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.
Capital budgeting with NPV, explained simply
To decide on a project, build its yearly after-tax cash flows (operating cash flow, equipment and working capital), discount them at the required return and add them up. In the example, a $50,000 machine with $5,000 of working capital and 25% tax has an NPV of about $14,443 at 10%, so accept.
What this capital budgeting lesson covers
- 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
Capital budgeting formulas, explained
- 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
How to do a capital budgeting NPV step by step (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.
What goes into each year's cash flow
| Year 0 | Years 1–4 | Year 5 | |
|---|---|---|---|
| Equipment | −$50,000 | — | — |
| Working capital | −$5,000 | — | +$5,000 back |
| Operating cash flow | — | +$17,500 | +$17,500 |
| Total | −$55,000 | +$17,500 | +$22,500 |
Should you forecast five years before you start? David's take
This machine shows a positive NPV of $14,443, so the rule says accept. For a $50,000 machine, a careful forecast makes sense, because once it's bought it's hard to undo. For a lot of digital work today, building a small version is cheaper and faster than the analysis that used to come first. School rewards the 'should' document because it's easy to grade. Real results come from implementing and iterating. Plan when undoing is expensive; build when it's cheap.
From David's concept: Should-and-Shall vs Implement-and-Iterate. This is David's opinion, alongside the standard textbook answer above.
Harder capital budgeting questions
How is the $17,500 operating cash flow calculated?
Depreciation is 50,000 ÷ 5 = $10,000. OCF = (20,000 − 10,000) × (1 − 0.25) + 10,000 = $17,500. Depreciation isn't cash, but it lowers taxes, so it's added back.
What is the NPV at 15%, and what is the IRR?
At 15%, NPV is about $6,149, still positive. The IRR is about 19.5%, so the project stays worth doing up to roughly that required return.
Common capital budgeting 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.