In an ideal world, every opportunity for growth should be embraced by business

management. The real world, however, offers only finite resources to business entities so it is

crucial for management to discern on which investment to pursue. This process of discerning if

investments are profitable or more superior to another prospective investment is called Capital

Budgeting. This academic writing will centre on a case study on capital budgeting. The case

study is a company called WePROMOTE which is involved in promotional materials. Owners of

the company are trying to decide if a project is worth the investment. The Net Present Value

calculation is a capital budgeting tool that takes into account the time value of money and this

will be used to analyse if the project is worth pursuing. Evidence based references will then be

utilised to aid in analysis of the Net Present Value Calculations.

The Net Present Value, as stated beforehand, takes into account the time value of money

as it uses the “present value” of the cumulative cash inflows and outflows to accept or reject a

potential investment or project (Pandey, 2015). The time value of money is the notion that a

certain amount at present time is worth more than the same amount in the future because money

at present already has earning capacity (Pandey, 2015). The deviation between the present value

of money and future value of it depends on two factors. The first factor is the period of time in the

future and the discount rate or the interest rate. The discount rate

Initially, cash inflows and outflows should be determined and categorised according to

when will they take place (Heisinger, 2009). In this case study, the initial cash outflow is the

“purchase price” of the project which amounts to $105,000. Cash inflows are Gross Revenues

and the outflows are the annual project expenses. These are stated in the table below. Another

cash inflow is the potential cash that can be generated from the sale of the equipment at the end of

its lifetime or its salvage value. Again, this value is stated in the table below.

TABLE 1.
Year 0 1 2 3 4 5
Purchase Price -105000
Cash Inflow/ Revenues 25000 27000 27000 28000 23000
Cash Outflow/ Expenses -13000 -12000 -12000 -12000 -10000
Salvage Value 5000

The Net Cash Flow can already be calculated from the information from table 1.

However, the case study states that there are other factors that might influence the Net Cash

Flow. These factors are the Income Tax Rate and Depreciation. In real business situations, tax

payments are made from the income generated by a business at a specific tax rate (Stittle, 2008).

The tax rate that the business must pay is 30 percent as stated in the case study. As the name

implies, income tax is calculated by deducting a calculated amount from the “Income” or

earnings based on the tax rate (Stittle, 2008). The case study, however, does not specifically state

the “Income” which can be calculated by deducting Expenses from Revenues (Heisinger, 2009).

The Income Tax, on the other hand, can be determined by calculating 30 percent of the Net

Income . The formula for this calculation is as of follows: Income tax= Net income x Tax rate

(30%). Income Tax payments are “cash outflows” and should be included in the NPV analysis

(Stittle, 2008). Subsequently, Income Tax payments can be subtracted from the Income to

determine the Net Income After Tax (Stittle, 2008). The calculation for the Net Income after Tax

is stated in Table 2 below.

TABLE 2.

Year 0 1 2 3 4 5
Cash Inflow/ Revenues 25000 27000 27000 28000 23000
Cash Outflow/ Expenses -13000 -12000 -12000 -12000 -10000
Net Cash Receipts 12000 15000 15000 16000 13000
Less: 30% Income Tax 3600 4500 4500 4800 3900
Net Income After Tax 8400 10500 10500 11200 9100

Another factor to consider in determining Net Cash Flows is Depreciation. Deprecation is the

process of distributing the cost of a fixed or tangible asset over the course of the estimated life of

an asset (Heisinger, 2009). The business, initially, incurs the full cash expense of the investment

(Heisinger, 2009). Full expense of the asset is systematically divided over the perceived life span
of the asset (Heisinger, 2009). Deprecation, therefore, is considered as a non-cash expense and is

not reflected in the cash flow statement or analysis of the capital investment (Heisinger, 2009).

However, depreciation has tax benefits which ultimately impacts cash flow (Parker, 2017).

Depreciation expense can be calculated by dividing the actual purchase price of the project to the

estimated life span of it . In this case, $ 105,000 (Purchase Price) divide by 5 years (Estimated life

span) will yield a depreciation expense of $ 21,000. Since depreciation is a non-cash expense, it

will not affect calculation of net cash flows. It will, however, aid in calculating the income tax

shield or benefits which is calculated by multiplying the Depreciation Expense to the Tax Rate

(Kapil, 2010). The Depreciation Tax Benefit of the business is calculated as follows: $ 21, 000

(Depreciation Expense) x 0.30 (30% Tax Rate) will yield $ 6,300 which is a “cash inflow”.

