Diploma – Business Finance

Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

CHAPTER 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Learning objectives:

Aarsheeya should be able to: -

1. Identify and classify cash flows that are relevant for investment appraisal.
2. Distinguish between relevant and irrelevant costs in the context of capital budgeting.
3. Analyse the treatment of various components such as sunk costs, opportunity costs, working capital,
and tax implications.
4. Apply appropriate adjustments to cash flows for accurate project evaluation.
5. Enhance decision-making skills in selecting profitable investment projects using relevant financial
information.

Section A: Theory and Concepts

1. Introduction
In Session 7, we learned about the Time Value of Money, which helps us make better investment
decisions. In this session, we will learn how to find the important cash flows (money going in and
out) from investment plans. This is important because it helps us get ready for the final step in capital
budgeting—deciding if we should accept or reject an investment based on these cash flows.

2. Capital Budgeting
Capital Budgeting (also called Capital Expenditure) means the money a company spends on buying
long-term assets, like machines or buildings, to help it earn more in the future. The company decides
to invest in these assets only if it believes they will give it an advantage over competitors and help
increase its profits or value.

3. Reasons for Capital Budgeting

(a) Expansion
What it means: A company buys new assets to grow its business and make more products or
services.
Example: McDonald's opens new outlets and buys kitchen equipment to serve more customers.

(b) Replacement
What it means: A company replaces old machines or tools that are worn out or outdated.
Example: A printing company replaces its old printers with faster, more modern machines to stay
competitive.

(c) Renewal
What it means: Instead of buying new machines, the company upgrades or repairs old ones to make
them work like new.
Example: A public bus company overhauls old buses by changing engines and updating seats and
software, so they run better without buying new buses.

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

4. Capital Budgeting Process

When a company spends money on big things like buildings or machines, it often takes a long time to
get that money back. These investments are expensive, and the benefits (like profits) usually come in
slowly over many years. So, it's very important to carefully plan and check everything before
spending the money. Here's how the capital budgeting process works:

1. Identify Cash Flows

Look at all the money involved:

o Initial investment (how much we spend at the start)

o Operating cash flows (money we earn each year from using the asset)
o Terminal cash flows (money we get at the end, like from selling the asset)
2. Evaluate the Investment
Use the cash flows to see if the investment is a good idea.

3. Make a Decision
Use methods like:

o Payback period (how long it takes to get the money back)

o Net Present Value (NPV) (whether we earn more than we spent)
o Internal Rate of Return (IRR) (the rate of return the project gives)
Based on these, decide if the investment should be accepted or rejected.

Example:
Imagine a delivery company wants to buy electric vans.

 They first look at the cost of buying the vans (initial investment).
 Then they estimate how much they’ll save on fuel and earn from faster deliveries each year
(operating cash flow).
 After a few years, they plan to sell the old vans (terminal cash flow).
Using capital budgeting tools, they check if this investment is worth it. If yes, they go ahead
and buy the vans.
5. Relevant Cash Flows
When deciding whether to invest in something, a company should only look at the relevant cash
flows — the money that comes in or goes out because of the investment.
These include:
 Opportunity costs (what the company gives up by choosing this investment),
 Working capital costs (money tied up in operations),
 Infrastructure and training costs (if needed to support the project).
Do not include any costs that:
 Happened in the past (like old expenses),

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

 Will happen no matter what (even if the company doesn’t invest).

3 Main Types of Cash Flows in Capital Budgeting

As shown in the diagram:
1. Initial Investment (II)
This is the money spent at the beginning (at time 0) to start the project, like buying
equipment or setting up a facility.
2. Operating Cash Flows (OCF₁, OCF₂, OCF₃, ..., OCFₙ)
These are the yearly earnings (profits or savings) the company gets from using the
investment, starting from year 1 to year n.
3. Terminal Cash Flow (TCF)
This is the final cash flow at the end of the project (year n), like money from selling old
equipment or recovering working capital.
5.1 Initial Investment (II)

The Initial Investment (II) is the money spent at the beginning of a project. It includes:

Cost of the Asset (like buying a machine or building)

➕
Change in Net Working Capital (NWC)

Formula:

When a business expands, it often needs more inventory (stock) and may give more credit to
customers (increasing accounts receivable). This increases Net Working Capital — which means
more cash is needed upfront.

