Capital Budgeting
Capital Budgeting
Long-lived projects commit cash before their benefits are known. The model must therefore capture timing, risk, reversibility and terminal effects.
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.
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 salvage value: £20,000;
- year-4 working-capital recovery: £20,000;
- discount rate: 10%.
| Time | Cash flow | Explanation |
|---|---|---|
| 0 | −£260,000 | Equipment plus working capital |
| 1 | +£75,000 | Operating |
| 2 | +£75,000 | Operating |
| 3 | +£75,000 | Operating |
| 4 | +£115,000 | Operating + salvage + working-capital recovery |
The project narrowly passes the 10% base case. Its approximate IRR is 10.84%; small forecast errors can reverse the decision.
Reproduce and stress-test
Northstar NPV, IRR and rate sensitivity
Try reducing annual operating inflow by 5% or delaying year 1. A base-case recommendation should state which assumption has the lowest margin for error.
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.
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.
The purpose is learning and corrective action, not rewriting the business case to appear correct.
Quick check
Why is recovering £20,000 working capital in year 4 a cash inflow even though it is not revenue?