1. Fundamentals of Capital Budgeting
Chapter 9
Fundamentals of Capital Budgeting

2. Chapter Outline
The Capital Budgeting Process Forecasting Incremental Earnings Determining Incremental Free Cash Flow Other Effects on Incremental Free Cash Flows Analyzing the Project Real Options in Capital Budgeting

3. Learning Objectives
Identify the types of cash flows needed in the capital budgeting process
Forecast incremental earnings in a pro forma earnings statement for a project
Convert forecasted earnings to free cash flows and compute a project’s NPV
Recognize common pitfalls that arise in identifying a project’s incremental free cash flows
Assess the sensitivity of a project’s NPV to changes in your assumptions
Identify the most common options available to managers in projects and understand why these options can be valuable

4. Cash Flows in a Typical Project

5. Forecasting Incremental Earnings
Operating Expenses Versus Capital Expenditures
Operating Expenses
Capital Expenditures

6. Forecasting Incremental Earnings
Operating Expenses Versus Capital Expenditures
Depreciation
Depreciation expenses do not correspond to actual cash outflows
Straight-Line Depreciation

7. Forecasting Incremental Earnings
Incremental Revenue and Cost Estimates
Factors to consider when estimating a project’s revenues and costs:
A new product typically has lower sales initially
The average selling price of a product and its cost of production will generally change over time
For most industries, competition tends to reduce profit margins over time

8. Forecasting Incremental Earnings
Incremental Revenue and Cost Estimates
The evaluation is on how the project will change the cash flows of the firm
Thus, focus is on incremental revenues and costs

9. Forecasting Incremental Earnings
Incremental Revenue and Cost Estimates
Incremental Earnings Before Interest and Taxes (EBIT) = Incremental Revenue – Incremental Costs – Depreciation

10. Forecasting Incremental Earnings
Taxes
Marginal Corporate Tax Rate
The tax rate a firm will pay on an incremental dollar of pre-tax income
Income Tax = EBIT  The Firm’s Marginal Corporate Tax Rate

11. Forecasting Incremental Earnings
Incremental Earnings Forecast
Incremental Earnings = (Incremental Revenues –
Incremental Costs – Depreciation)  (1 – Tax Rate)

12. Example Incremental Earnings
Problem:
Suppose that Linksys is considering the development of a wireless home networking appliance, called HomeNet, that will provide both the hardware and the software necessary to run an entire home from any Internet connection. HomeNet will also control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on.
Based on extensive marketing surveys, the sales forecast for HomeNet is 50,000 units per year. Given the pace of technological change, Linksys expects the product will have a four-year life and an expected wholesale price of $260 (the price Linksys will receive from stores). Actual production will be outsourced at a cost (including packaging) of $110 per unit.

13. Example Incremental Earnings
Problem (cont'd):
To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Linksys must also establish a new lab for testing purposes. They will rent the lab space, but will need to purchase $7.5 million of new equipment. The equipment will be depreciated using the straight-line method over a 5-year life. Linksys' marginal tax rate is 40%.
The lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2.8 million per year on rental costs for the lab space, as well as rent marketing and support for this product. Forecast the incremental earnings from the HomeNet project.

14. Example Incremental Earnings
Solution:
We need 4 items to calculate incremental earnings:
(1) incremental revenues,
(2) incremental costs,
(3) depreciation, and
(4) the marginal tax rate:
Incremental Revenues are: additional units sold  price
= 50,000  $260 = $13,000,000
Incremental Costs are: additional units sold  production costs
= 50,000  $110 = $5,500,000

15. Example Incremental Earnings
Plan:
Selling, General and Administrative = $2,800,000 for marketing and support
Depreciation is: Depreciable basis / Depreciable Life = $7,500,000 / 5 = $1,500,000
Marginal Tax Rate: 40%
Note that even though the project lasts for 4 years, the equipment has a 5-year life, so we must account for the final depreciation charge in the 5th year.