So, the total Initial Investment is the cost of the asset plus the extra money needed to support the
increased day-to-day operations.

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Example:
A bakery buys a new oven for $50,000. It also needs $5,000 more in ingredients and supplies (NWC).
Initial Investment = $50,000 + $5,000 = $55,000

5.2 Operating Cash Flows (OCF)

Operating Cash Flows are the yearly cash profits a company earns from a project after paying costs
and taxes.

Formula:

This formula has two parts:

1. Cash profit after tax

This is the actual profit the company earns each year, after paying for costs and taxes.
(Revenue – Cost) × (1 – Tax Rate)

2. Depreciation Tax Shield

Even though depreciation is not a real cash expense, it helps the company pay less tax.
That tax savings is added back into the cash flow.
Calculated as: Depreciation × Tax Rate
Why Depreciation Helps Cash Flow:
 When a company buys an asset, it spreads the cost over several years through depreciation.
 Depreciation reduces taxable income, so the company pays less tax.
 This tax saving is a real cash benefit, called a tax shield.
Example:

 Revenue: $100,000
 Cost: $60,000
 Depreciation: $10,000
 Tax Rate: 20%
Step 1:
(100,000 – 60,000) × (1 – 0.20) = 40,000 × 0.80 = $32,000

Step 2:
10,000 × 0.20 = $2,000

Total OCF = $32,000 + $2,000 = $34,000

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

5.3 Terminal Cash Flows (TCF)

Terminal Cash Flow is the cash the company receives at the end of the project. It includes:

Formula:

Breakdown of the Two Parts:

1. After-tax Proceeds from Sale of Asset

When the project ends, the company sells the asset (like a machine or building).
If it sells for more than the remaining value (book value), the company made a gain and has
to pay tax on it.
If it sells for less than book value, it's a loss, and the company pays less tax.

2. Change in Net Working Capital (NWC)

At the start of the project, the company may have used cash to increase inventory or
accounts receivable.
At the end, those items are sold or collected, so the company gets that money back.
This recovered amount is added to the TCF.

Example:

 Asset sold for: $20,000

 Book value: $15,000

 Tax rate: 20%

 Change in NWC (from earlier): $5,000

Step 1:
Gain = 20,000 – 15,000 = $5,000
Tax on gain = 5,000 × 20% = $1,000
After-tax sale proceeds = 20,000 – 1,000 = $19,000

Step 2:
Add back NWC = $5,000

Total TCF = 19,000 + 5,000 = $24,000

Illustration:

SIM Corporation has to evaluate whether it should invest in a machine that costs $1,000,000. The
machine would be fully depreciated over 4 years to zero value using the straight-line depreciation
method. The company believes that it can sell the machine for $40,000 at the end of 4 years.

With the new machine, the company projects that it will be able to generate an additional $250,000
annually in sales revenue, while its costs are an additional $150,000 annually. The company would

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

also need an additional net working capital of $40,000 to fund accounts receivable, account payable
and inventories. The company’s cost of capital is 8%. The tax rate for the company is 14%.

(a) What is the initial investment (II) of this machine?

(b) What is the annual operating cash flow (OCF) of this machine?

(c) What is the terminal cash flow (TCF) of this machine?

