce multiple/no meaningful roots |
| Payback | Liquidity and exposure duration | Ignores later cash; simple version ignores time value |
| Discounted payback | Time-adjusted recovery | Still ignores cash after recovery |
When NPV and IRR conflict for mutually exclusive projects, NPV is normally the stronger value-creation rule if the discount rate and cash flows are well specified.
Payback depends on when receipts arrive
Northstar has recovered £225,000 after year 3, leaving £35,000 unrecovered. Under the stated year-end receipts, recovery occurs at the end of year 4; discounted recovery also occurs then. Do not report a fractional year while retaining the assumption that no cash arrives within that year.
If the £75,000 operating receipts instead arrived evenly through year 4, simple payback could be approximated as 3 + £35,000 / £75,000 = 3.47 years. The terminal £40,000 still arrives at year-end and must not be spread through the year. This alternative timing assumption would also require revisiting the discounting model. Practise these distinctions with the two-project decision workshop.
Risk is more than changing the rate
Separate:
- sensitivity: one input changes;
- scenario: coherent combinations such as weak demand plus high material cost;
- simulation: distributions and dependencies across many outcomes;
- real options: delay, expand, abandon or stage the project.
Do not hide operational uncertainty by adding an arbitrary percentage to the discount rate.
Post-investment review
After approval, preserve the original forecast and compare:
- implementation spend and date;
- realised volume, price, savings and working capital;
- reasons for deviations;
- benefits still achievable;
- whether to continue, redesign or stop.
Use the review to learn from deviations and decide what to change. Keep the original business case intact so that the comparison remains meaningful.
Quick check
Why is recovering £20,000 working capital in year 4 a cash inflow even though it is not revenue?