16. Example 9.1 Incremental Earnings

17. Determining Incremental Free Cash Flow
Converting from Earnings to Free Cash Flow
Free Cash Flow
The incremental effect of a project on a firm’s available cash
Capital Expenditures and Depreciation

18. Determining Incremental Free Cash Flow
Calculating Free Cash Flow Directly

19. Determining Incremental Free Cash Flow
Converting from Earnings to Free Cash Flow
Net Working Capital
Trade Credit
The difference between receivables and payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions
Net Working Capital = Current Assets  Current Liabilities
= Cash + Inventory + Receivables  Payables

20. Incremental Free Cash Flows

21. Incorporating Changes in Net Working Capital
Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers).
However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS). Fifteen percent of $13 million in sales is $1.95 million and 15% of $5.5 million in COGS is $825,000.
HomeNet’s net working capital requirements are shown in the table below.

22. Incorporating Changes in Net Working Capital
Change in NWC

23. Incorporating Changes in Net Working Capital
The incremental free cash flows would then be:

24. Calculating the NPV
To compute a project’s NPV, one must discount its free cash flow at the appropriate cost of capital
Assume that Linksys’s managers believe that the HomeNet project has risks similar to its existing projects, for which it has a cost of capital of 12%. Compute the NPV of the HomeNet project.

25. Example 9.5 Calculating the Project’s NPV
Solution:
The incremental free cash flows for the HomeNet project are (in $000s):

26. Other Effects on Incremental Free Cash Flows
Opportunity Costs
Project Externalities
Cannibalization
Sunk Costs
Fixed Overhead Expenses
Past Research and Development

27. Other Effects on Incremental Free Cash Flows
Adjusting Free Cash Flow
Time of Cash Flows
Accelerated Depreciation
MACRS
Modified Accelerated Cost Recovery System

28. Computing Accelerated Depreciation
Problem:
What depreciation deduction would be allowed for HomeNet’s $7.5 million lab equipment using the MACRS method, assuming the lab equipment is designated to have a five-year recovery period?

29. Computing Accelerated Depreciation
Solution:
Under MACRS, we take the percentage in the table for depreciation for each year and multiply it by the original purchase price of the equipment to calculate the depreciation for that year.
Based on the table, the allowable depreciation expense for the lab equipment is shown below (in thousands of dollars).

30. Computing Accelerated Depreciation
Evaluate:
Compared with straight-line depreciation, the MACRS method allows for larger depreciation deductions earlier in the asset’s life, which increases the present value of the depreciation tax shield and so will raise the project’s NPV. In the case of HomeNet, computing the NPV using MACRS depreciation leads to an NPV of $3.179 million.

31. Other Effects on Incremental Free Cash Flows
Adjusting Free Cash Flow
Liquidation or Salvage Value
When an asset is liquidated, any capital gain is taxed as income
Capital Gain = Sale Price  Book Value
Book Value = Purchase Price  Accumulated Depreciation
After-Tax Cash Flow from Asset Sale
= Sale Price  (Tax Rate  Capital Gain)

32. Computing After-Tax Cash flows from an Asset Sale
Problem:
As production manager, you are overseeing the shutdown of a production line for a discontinued product. Some of the equipment can be sold for a total price of $50,000. The equipment was originally purchased 4 years ago for $500,000 and is being depreciated according to the 5-year MACRS schedule. If your tax rate is 35%, what is the after-tax cash flow you can expect from selling the equipment?

33. Computing After-Tax Cash flows from an Asset Sale
Solution:
In order to compute the after-tax cash flow, you will need to compute the capital gain, which requires you to know the book value of the equipment. The book value is given as the original purchase price of the equipment less accumulated depreciation. Thus, you need to follow these steps:
Use the MACRS schedule to determine the accumulated depreciation.
Determine the book value as purchase price minus accumulated depreciation
Determine the capital gain as the sale price less the book value.
Compute the tax owed on the capital gain and subtract it from the sale price.

