CFA Level I Exam · Capital Investments and Capital Allocation

Cash Flow Estimation for Capital Projects in CFA Level I

Updated 7 October 2026 · Fact-checked

Cash flow estimation for capital projects means forecasting only the incremental, after-tax cash flows a project causes: the initial outlay, yearly operating cash flows including the depreciation tax shield, and terminal cash flows such as after-tax salvage and recovered working capital. Ignore sunk costs and financing costs; include opportunity costs and externalities.

Understand Cash Flow Estimation for Capital Projects

A capital project is worth what it adds to the firm's cash. So you do not forecast accounting profit. You forecast incremental cash flows: the firm's cash flows with the project minus its cash flows without it.

This one idea decides what goes in and what stays out. Sunk costs are already spent and cannot be recovered, such as a feasibility study paid last year. Leave them out. Opportunity costs are the value of the best alternative use of a resource the project takes, such as land the firm already owns that could be sold. Include them. Externalities are effects on other products. Lost sales of an existing product (cannibalization) reduce cash flow, so include them. Financing costs such as interest are left out of the cash flows because the discount rate already reflects them.

Think of the cash flows in three stages. The initial outlay at time 0 covers the cost of the new asset, installation, the extra net working capital needed, and, for a replacement, the after-tax proceeds from selling the old asset. Operating cash flows come each year after that. Terminal cash flows come in the final year: the after-tax salvage value and the release of the working capital built up earlier.

Depreciation is not a cash cost, but it lowers taxable income, so it saves tax. That saving is the depreciation tax shield, equal to tax rate × depreciation. This is why operating cash flow is higher than after-tax profit by exactly the depreciation amount.

Working capital is a real cash use. If the project needs more inventory and receivables than it gets in payables, the net increase is a cash outflow at the start. It is usually assumed to be recovered at the end of the project's life.

Key formulas to remember

Incremental cash flow: Incremental CF = CF with the project − CF without the project; Include opportunity costs and externalities. Exclude sunk costs and financing costs.
Initial outlay: Outlay = FCInv + NWCInv − Sal₀ + T(Sal₀ − B₀); FCInv = fixed capital investment including installation; NWCInv = increase in net working capital; Sal₀ = sale proceeds of the old asset; B₀ = its book value; T = tax rate. The last two terms apply only to replacements. The tax term is a cost when there is a gain and a saving when there is a loss.
Operating cash flow (two forms): CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + T × D; S = incremental sales, C = incremental cash operating costs, D = depreciation. Both forms give the same answer.
Depreciation tax shield: Tax shield = T × D; Real cash saving each year, as long as the firm has taxable income to shelter.
Terminal cash flow: TNOCF = Sal_T + NWCInv − T(Sal_T − B_T); Sal_T = salvage at the end; B_T = book value then; NWCInv = working capital recovered. Add it to the final year's operating cash flow.
Straight-line depreciation: D = (Cost − Salvage for depreciation) ÷ Useful life; Cost includes installation if it is capitalized.

How to solve Cash Flow Estimation for Capital Projects questions

Use this order for any cash flow estimation question. It stops you from mixing items between stages.

1List every item in the question and mark each as incremental or not. Cross out sunk costs, financing costs and allocated overhead that does not change.
2Compute the initial outlay: asset cost plus installation plus increase in net working capital. For a replacement, subtract the old asset's sale proceeds and adjust for tax on the gain or loss against its book value.
3Compute annual depreciation from the capitalized cost, life and salvage assumption.
4Compute each year's operating cash flow with (S − C)(1 − T) + T × D. Subtract any cannibalized after-tax cash flows.
5Compute the terminal cash flow: salvage minus tax on any gain over book value (or plus the tax saving on a loss), plus recovery of working capital.
6Add the terminal cash flow to the final year's operating cash flow.
7Only then discount, or answer the specific part the question asks for. Check the timing: outlay at time 0, operating flows at year-ends.

Quickest way: Three-bucket shortcut

When to use it: Use it when the question asks for one number, such as the outlay or the final-year cash flow, and the options are three close values.

Pick the bucket: time 0, a middle year, or the final year.
For a middle year, calculate (S − C)(1 − T) first, then add T × D. Do not build an income statement.
For the outlay, add up costs and working capital, then subtract after-tax sale proceeds of any old asset.
For the final year, take the normal operating cash flow and add after-tax salvage and the working capital recovery.
Check against the options. A value that ignores tax on salvage, or leaves out working capital, is usually one of the wrong choices.
For NPV on the BA II Plus: press CF, then 2nd CLR WORK to clear the worksheet. Enter CF0 and press ENTER then ↓. Enter C01 and press ENTER then ↓, then F01 and press ENTER then ↓, and repeat for each later flow. Press NPV, enter the rate I and press ENTER then ↓, then press CPT. On the HP 12C: enter CF0 (use CHS for an outflow) and press g CF₀. Enter each later flow and press g CFj (use g Nj for repeated flows). Enter the rate and press i, then press f NPV.