After factoring in all of the necessary variables that affect Cash Flow, the Net

Cash Flow can then be calculated by consolidating the cash inflows and outflows per year. The

calculation for the Net Cash Flow is stated in Table 3 below. Extraordinary cash flows were also

included such as the Purchase Price and the Salvage Value.

TABLE 3.

Year 0 1 2 3 4 5
Purchase Price -105000
Cash Inflow/
Revenues 25000 27000 27000 28000 23000
Cash Outflow/
Expenses -13000 -12000 -12000 -12000 -10000
Net Cash Receipts 12000 15000 15000 16000 13000
Net Income After
Tax 8400 10500 10500 11200 9100
Depreciation Tax
Savings 6300 6300 6300 6300 6300
Salvage Value 5000

Net Cash flow (105,000) 14,700 16,800 16,800 17,500 20,400

*Significant lines are marked as RED while Net Cash Flow per period are marked GREEN
 The next step in the Net Present Value Analysis is establishing the discount rate. The

interest rate or discount rate is usually determined by the Weighted Average Cost of Capital

(Kapil, 2010). The Weighted Average Cost of Capital is the combined rate of costs associated

with debt and equity. Cost of debt is the interest rate for bank loans or bond issues whereas cost

of equity is the rate of return that shareholders or owners expect from the investment (Kapil,

2010). Estimating the most appropriate interest rate is crucial because minute changes in the

interest rate can drastically alter the results of the calculation (Kapil, 2010). The interest rate

given in the case study is 7 percent.

Present Value calculations are then carried out. Present Value Calculation which takes

into account the number of years in the future when the cash flow occurred, the annual interest

rate and the amount received on that particular year (Goyal & Goyal, 2012). The formula is of

follows: where P is the present value, F is the future cash flow, r is the interest rate and n is the

number of years in the future.

A variation of this equation requires the Net Cash Flow to be multiplied to the Present

Value Factor to arrive to the Present Value. The Present Value Factor is computed using the

formula as follows: where r is the rate of return and n is the time period or

in this case, the number of years.

Present Value Calculations are applied on Net Cash Flows of every time period. The

results are then accumulated to arrive at a Net Present Value of the project. The Net Present

Value Calculation for the WePROMOTE project is showed below:

Interest rate 0.07

Year 0 1 2 3 4 5
Purchase Price -105000
Cash Inflow/ 25000 27000 27000 28000 23000
Revenues
Cash Outflow/
Expenses -13000 -12000 -12000 -12000 -10000
Net Cash
Receipts 12000 15000 15000 16000 13000
After Tax Cash
Receipts 8400 10500 10500 11200 9100
Depreciation Tax
Savings 6300 6300 6300 6300 6300
Salvage Value 5000

Net Cash flow (105,000) 14,700 16,800 16,800 17,500 20,400

PV of cash flow (105,000) 13,738 14,674 13,714 13,351 14,545

Cumulative PV (105,000) (91,262) (76,588) (62,874) (49,523) (34,979)

Lastly, interpretation of the results is as crucial as the calculation itself. Generally, a

project should be carried out if Net Present Value is greater than zero (Stittle, 2008). This means

that the return from the investment can offset the required rate of return (Stittle, 2008). The

calculated Net Present Value for the WePromote project is negative. Specifically, the NPV is

negative $ 34, 979 which is well below the standard. Even accounting for variables that affect net

cash flow, such as income tax and depreciation tax shield, the project did not generate cash

inflows to offset its expenses. Of course, the calculation is only as good as the estimations of

future cash flows and discount rates. Also, quantitative measures should not be the sole standard

upon which capital budgeting is based. It is still beneficial for the owners of the business to

conduct a qualitative assessment to determine the economic benefits of the prospective

investment. If the Net Present Value calculation is the only grounds for decision making then the

investment should be rejected.

Goyal, V. K., & Goyal, R. (2012). FINANCIAL ACCOUNTING: PHI Learning.

Heisinger, K. (2009). Essentials of Managerial Accounting: Houghton Mifflin.

Kapil, S. (2010). Financial Management: Pearson Education India.

Pandey, I. M. (2015). Financial Management, 11th Edition: Vikas Publishing House PVT

Limited.

Parker, J. (2017). Depreciation Can Shield Taxes, Bolster Cash Flow. [online] Investopedia.

Available at: [Link]

[Link] [Accessed 16 Sep. 2017].

Stittle, J. (2008). Financial Accounting. London: London : SAGE Publications.