34. Computing After-Tax Cash flows from an Asset Sale
Execute:
From the chapter appendix, we see that the first four years of the 5-year MACRS schedule (including year 0) are:

35. Computing After-Tax Cash flows from an Asset Sale
Thus, the accumulated depreciation is 100, , , , ,600 = 471,200, such that the remaining book value is $500,000 - $471,200 = 28,800. (Note we could have also calculated this by summing any years remaining on the MACRS schedule (Year 5 is 5.76%, so  500,000 = 28,800).
The capital gain is then $50,000 - $28,800 = $21,200 and the tax owed is 0.35  $21,200 = $7,420.
Your after-tax cash flow is then found as the Sale price minus the tax owed: $50,000 - $7,420 = $42,580.

36. Other Effects on Incremental Free Cash Flows
Replacement Decisions
Often the financial manager must decide whether to replace an existing piece of equipment
The new equipment may allow increased production, resulting in incremental revenue, or it may simply be more efficient, lowering costs

37. Replacing an Existing Machine
Problem:
You are trying to decide whether to replace a machine on your production line. The new machine will cost $1 million, but will be more efficient than the old machine, reducing costs by $500,000 per year. Your old machine is fully depreciated, but you could sell it for $50,000. You would depreciate the new machine over a 5-year life using MACRS. The new machine will not change your working capital needs. Your tax rate is 35%, and your cost of capital is 9%. Should you replace the machine?

38. Replacing an Existing Machine
Plan:
Incremental revenues: 0
Incremental costs: -500,000
Depreciation schedule (from the appendix):
Capital Gain on salvage = $50,000 - $0= $50,000
Cash flow from salvage value: +50,000 – (50,000)(.35) = 32,500

39. Replacing an Existing Machine
Execute:

40. Replacing an Existing Machine
Execute (cont’d):

41. Replacing an Existing Machine
Evaluate:
Even though the decision has no impact on revenues, it still matters for cash flows because it reduces costs. Further, both selling the old machine and buying the new machine involve cash flows with tax implications. The NPV analysis shows that replacing the machine will increase the value of the firm by almost $599 thousand.

42. Replacing an Existing Machine
Problem:
You are trying to decide whether to replace a machine on your production line. The new machine will cost $5 million, but will be more efficient than the old machine, reducing costs by $1,500,000 per year. Your old machine is fully depreciated, but you could sell it for $100,000. You would depreciate the new machine over a 5-year life using MACRS. The new machine will not change your working capital needs. Your tax rate is 40%and your cost of capital is 9%. Should you replace the machine?

43. Analyzing the Project Sensitivity Analysis
A capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed

44. Best & Worst-Case Assumptions for Each Parameter in the HomeNet Project

45. HomeNet’s NPV Under Best & Worst-Case Parameter Assumptions

46. Analyzing the Project Break-Even Analysis Break Even
The level of a parameter for which an investment has an NPV of zero

47. Analyzing the Project Break-Even Analysis Operating breakeven point
Accounting Break-Even
Sales
P x Q
less: Variable Cost
(v x Q)
less: Fixed Cost
(F)
EBITDA
(P-v)Q - F
Less: Depreciation
(Dep)
EBIT
(P-v)Q - F - Dep
less: Interest payment
(I)
EBT
(p-v)Q -F - Dep - I
Less: TAX= t%
-t[(P-v)Q -F- Dep - I]
Net Income
[(P-v)Q - F - Dep - I](1 - t)
Plus: Depreciation
+Dep
Cash Flow
[(P-v)Q -F - Dep - I](1 -t) + Dep

48. Analyzing the Project OVERALL BREAK-EVEN POINT
PRESENT VALUE BREAK-EVEN POINT

49. Break-Even Analysis Graphs

50. Analyzing the Project Scenario Analysis
A capital budgeting tool that determines how the NPV varies as a number of the underlying assumptions are changed simultaneously

51. Scenario Analysis of Alternative Pricing Strategies

52. MACRS Depreciation Table Showing the Percentage of the Asset’s Cost That May Be Depreciated Each Year Based on Its Recovery Period