Capital Budgeting Using NPV in 10 Minutes
Real capital budgeting questions are NPV with extra steps. Before discounting, you build the project's cash flows: the upfront investment, yearly operating cash flow after tax, and any working capital tied up and later released. Once the cash flows are right, NPV tells you whether the project creates value.
What you will learn
- Which cash flows belong in a capital budgeting NPV
- How to calculate after-tax operating cash flow
- Why depreciation matters even though it is not cash
- How working capital enters at the start and comes back at the end
- How to turn the cash flow timeline into an NPV decision
The formulas
- T
- tax rate
- Depreciation
- non-cash expense that lowers taxable income
- Capex
- upfront equipment cost
- NWC
- net working capital invested, recovered in year n
- r
- discount rate
Worked example
A $50,000 machine is depreciated straight-line to zero over 5 years. It adds $20,000 a year of revenue minus cash costs. Tax is 25%, $5,000 of working capital is needed now and recovered in year 5, and the discount rate is 10%. Find the NPV.
- Depreciation: 50,000 ÷ 5 = 10,000 a year
- OCF: (20,000 − 10,000) × 0.75 + 10,000 = 17,500 a year
- Year 0 outflow: 50,000 + 5,000 = 55,000
- PV of OCF: 17,500 × 3.790787 ≈ 66,338.77; PV of NWC back: 5,000 ÷ 1.10⁵ = 3,104.61
- NPV = 66,338.77 + 3,104.61 − 55,000 = 14,443.38
Answer: NPV ≈ $14,443 (rounded to the dollar). It is positive, so the project should be accepted.
Common questions
What cash flows are included in capital budgeting?
Include the initial investment, after-tax operating cash flows, changes in working capital, and any after-tax salvage value at the end. Exclude sunk costs and financing costs like interest, because the discount rate already accounts for the cost of funding.
Why do we add back depreciation in capital budgeting?
Depreciation is not a cash payment, but it reduces taxable income and therefore reduces tax paid. So you subtract it to calculate tax, then add it back. The tax saving, depreciation × tax rate, is called the depreciation tax shield.
How does working capital affect NPV?
Money tied up in inventory and receivables is a cash outflow when the project starts and is usually recovered when the project ends. Because you get it back later, its present value is lower, so working capital reduces NPV.
What is the NPV rule in capital budgeting?
Accept a project if its NPV is positive, because it earns more than the required return. Reject it if NPV is negative. When choosing between competing projects, pick the one with the highest positive NPV.