Big, long, hard to reverse — and cash, not income

What makes a decision a capital investment

Module 12 decided whether to keep a segment or move a warehouse — decisions whose consequences mostly land within a year or two. Capital budgeting is the same relevant-cost logic applied to a different kind of decision: one that is large relative to the company, long-lived (the cash comes back over years), and hard to reverse (a boat lift, once poured into concrete, cannot be returned). Because the money is committed for years, a capital investment belongs to the strategic plan (Module 11): it is how a strategy — "handle larger vessels", "open the second clinic" — turns into assets. The board approves it; the finance function’s job is to tell the board what the project is worth.

Cash, not income

Lakehead Marine Corp., a Thunder Bay boatyard, proposes a boat lift. The accountant’s summary reads: investment 900,000; five-year life; straight-line depreciation 180,000 a year; accounting income after depreciation 90,000 a year; salvage 50,000 at the end of year 5; and 40,000 of extra working capital (spare parts and receivables) tied up from day one. A capital-budgeting analysis throws the accounting income away and rebuilds the project as cash by year, because a dollar of depreciation never left the bank:

Year   Investment   Working capital   Operating cash   Salvage   Net cash flow
t0       (900,000)         (40,000)                                 (940,000)
t1                                          270,000                   270,000
t2                                          270,000                   270,000
t3                                          270,000                   270,000
t4                                          270,000                   270,000
t5                          40,000          270,000    50,000         360,000

Three conversions do all the work. The annual operating cash inflow is accounting income plus depreciation: $90,000+180,000=270,000$. Working capital is a cash outflow at t0 — the parts must be bought and the customers financed before the lift earns anything — and it comes back as a cash inflow when the project ends and the parts are sold and the receivables collected. Salvage is cash in the final year, whether or not the asset is fully depreciated by then. So the project is $-940,000$ today, then $270,000$ for four years, then $360,000$ in year 5.

The same three moves on a smaller project — equipment 300,000, income 40,000 a year, depreciation 60,000, working capital 30,000, no salvage — give t0 of $-330,000$, then $100,000$ a year, and $130,000$ in the last year.

Where the 940,000 comes from

A project needs a source of cash before it needs a valuation. Four sources, in the order a board usually prefers them: operating cash flow (Tamarack’s 460 in lesson 10.4 — the repeatable source); new debt (fast, but it adds interest and covenants); new shares (no fixed charge, but it dilutes the owners and, for a public company, involves the Module 4 machinery); and asset sales (one-off, and only if something is surplus). When the cash available is less than the good projects on the table the company is under capital rationing: it must choose among positive-NPV projects, not reject them — which is what lesson 13.5’s profitability index is for.

What the board weighs besides the number

The number decides nothing by itself. Lakehead’s board will also weigh strategic fit (does the lift serve the "larger vessels" strategy?), risk (what if the market for large-vessel storage does not arrive?), flexibility (can the lift be re-purposed or sold?), ESG (the shoreline permit, the environmental review), and people (safety, the crew’s skills, morale). Lesson 13.6’s memo puts these beside the NPV, never instead of it.