Common mistakes in Cash Flow Estimation for Capital Projects

Including sunk costs such as a past study fee or old equipment's original cost.
The numbers appear in the question and look relevant.
Fix: Ask: would this cash flow change if we accept the project? If not, leave it out.
Subtracting depreciation and stopping, so the cash flow is just after-tax profit.
Students confuse accounting income with cash flow.
Fix: Add depreciation back, or use (S − C)(1 − T) + T × D. Depreciation only matters through its tax effect.
Ignoring tax on the salvage value, or taxing the whole sale price instead of the gain over book value.
Students treat the sale price as pure cash.
Fix: Tax = T × (sale price − book value). A gain reduces cash received; a loss gives a tax saving.
Forgetting to recover working capital in the final year, or counting it as an expense in the middle years.
Working capital is seen as a one-off cost.
Fix: Treat it as an outflow at time 0 and an inflow at the end. Any further increase in working capital during the project life is an additional outflow in that year, and the total accumulated working capital is recovered at the end.
Including interest or dividends in project cash flows.
Students think a loan is a project cost.
Fix: Financing costs are captured in the discount rate. Keep them out of the cash flows to avoid double counting.
Leaving out opportunity costs and cannibalization, or including them only when the question labels them clearly.
They are not a cost the firm pays out directly.
Fix: Treat the value of a foregone alternative use and lost sales elsewhere in the firm as incremental outflows.

Worked examples

Example 1

A company buys equipment for $800,000 and pays $50,000 for installation, which is capitalized. The project needs a $60,000 increase in net working capital. The equipment is depreciated straight-line over 5 years to zero book value. The project adds $500,000 of sales and $200,000 of cash costs each year. The tax rate is 30%. At the end of year 5 the equipment is sold for $100,000 and the working capital is recovered. What is the total cash flow in year 5? (A) $331,000 (B) $391,000 (C) $421,000

Show the solution

Initial outlay = 800,000 + 50,000 + 60,000 = $910,000 (not needed for year 5). Depreciable cost is 800,000 + 50,000 = $850,000. The $60,000 of working capital is not depreciated.
Depreciation = 850,000 ÷ 5 = $170,000 a year.
Operating cash flow = (500,000 − 200,000)(1 − 0.30) + 0.30 × 170,000 = 210,000 + 51,000 = $261,000.
Book value at the end of year 5 = $0, so the gain on sale = $100,000 and tax = 0.30 × 100,000 = $30,000.
After-tax salvage = 100,000 − 30,000 = $70,000.
Terminal cash flow = 70,000 + 60,000 working capital = $130,000.
Year 5 total = 261,000 + 130,000 = $391,000. Option A leaves out the working capital recovery (261,000 + 70,000). Option C uses pre-tax salvage (261,000 + 100,000 + 60,000).

Answer: (B) $391,000

Example 2

A firm plans to replace an old machine with a new one costing €400,000. The old machine has a book value of €100,000 and can be sold for €150,000. Net working capital will rise by €20,000. The tax rate is 25%. What is the initial outlay? (A) €257,500 (B) €282,500 (C) €382,500

Show the solution

Fixed capital investment = €400,000 and the increase in net working capital = €20,000.
Sale proceeds of the old machine = €150,000, which reduce the outlay.
Gain on sale = 150,000 − 100,000 = €50,000, so tax = 0.25 × 50,000 = €12,500. A gain means tax is paid, which raises the outlay.
Outlay = 400,000 + 20,000 − 150,000 + 12,500 = €282,500.
Option A treats the tax as a saving (420,000 − 150,000 − 12,500 = 257,500). Option C adds the old machine's book value of €100,000 to the outlay (282,500 + 100,000 = 382,500). That is wrong: book value is not added to the outlay, though it is used to calculate the tax on the sale.

Answer: (B) €282,500

Exam tips

Read the question for what the cash flow is asked at: time 0, a middle year or the final year. Many wrong options are right numbers for the wrong year.
Mark sunk cost, opportunity cost and externality items first. A conceptual question often asks only which item should be included, and the answer is the one that changes with the decision.
Check whether installation is capitalized, since it raises depreciation as well as the outlay.
Compare each option to the usual errors: no tax on salvage, no working capital recovery, depreciation not added back. This lets you eliminate two options fast.
No calculator is needed for most items here. Use the BA II Plus cash flow keys only when the question goes on to ask for NPV.

Practice questions from Capital Investments and Capital Allocation

Cash Flow Estimation for Capital Projects in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cash Flow Estimation for Capital Projects: frequently asked questions

What is an incremental cash flow in capital budgeting?

It is the change in the firm's total cash flows caused by accepting the project. You find it by comparing cash flows with the project and without it. Sunk costs do not change with the decision, so they are excluded.

What is the difference between sunk cost and opportunity cost?

A sunk cost has already been spent and cannot be recovered, so it is ignored. An opportunity cost is the value of the best alternative use of a resource the project will use. It is included as a cost even though no cash is paid out.

How do you calculate the depreciation tax shield?

Multiply the tax rate by the depreciation expense. With a 30% tax rate and $170,000 depreciation, the shield is $51,000. It is a real saving because depreciation reduces taxable income without using cash.

How do you calculate terminal cash flow?

Take the salvage value, subtract tax on any gain over book value (or add the saving on a loss), then add back the net working capital recovered. Add the result to the final year's operating cash flow.