1. Chapter 8 Fundamentals of Capital Budgeting

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-2 8.1 Forecasting Earnings Capital Budget –Lists the investments that a company plans to undertake Capital Budgeting –Process used to analyze alternate investments and decide which ones to accept Incremental Earnings –The amount by which the firm’s earnings are expected to change as a result of the investment decision

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-3 Interest Expense In capital budgeting decisions, interest expense is typically not included. The rationale is that the project should be judged on its own, not on how it will be financed.

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-4 The Baldwin Company Increase in net working capital: $10,000. Initial investment of working capital 30,000 cash, 20,000 inv, 10,000 A/P Maintain following ratios DSO 35 days, DCI 27 days, DPO 45 days, cash to sales 15% Working Capital: initially $10,000 changes with sales. Production (in units): 10,000 the first year with a 10% growth per year. Price during first year is $20; price increases 2% per year thereafter. 5 year project life Production costs per unit: Labor $3 (4% growth), Materials $2 (2% growth), indirect costs ($.75) (0 growth), $30,000 fixed Costs of test marketing (already spent): $250,000. Salaries will be 50,000 per year. Advertising budget starts at 3,000 and will grow by 10% per year. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value in 5 years 15,000 Discount rate 12% reinvestment rate 14% Comprehensive CB Problem

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-5 Comprehensive CB Problem

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-6 The Baldwin Company Increase in net working capital: $10,000. Initial investment of working capital 30,000 cash, 20,000 inv, 10,000 A/P Maintain following ratios DSO 35 days, DCI 27 days, DPO 45 days, cash to sales 15% Working Capital: initially $10,000 changes with sales. Production (in units): 10,000 the first year with a 10% growth per year. Price during first year is $20; price increases 2% per year thereafter. Production costs per unit: Labor $3 (4% growth), Materials $2 (2% growth), indirect costs ($.75) (0 growth), $30,000 fixed Costs of test marketing (already spent): $250,000. Salaries will be 50,000 per year. Advertising budget starts at 3,000 and will grow by 10% per year. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value in 5 years 15,000 Discount rate 12% reinvestment rate 14%

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-7 Comprehensive CB Problem

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-8 The Baldwin Company Increase in net working capital: $10,000. Initial investment of working capital 30,000 cash, 20,000 inv, 10,000 A/P Maintain following ratios DSO 35 days, DCI 27 days, DPO 45 days, cash to sales 15% Working Capital: initially $10,000 changes with sales. Production (in units): 10,000 the first year with a 10% growth per year. Price during first year is $20; price increases 2% per year thereafter. Production costs per unit: Labor $3 (4% growth), Materials $2 (2% growth), indirect costs ($.75) (0 growth), $30,000 fixed Costs of test marketing (already spent): $250,000. Salaries will be 50,000 per year. Advertising budget starts at 3,000 and will grow by 10% per year. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value in 5 years 15,000 Discount rate 12% reinvestment rate 14%

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-9 Comprehensive CB Problem

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-10 The Baldwin Company Beginning Cash: 30,000 Initial investment of working capital 5,000 inv, 4,500 A/P, 17,000 A/R Maintain following ratios DSO 35 days, DCI 27 days, DPO 45 days, cash to sales 15% Production (in units): 10,000 the first year with a 10% growth per year. Price during first year is $20; price increases 2% per year thereafter. Production costs per unit: Labor $3 (4% growth), Materials $2 (2% growth), indirect costs ($.75) (0 growth), $30,000 fixed Costs of test marketing (already spent): $250,000. Salaries will be 50,000 per year. Advertising budget starts at 3,000 and will grow by 10% per year. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value in 5 years 15,000 Discount rate 12% reinvestment rate 14%

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-11 Comprehensive CB Problem