Solution-

(a) Initial Investment (II)

 Cost of new machine: $1,000,000

 Additional net working capital needed: $40,000

Calculation:

(b) Annual Operating Cash Flow (OCF)

 Additional annual revenue: $250,000

 Additional annual cost: $150,000

 Tax rate: 14%

 Depreciation: Straight line over 4 years on $1,000,000 → $250,000 per year

 Depreciation tax shield: depreciation × tax rate = $250,000 × 0.14 = $35,000

Calculation:

OCF = (Revenue – Cost) x (1 – Tax Rate) + (Depreciation) x (Tax Rate)

(c) Terminal Cash Flow (TCF)

 Sale price at end of 4 years: $40,000

 Tax on sale proceeds: 14%

 Recovery of net working capital: $40,000

Calculation:

TCF = After-Tax Proceeds from Sale of Asset + Change in Working Capital

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Section B: Questions and Answers

Multiple Choice Questions

1. The typical capital budgeting decision involves a large up-front investment followed by a
series of small cash inflows.
(A) large; negative cash flows
(B) large; small cash inflows
(C) small; larger cash inflows
(D) small; irregular cash inflows
2. Which of the following is NOT a major cash flow component in capital budgeting?
(A) Operating cash inflows
(B) Taxes
(C) Terminal cash flow
(D) Initial investment
3. When identifying cash flows in capital budgeting, depreciation is considered in the
computation of annual operating cash flow because the depreciation amount is a
tax-deductible expense.
(A) reduces the initial investment of the asset
(B) is a tax-deductible expense
(C) increases the terminal cash flow
(D) affects the change in net working capital
4. In capital budgeting, a financial manager has to balance the risks and returns of an
investment such as machinery and equipment.
(A) accounts receivable
(B) inventory
(C) machinery and equipment
(D) marketable securities
5. Pete’s Pizza is considering the purchase of an additional oven for its kitchen to meet the
increasing number of customers. How would you classify the motive for this expenditure?
(A) Expansion
(B) Replacement
(C) Renewal
(D) Operating expenses

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Section C: Activities

Practice Questions

1. To buy or not to buy?

• Cost of new equipment = $99,000
• Straight-line depreciation to zero value in 3 years.
• We can sell the equipment at $10,000 at the end of 3 years.
• We need to invest an additional $5,000 in NET WORKING CAPITAL (NWC).
• TAX RATE is 20%
• REVENUE = $20,000 per year (for Years 1,2,3)
• COSTS = $15,000 per year (for Years 1,2,3)
• Depreciation per year =?

Calculate:

(a) INITIAL INVESMENT

(b) OPERATING CASH FLOWS (OCF)

(c) TERMINAL CASH FLOW

Solution-

Given:

 Cost of equipment = $99,000

 Depreciation (Straight-line over 3 years to $0)

 Salvage value at end of year 3 = $10,000

 Additional Net Working Capital (NWC) = $5,000

 Tax rate = 20%

 Annual Revenue = $20,000

 Annual Costs = $15,000

 Life of project = 3 years

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Final Answers:

 (a) Initial Investment = $104,000

 (b) OCF = $10,600

 (c) Terminal Cash Flow = $13,000

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

2. R&Z is evaluating an investment in equipment. The cost of the new equipment is $200,000, and
the company will use the straight-line depreciation method to depreciate the asset to zero value in 5
years. R&Z will be able to sell the equipment at $50,000 at the end of 5 years and will need to invest
an additional $30,000 in net working capital (NWC). Given the company’s tax rate is 20%, additional
revenue of $100,000 per year and additional cost of $80,000 per year, calculate the following for the
investment:

(a) Initial Investment (II)

(b) Operating Cash Flows (OCF)

(c) Terminal Cash Flow (TCF)

Diagram the three components of the relevant cash flows for this capital budgeting project

Solution-

Given:

 Cost of equipment = $200,000

 Straight-line depreciation over 5 years → Depreciation = ?

