CAPITAL BUDGETING · FORMULA AND EXCEL
1. What is capital budgeting?
Capital budgeting is the process of identifying, forecasting, evaluating, selecting and reviewing investments whose consequences extend over several periods. It asks whether committing resources now is expected to create value after allowing for timing, risk and the opportunity cost of capital.
CapEx versus OpEx
CapEx normally acquires or improves a long-lived asset. OpEx supports current operations. Accounting classification follows the applicable rules; economic appraisal includes every incremental cash consequence, including expenses, tax, working capital and closure costs. A strategic software initiative can require appraisal even if much of its expenditure is expensed.
Why estimation deserves priority
Capital commitments can be large, long-lived and costly to reverse. Their benefits are difficult to measure and uncertain. Chandra’s overview reinforces why demand evidence, technical feasibility and incremental cash-flow estimates must come before selecting a financial metric.
Strategic alignment
Check the business need, customers, capacity, technology, implementation and compliance before relying on a spreadsheet. For a mandatory safety project, compare feasible ways to meet the requirement and their life-cycle costs.
CAPITAL BUDGETING · FORMULA AND EXCEL
2. Applications and practical use cases
| Decision | Business example | Main cash-flow question |
|---|---|---|
| Expansion | Add a manufacturing line | Will incremental demand justify new capacity? |
| Replacement | Replace an ageing machine | What changes relative to keeping the old machine? |
| Cost reduction | Warehouse automation | Do savings cover purchase, training and maintenance? |
| New market | Open a retail outlet | How much sales growth is genuinely incremental? |
| Technology | Install an ERP platform | What savings, implementation risks and recurring costs arise? |
| Sustainability / compliance | Solar generation or effluent treatment | What are the achievable benefits and required obligations? |
The appraisal cycle
Define alternatives; forecast cash flows; choose a risk-consistent required return; evaluate and stress the proposals; approve and implement; then compare actual results with the forecast. A post-investment review improves the next decision.
CAPITAL BUDGETING · FORMULA AND EXCEL
3. The incremental cash-flow principle
| Item | Treatment | Reason |
|---|---|---|
| Sunk feasibility cost | Exclude a payment already irreversibly incurred | Today’s decision cannot change it |
| Opportunity cost | Include foregone net rent or after-tax sale proceeds | The project consumes a valuable alternative |
| Allocated overhead | Include only the amount that changes | Allocation alone is not an incremental payment |
| Cannibalisation | Include lost contribution and related cash effects | The project can reduce existing business |
| Synergy | Include additional cash benefits elsewhere | The project can support existing business |
| Tax | Include incremental cash tax when payable | Tax changes the cash available to investors |
Illustration: land and research
Research costing ₹3 lakh was paid last year. Owned land could be sold now for ₹25 lakh after tax. Using the land has a ₹25 lakh opportunity cost; exclude the already-paid ₹3 lakh. If its eventual sale differs between the two alternatives, model that later difference too.
Reproduce it in Excel
Use a separate worksheet for this illustration.
| Cell / range | Enter / formula | Meaning |
|---|---|---|
| B2 | 3 | Already-paid study cost; excluded |
| B3 | 25 | After-tax land sale proceeds foregone |
| B4 | =B3 | Incremental opportunity cost today |
Measure cannibalisation against a realistic without-project case. Sales that competitors would capture anyway may not be fully attributable to the new product.
CAPITAL BUDGETING · FORMULA AND EXCEL
4. One project case: set up the assumptions
All case amounts are ₹ lakh unless a per-unit ₹ price is stated. Inputs are original teaching assumptions, not a company forecast. Cash flows occur at year-end unless otherwise stated.
| Input | Assumption |
|---|---|
| Equipment plus installation | 100 |
| Initial operating net working capital | 20 |
| Life | 5 years |
| Annual sales volume | 20,000 units |
| Price / variable cost per unit | ₹1,000 / ₹600 |
| Annual fixed cash operating costs | 40 |
| Annual tax depreciation | 20 (straight-line to zero) |
| Tax rate / required return | 25% / 12% |
| Gross disposal proceeds in year 5 | 8 |
| Terminal recovery of working capital | 20 |
Reproduce it in Excel
Use a sheet named Core. All monetary cells are ₹ lakh except B6:B7 (₹ per unit).
| Cell / range | Enter / formula | Meaning |
|---|---|---|
| B2 | 100 | Installed asset cost |
| B3 | 20 | Initial NWC |
| B4 | 5 | Project years |
| B5 | 20000 | Annual units |
| B6 | 1000 | ₹ price per unit |
| B7 | 600 | ₹ variable cost per unit |
| B8 | 40 | Fixed cash costs in ₹ lakh |
| B9 | 0.25 | Tax rate; format as % |
| B10 | 0.12 | Required return; format as % |
| B11 | 8 | Gross terminal disposal value |
| B12 | =B2/B4 | Annual tax depreciation |
CAPITAL BUDGETING · FORMULA AND EXCEL
5. Initial outlay: CF₀
In our case: CF₀ = −100 − 20 = −₹120 lakh. No old asset is sold and no other start-up costs are assumed.
Reproduce it in Excel
Continue on Core. Installed asset cost is B2 and NWC is B3.
| Cell / range | Enter / formula | Meaning |
|---|---|---|
| B14 | =-B2-B3 | Time-zero cash flow |
Replacement project extension
Subtract the cash flows of keeping the old asset from those of replacing it. Include after-tax proceeds from selling the old asset now, incremental operating savings, changes in tax depreciation and differences in terminal proceeds.
