6.1 Capital Budgeting & Relevant Cash Flows

The Capital Budgeting Process

Capital budgeting is the process of evaluating and selecting long-term investments — new equipment, plant expansion, product lines — whose cash flows extend over several years. Because these commitments are large and hard to reverse, the CMA exam tests a disciplined, cash-based approach rather than accrual net income.

The process has five stages: (1) identify potential projects, (2) estimate relevant cash flows, (3) apply a discounting method (NPV, IRR), (4) select projects within the capital budget, and (5) post-audit actual results against the forecast.

Relevant, Incremental, After-Tax Cash Flows

Only incremental cash flows — the additional cash flows that occur because the project is accepted — are relevant. Three rules govern what to include:

• Sunk costs are excluded. A cost already incurred (e.g., a market study paid last year) cannot change with the decision, so it is irrelevant.
• Opportunity costs are included. If a project uses land the firm already owns, the cash the land could otherwise earn (rent or sale value) is a real cost of the project.
• Financing costs are excluded from the cash flows themselves; the cost of capital enters through the discount rate, so subtracting interest would double-count it.

Also watch for side effects: positive ones such as a complementary product whose sales rise, and negative ones such as cannibalization (erosion) of an existing product's sales, which is an incremental cost. The relevant test is always cash flows with the project minus cash flows without it.

The Three Cash-Flow Categories

1. Initial Outlay (Time 0)

The upfront investment: equipment purchase price + installation and shipping + any initial increase in net working capital (extra inventory and receivables the project requires), less the after-tax proceeds from selling any old asset being replaced.

2. Operating Cash Flows (Years 1–n)

These are the annual after-tax cash flows from operations. Because depreciation is a non-cash expense that still lowers taxable income, it creates a depreciation tax shield:

Depreciation tax shield = Depreciation expense × Tax rate

The standard formula for annual after-tax operating cash flow:

OCF = (Revenue − Cash operating expenses) × (1 − Tax rate) + (Depreciation × Tax rate)

Equivalently: OCF = After-tax operating income + Depreciation. The two forms always agree.

3. Terminal Value (Final Year)

At the end of the project's life, add: after-tax salvage value of the equipment, plus recovery of the working capital invested at time 0 (inventory is sold and receivables collected). After-tax salvage = Salvage − (Salvage − Book value) × Tax rate.

Working-Capital Changes

Net working capital (NWC) is current assets minus current liabilities tied to the project. An increase in NWC is a cash outflow because cash is sunk into inventory and receivables; a decrease is an inflow. The model assumes the firm fully recovers NWC in the final year, so it appears as an outflow at time 0 and an equal inflow at the end. Growing projects often add NWC in several years.

Depreciation Method Matters

The amount and timing of the depreciation tax shield depend on the method. Straight-line spreads it evenly; accelerated methods such as MACRS (Modified Accelerated Cost Recovery System) front-load depreciation, pulling tax savings into earlier years where they have higher present value. Faster depreciation therefore raises a project's NPV, all else equal, even though total depreciation is identical.

Replacement Decisions

A frequent exam scenario replaces an old asset with a new one. Here you analyze incremental flows only. The initial outlay is the new machine's cost less the after-tax proceeds from selling the old machine. If the old asset is sold below book value, the loss generates a tax saving that reduces the net outlay; if sold above book value, the gain is taxed and raises it.

Operating cash flows are the change in revenue and costs (the new machine may cut labor or scrap), and the depreciation tax shield is based on the incremental depreciation — new-machine depreciation minus the depreciation the old machine would still have provided. Never analyze the new project in isolation; always compare "replace" against "keep."

Worked Cash-Flow Schedule

A firm buys a $100,000 machine (4-year life, straight-line, zero book salvage but $10,000 expected market salvage). It needs $15,000 of additional working capital at the start. The machine generates $60,000 revenue and $25,000 cash operating costs per year. Tax rate is 25%.

• Annual depreciation = $100,000 / 4 = $25,000.
• Depreciation tax shield = $25,000 × 25% = $6,250 per year.
• Annual OCF = ($60,000 − $25,000) × (1 − 0.25) + $6,250 = $35,000 × 0.75 + $6,250 = $26,250 + $6,250 = $32,500.

Cash-Flow Timeline

After-tax salvage = $10,000 − ($10,000 − $0) × 25% = $7,500 (the full gain is taxed because book value is zero). The final-year total cash flow is $32,500 + $15,000 + $7,500 = $55,000. Note that sunk costs (e.g., a prior feasibility study) never appear, and any opportunity cost of displaced capacity would be added as an outflow.