 Salvage value (end of year 5) = $50,000

 Additional Net Working Capital (NWC) = $30,000

 Tax rate = 20%

 Additional Revenue = $100,000/year

 Additional Costs = $80,000/year

 Project life = 5 years

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Practice Again before Exams

MCQs

1. Which of the following best describes "relevant cash flows" in capital budgeting?
(A) Cash flows incurred before the investment decision is made
(B) Cash flows that arise only because of the investment decision
(C) All historical cash flows of the company
(D) Cash flows related to financing activities

2. When calculating the initial investment for a new project, which of the following should be
included?
(A) Cost of asset only
(B) Change in net working capital only
(C) Cost of asset and change in net working capital
(D) Only incremental revenues

3. Depreciation is added back in the calculation of Operating Cash Flow because:

(A) It is a non-cash expense that provides a tax shield
(B) It represents actual cash outflow
(C) It increases the market value of the asset
(D) It is included in terminal cash flows

4. What does the terminal cash flow include at the end of a project?
(A) Sale proceeds of the asset only
(B) Recovery of net working capital only
(C) After-tax sale proceeds of the asset plus recovery of net working capital
(D) Operating cash flows of the last year only

5. Which motive for capital budgeting involves fixing or overhauling existing assets to extend
their useful life?
(A) Expansion
(B) Replacement
(C) Renewal
(D) Growth

6. Opportunity cost is considered in capital budgeting because:

(A) It is a sunk cost
(B) It represents the benefit foregone by using a resource for the project
(C) It is always recorded as depreciation
(D) It increases the book value of the asset

Short Subjective Questions

1. Define "relevant cash flows" in the context of capital budgeting and explain why only relevant
cash flows should be considered in investment decisions.

2. Describe the three major components of cash flows involved in a capital budgeting project.
Provide examples for each component.

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

3. Explain the difference between the motives of expansion, replacement, and renewal in capital
budgeting decisions with appropriate examples.

4. Discuss how depreciation affects operating cash flows and why it is important to consider it
when calculating relevant cash flows.

5. Explain the importance of net working capital changes in the initial investment and terminal
cash flow calculations.

Practical Questions

1. A company is considering purchasing a machine costing $120,000. The machine will increase
net working capital by $15,000. Calculate the initial investment for the project.

2. Given the following data for a project:

o Revenue: $150,000 per year

o Operating costs: $90,000 per year

o Depreciation: $20,000 per year

o Tax rate: 30%

Calculate the annual operating cash flow.

3. At the end of a project, the asset is sold for $40,000. The book value of the asset is $30,000,
and the company’s tax rate is 25%. The net working capital of $10,000 is recovered. Calculate
the terminal cash flow.

4. A project requires an initial investment of $250,000 including $40,000 in net working capital.
Explain how the net working capital affects the initial investment and the cash flows at the end
of the project.

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

QP – 2024 November
Question 1 –
(c) HIC Manufacturing Ltd is exploring investing in a machine that costs $100,000. With the machine,
the firm projects that it will be able to generate an additional $200,000 in sales revenue per year
while incurring additional costs of $50,000 per year. The machine would be fully depreciated over
five years using the straight-line depreciation method. HIC Ltd would also need an additional net
working capital of $50,000. The firm’s cost of capital is 10%, and the tax rate is 20%.
(i) Calculate the “initial investment” of the machine. (2 marks)
(ii) Calculate the “annual operating cash flow” of the machine. (2 marks)
(iii) Assume that HIC Ltd believes that it can sell the machine for $10,000 at the end of
five years. Calculate the “terminal cash flow” of the machine. (3 marks)
[7 Marks, Page Number – 2]
Solution –
(i) Initial Investment (2 marks)

Initial investment includes:

 Cost of the machine: $100,000

 Increase in Net Working Capital (NWC): $50,000

(ii) Annual Operating Cash Flow (2 marks)

We use the formula:

Revenues = $200,000
Costs = $50,000
Depreciation = $100,000 / 5 = $20,000
EBIT = $200,000 - $50,000 - $20,000 = $130,000
Taxes = 20% × $130,000 = $26,000

Now calculate OCF:

(iii) Terminal Cash Flow (3 marks)

At the end of year 5:

 Salvage value of machine = $10,000

 Tax on salvage = (Salvage - Book Value) × Tax rate

Since machine is fully depreciated, Book Value = $0

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

 Recovery of NWC = $50,000

QP – 2024 November
Question 2 –
(a) Discuss the THREE (3) common motives for capital expenditure
[6 Marks, Page Number – 3]
Solution –
1. Expansion of Operations

Purpose:
To increase the company’s productive capacity by acquiring new assets, such as machinery,
equipment, or buildings.