CAPITAL BUDGETING · FORMULA AND EXCEL
6. Operating cash flow and the depreciation tax shield
OCF = (sales − cash operating costs) × (1 − T) + D × T
Sales = 20,000 × ₹1,000 / 100,000 = ₹200 lakh. Variable costs = ₹120 lakh; fixed cash costs = ₹40 lakh. EBITDA = 40; depreciation = 20; EBIT = 20; tax = 5; PAT = 15.
OCF = 20 × 75% + 20 = ₹35 lakh. Equivalently, 40 × 75% + 20 × 25% = 35. The depreciation tax shield is ₹5 lakh.
Reproduce it in Excel
Continue on Core. Assume depreciation is tax-allowable and tax benefits can be used immediately.
| Cell / range | Enter / formula | Meaning |
|---|---|---|
| B15 | =B5*B6/100000 | Sales in ₹ lakh |
| B16 | =B5*B7/100000 | Variable costs in ₹ lakh |
| B17 | =B15-B16-B8 | EBITDA |
| B18 | =B17-B12 | EBIT |
| B19 | =B18*B9 | Cash tax under the stated assumption |
| B20 | =B18-B19 | PAT before financing |
| B21 | =B20+B12 | OCF = 35 |
| B22 | =B17*(1-B9)+B12*B9 | Independent formula route = 35 |
Depreciation is non-cash, but tax depreciation can change cash taxes. Actual tax rules, loss relief and tax-payment lags can alter the timing. Negative EBIT does not automatically create an immediate cash refund.
CAPITAL BUDGETING · FORMULA AND EXCEL
7. Terminal cash flow and working capital
TCF = after-tax salvage + NWC recovered − after-tax closure costs
Assume the entire disposal gain is taxed at 25%, tax book value is zero and no closure costs arise. After-tax salvage = 8 − 25% × 8 = ₹6 lakh. Recover NWC of ₹20 lakh: TCF = ₹26 lakh. Year 5 total cash flow = 35 + 26 = ₹61 lakh.
Reproduce it in Excel
Continue on Core. Disposal-tax treatment is a simplified assumption, not an Indian statutory tax calculation.
| Cell / range | Enter / formula | Meaning |
|---|---|---|
| B24 | 0 | Tax book value at end |
| B25 | =B11-(B11-B24)*B9 | After-tax salvage = 6 |
| B26 | =B25+B3 | Terminal flow = 26 |
| B27 | =B21+B26 | Final-year total flow = 61 |
NWC changes rather than balances
Operating NWC = operating receivables + inventory − operating payables. An increase consumes cash; a decrease releases cash. If the required balance rises from ₹20 lakh to ₹24 lakh next year, the additional outflow is ₹4 lakh. Recover only balances that are realistically collectible or realisable.
CAPITAL BUDGETING · FORMULA AND EXCEL
8. Build the project timeline and keep financing consistent
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| Cash flow | -120 | 35 | 35 | 35 | 35 | 61 |
These are unlevered project cash flows before debt interest or principal payments. Discount them at a suitable WACC only when the project risk and financing assumptions justify that rate. Subtracting interest here and also using an after-tax WACC can count financing effects twice. Topic 7 explains APV and equity-cash-flow alternatives.
Why do we add depreciation back after PAT?
Depreciation reduced accounting profit but did not consume cash in that period. Its tax effect remains in OCF.
Is a positive accounting profit sufficient?
No. The project must recover investment and meet the required return after accounting for timing and risk.
Sources and further reading
Selected relevant sections of the supplied materials informed this series. Prasanna Chandra’s planning framework also informs the emphasis on estimation and strategic fit. These are original explanations and teaching cases, not reproduced textbook examples.
- Prasanna Chandra (2019), Projects: Planning, Analysis, Selection, Financing, Implementation, and Review, 9th edition, McGraw Hill. The uploaded 150-page scan was visually checked in selected opening sections: importance and difficulties of capital investment, project categories, planning–analysis–selection–financing–implementation–review, strategy and demand forecasting. It ends during Chapter 4; later detailed appraisal chapters appear in its contents but are not present in this extract.
- Dayananda, Irons, Harrison, Herbohn and Rowland (2002), Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press. Reviewed selected passages on relevant cash flows, appraisal methods, sensitivity, simulation and capital constraints. The chapter structure also guides further reading.
- Dr. Vijay Shankar Pandey, Capital Budgeting Techniques, uploaded as “Basics of Capital Budgetings”: process, payback, ARR, NPV, IRR and comparison. Rounded examples and conventions are checked independently rather than copied.
- Professor James P. Dow Jr., FIN 303, Part 8: Topics in Capital Budgeting: uncertainty, flexibility and unequal project lives.
- Capital Budgeting – Risk Analysis, uploaded five-page extract: probability, certainty equivalents and risk-adjusted approaches.
For continued study: Dayananda Chapters 1–2 for foundations; 5–6 for appraisal; 7–9 for risk; 11–12 for constrained selection; 16 for international appraisal. Review here is targeted, not a claim that the entire 343-page book was read.
Prasanna Chandra: further-reading map
The 9th-edition contents identifies Chapter 8 (Investment Criteria), Chapter 9 (Project Cash Flows), Chapter 10 (Cost of Capital), Chapter 11 (Project Risk Analysis), Chapter 12 (Project Rate of Return) and Chapter 13 (Special Decision Situations). These are reading directions, not claims that their absent pages were consulted.
Public reference links
All rates, taxes, exchange rates and business figures in the examples are teaching assumptions. Results use unrounded calculations and are rounded for display. Excel formulas use English function names and commas.