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-12 The Baldwin Company Initial investment of working capital 30,000 cash, 5,000 inv, 4,500 A/P, 17,000 in A/R Maintain following ratios DSO 35 days, DCI 27 days, DPO 45 days, cash to sales 15% Working Capital: initially $10,000 changes with sales. Production (in units): 10,000 the first year with a 10% growth per year. Price during first year is $20; price increases 2% per year thereafter. Production costs per unit: Labor $3 (4% growth), Materials $2 (2% growth), indirect costs ($.75) (0 growth), $30,000 fixed Costs of test marketing (already spent): $250,000. Salaries will be 50,000 per year. Advertising budget starts at 3,000 and will grow by 10% per year. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value in 5 years 15,000 Discount rate 12% reinvestment rate 14%

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-13 Comprehensive CB Problem

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-14 Comprehensive CB Problem

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-15 The Baldwin Company Increase in net working capital: $10,000. Initial investment of working capital 30,000 cash, 20,000 inv, 10,000 A/P Maintain following ratios DSO 35 days, DCI 27 days, DPO 45 days, cash to sales 15% Working Capital: initially $10,000 changes with sales. Production (in units): 5,000 the first year with a 10% growth per year. Price during first year is $20; price increases 2% per year thereafter. Production costs per unit: Labor $3 (4% growth), Materials $2 (2% growth), indirect costs ($.75) (0 growth), $30,000 fixed Costs of test marketing (already spent): $250,000. Salaries will be 50,000 per year. Advertising budget starts at 3,000 and will grow by 10% per year. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value in 5 years 15,000 Discount rate 12% reinvestment rate 14%

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-16 Comprehensive CB Problem

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-17 Indirect Effects on Incremental Earnings Opportunity Cost –The value a resource could have provided in its best alternative use –In the HomeNet project example, space will be required for the investment. Even though the equipment will be housed in an existing lab, the opportunity cost of not using the space in an alternative way (e.g., renting it out) must be considered.

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-18 Textbook Example 8.2

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-19 Textbook Example 8.2 (cont'd)

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-20 Indirect Effects on Incremental Earnings (cont'd) Project Externalities –Indirect effects of the project that may affect the profits of other business activities of the firm. Cannibalization is when sales of a new product displaces sales of an existing product.

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-21 Indirect Effects on Incremental Earnings (cont'd) Project Externalities –In the HomeNet project example, 25% of sales come from customers who would have purchased an existing Linksys wireless router if HomeNet were not available. Because this reduction in sales of the existing wireless router is a consequence of the decision to develop HomeNet, we must include it when calculating HomeNet’s incremental earnings.

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-22 Sunk Costs and Incremental Earnings Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is undertaken. –Sunk costs should not be included in the incremental earnings analysis.

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-23 Sunk Costs and Incremental Earnings (cont'd) Past Research and Development Expenditures –Money that has already been spent on R&D is a sunk cost and therefore irrelevant. The decision to continue or abandon a project should be based only on the incremental costs and benefits of the product going forward.

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-24 Real-World Complexities Typically, –sales will change from year to year. –the average selling price will vary over time. –the average cost per unit will change over time.

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-25 8.2 Determining Free Cash Flow and NPV The incremental effect of a project on a firm’s available cash is its free cash flow.

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-26 Calculating the Free Cash Flow from Earnings Capital Expenditures and Depreciation –Capital Expenditures are the actual cash outflows when an asset is purchased. These cash outflows are included in calculating free cash flow. –Depreciation is a non-cash expense. The free cash flow estimate is adjusted for this non-cash expense.

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-27 Calculating Free Cash Flow Directly Free Cash Flow –The term  c × Depreciation is called the depreciation tax shield.