Explanation:
Businesses invest in capital assets to expand into new markets, meet rising demand, or increase
output. For example, a manufacturing company might purchase a new production line to increase its
capacity.

Benefit:
This can lead to higher revenue and market share in the long term.

2. Replacement of Worn-Out or Obsolete Assets

Purpose:
To maintain operational efficiency and reduce downtime or maintenance costs.

Explanation:
Over time, machinery and equipment become outdated or inefficient. Replacing them with modern
alternatives helps improve productivity, reduce energy consumption, and lower repair costs.

Benefit:
Ensures smooth operations and often leads to cost savings in the long run.

3. Compliance and Safety Requirements

Purpose:
To meet regulatory, legal, or safety standards imposed by government or industry bodies.

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Explanation:
Companies may need to invest in equipment upgrades or new systems to comply with environmental
laws, health and safety standards, or other regulatory requirements.

Benefit:
Avoids legal penalties, enhances reputation, and ensures employee and environmental safety.

QP – 2025 March
Question 1 –
(b) Deluxe Bakery Ltd is considering an investment in a new oven machine that costs $250,000
because the existing machine was damaged and is beyond repair. The new machine is to be fully
depreciated to zero value over five years using the straight-line depreciation method.
With the new machine, the bakery is projected to generate an additional $280,000 annually in
sales revenue and an additional annual cost of $120,000. Deluxe Bakery also needs an additional
net working capital of $40,000 to fund its accounts receivable, accounts payable and inventories.
The bakery’s cost of capital is 6%, and the tax rate is 20%.
(i) What is the key motive for Deluxe Bakery’s capital expenditure? Explain your
answer. (2 marks)
(ii) Calculate the Initial Investment (II) of this investment. (3 marks)
(iii) Calculate the annual Operating Cash Flow (OCF) over the next five years. (3
marks)
(iv) If Deluxe Bakery can sell the machine for $20,000 at the end of the fifth year,
calculate the Terminal Cash Flow (TCF). (3 marks)

[11 Marks, Page Number – 2]

Solution –
(i) What is the key motive for Deluxe Bakery’s capital expenditure? (2 marks)

Key Motive:
Replacement of damaged or obsolete assets.

Explanation:
Deluxe Bakery is making the capital expenditure because the existing oven machine was damaged
and is beyond repair. This indicates that the motive is not expansion or compliance, but
replacement of an essential asset to maintain operational continuity.

(ii) Calculate the Initial Investment (II) (3 marks)

Initial Investment includes:

 Cost of the new machine = $250,000

 Additional Net Working Capital (NWC) = $40,000

(iii) Calculate the annual Operating Cash Flow (OCF) (3 marks)

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

Diploma – Business Finance
Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS

We use the formula:

Given:

 Additional revenue = $280,000

 Additional costs = $120,000

 Depreciation = $250,000 / 5 = $50,000

 EBIT = 280,000 - 120,000 - 50,000 = $110,000

 Tax = 20% × 110,000 = $22,000

Now calculate OCF:

(iv) Calculate the Terminal Cash Flow (TCF) (3 marks)

At end of Year 5:

 Salvage value = $20,000

 Book value = $0 (fully depreciated)

 Tax on salvage = 20% × $20,000 = $4,000

 After-tax salvage value = $20,000 − $4,000 = $16,000

 Recovery of NWC = $40,000

BF: Chapter 8: INVESTMENT DECISION: CAPITAL BUDGETING – RELEVANT CASH FLOWS