A plant manager pitches a $5M packaging line that promises $1.2M in annual savings. Whether to fund it depends on relevant after-tax cash flows discounted at the right hurdle rate, not on the pitch number. Capital budgeting is the discipline that converts the pitch into a defensible go or no-go.
Six stages run in sequence.
- Identification: generates ideas from strategy, customer demand, or compliance pressure.
- Screening: filters them against strategic fit and a minimum hurdle.
- Evaluation: runs DCF (NPV, IRR, payback) on the survivors using forecasted after-tax cash flows.
- Selection: ranks projects under a capital constraint, picking the bundle that maximizes NPV.
- Implementation: authorizes spending and tracks against budget.
- Postaudit: compares realized cash flows to forecast.
KEY: The postaudit is not paperwork. It calibrates future forecasts and disciplines optimistic sponsors.
Capital budgeting uses cash flows, not accounting profits. Accounting profit includes non-cash items (depreciation, amortization) and ignores the actual timing of cash receipts and disbursements. Three filters define which cash flows count:
Common mistakes
- Deducting sunk costs. Money already spent never enters the cash-flow forecast. A $400,000 prior feasibility study is irrelevant today.
- Skipping the depreciation tax shield. OCF = (R − E)(1 − t) alone understates cash by each year. Always add the shield term.
- Treating NWC as depreciable. NWC is recovered at project end as a lump-sum inflow. It generates no tax shield and is not amortized.
Bottom line
- The six stages: identify, screen, evaluate (DCF), select, implement, postaudit.
- After-tax operating cash flow = (Revenue − Cash Expense)(1 − t) + (Depreciation × t). The second term is the depreciation tax shield.
- Relevant cash flows are incremental, after-tax, opportunity-cost-inclusive; sunk costs are excluded.
- Initial NWC investment is a cash outflow at t=0, recovered at project end, and generates no tax shield.
Exam shortcut
When the question asks for after-tax operating cash flow, default to (R − E)(1 − t) + (D × t). If you have pretax cash flow and depreciation, build OCF in one line. When sunk costs appear in the prompt, they are a distractor. Subtract them from your figure only if the question explicitly asks for accounting profit, not cash flow.
The full lesson (about 2,086 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2E1
Browse all free CMA Part 2 lessons or jump into free CMA Part 2 practice questions.