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-28 8.4 Further Adjustments to Free Cash Flow Other Non-cash Items –Amortization Timing of Cash Flows –Cash flows are often spread throughout the year. Accelerated Depreciation –Modified Accelerated Cost Recovery System (MACRS) depreciation

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-29 Further Adjustments to Free Cash Flow (cont'd) Liquidation or Salvage Value

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-30 8.5 Analyzing the Project Break-Even Analysis –The break-even level of an input is the level that causes the NPV of the investment to equal zero. –Baldwin IRR Calculation

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-31 8.5 Analyzing the Project (cont'd) Break-Even Analysis –Break-Even Levels for HomeNet –EBIT Break-Even of Sales Level of sales where EBIT equals zero Table 8.8 Break-Even Levels for Baldwin

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-32 Sensitivity Analysis Sensitivity Analysis shows how the NPV varies with a change in one of the assumptions, holding the other assumptions constant.

33. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-33 Sensitivity Analysis (cont'd) Table 8.9 Best- and Worst-Case Parameter Assumptions for Baldwin VariableWorstAverageBest Units80001000012000 Price16$2025 Labor costs$3.50$3$2.50 Material Cost$3$2$1 Cost of financing16%12%10%

34. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-34 Sensitivity Analysis (cont'd) Table 8.9 Best- and Worst-Case Parameter Assumptions for Baldwin NPV Worst NPV Average NPV Best Units29,353122,994216,636 Price2,850122,994273,175 Labor costs 111,134122,994134,854 Material Cost 100,592122,994145,396 Cost of financing 94,103122,994139,408

35. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-35 Scenario Analysis Scenario Analysis considers the effect on the NPV of simultaneously changing multiple assumptions. Table 8.10 Scenario Analysis of Alternative Pricing Strategies

36. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-36 Figure 8.2 Price and Volume Combinations for HomeNet with Equivalent NPV PriceUnitsNPV 843444122,994 1220542122,994 1613,451122,994 2010,000122,994 247,957122,994 286,608122,994 325,650122,994

37. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-37 Capital Rationing Firm’s often operate under conditions of capital rationing –they have more acceptable independent projects than they can or want to fund. In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs. –research has found that management internally imposes capital expenditure constraints to avoid what it deems to be “excessive” levels of new financing, particularly debt. Thus, the objective of capital rationing is to select the group of projects within the firm’s budget that provides the highest overall NPV or IRR.

38. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-38 Tate Company, a fast growing plastics company with a cost of capital of 10%, is confronted with six projects competing for its fixed budget of $250,000. Capital Rationing

39. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-39 Capital Rationing IRR Approach Assume the firm’s cost of capital is 10% and has a maximum of $250,000 available for investment. Ranking the projects according to IRR, the optimal set of projects for Tate is B, C, and E, However project A and F are acceptable projects! They have an IRR greater than the cost of capital!! Capital Rationing

40. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-40 Capital Rationing NPV Approach Now we will rank by NPV. With the $250,000 limit in investment we will only do projects C, B, and A While projects E & F clearly will add wealth to the shareholder. Why? Capital Rationing

41. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-41 Capital Rationing: IRR Approach Investment Opportunities Schedule

42. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-42 Investments with Unequal Lives  A firm must purchase an electronic control device  First alternative is a cheaper device, higher maintenance costs, shorter period of utilization  Second device is more expensive, smaller maintenance costs, longer life span  Expected cash outflows  Maintenance costs are constant over time. Use real discount rate of 7% for NPV -1500 12000 A 1200 14000 B 43210 Device $15,936 A $18,065 B NPV Device

43. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-43 Investments of Unequal Lives Replacement Chain –Repeat projects until they begin and end at the same time. –Compute NPV for the “repeated projects.” The Equivalent Annual Cost Method –Convert the NPV into an annuity received each year of the projects life

44. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-44 Unequal Life Analysis Unequal Lives

45. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-45 Abandonment Analysis This procedure looks at the desirability of using the project at various life spans. Steps –Estimate the salvage value of the project at each period of time –Calculate the capital budgeting techniques to identify the optimal life span Engineering life span

46. Copyright ©2014 Pearson Education, Inc. All rights reserved.8-46 Assume that the last cash flow already incorporates the salvage value of the last year Abandonment Analysis