1. Fundamentals of Capital Budgeting Chapter 7 1

2. Forecasting earnings Capital budgeting is the process of deciding which projects to accept out of the set of possible investment projects that a company plans to undertake Example page 178 Linksys (division of Cisco Systems) is considering the development of a wireless home networking appliance – HomeNet HomeNet will allow the consumer to run the entire home through the internet Linksys has already conducted an intensive $300,000 feasibility study to assess the attractiveness of the new product 2

3. Forecasting earnings HomeNet targets upscale residential “smart” homes It expects annual sales of 100,000 units for four years, and nothing afterwards The product will be sold of a wholesale price of $260 (retail $375) Hardware: the product will require total engineering and design costs of $5 million prior to production at $110 per unit Software: the product will require a team of 50 software engineers for a full year 3

4. Forecasting earnings Example continued The annual cost of a software engineer is $200,000 Linksys must also build a new lab for testing the compatibility of their product to the internet ready appliances. The new lab will occupy existing facilities but will require an investment of $7.5 million in new equipment The hardware, software, and new lab will be done in one year. At that time HomeNet will be ready to ship Linksys expects to spend $2.8 million a year on marketing and support for the product 4

5. Forecasting earnings 5

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7. What about the capital expenditure of $7.5 million on the new lab? Investments in plant, property, and equipment are not directly listed as expenses when calculating earnings even though they are a cash expense The firm deducts a fraction of the cost each year as depreciation The simplest method is straight-line depreciation In our case – one year of set up and four years of production. This amounts to $1.5 million in depreciation at the end of each year for 5 years 7

8. Forecasting earnings We are ready to calculate EBIT Do we pay tax on negative earnings? If the firm pays positive tax on its total earnings then negative project-earnings serve as a tax shield 8

9. Forecasting earnings 9

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11. Indirect effects on Incremental earnings So far we have identified expected earnings from the project We need to consider incremental cash flows. That is, the difference between total cash flows with and without the project Examples where this could matter include – Opportunity cost (e.g., of using an existing facility such as the lab in our example) – Project externalities (e.g., reduction in sales of alternative products offered by the firm) 11

12. Forecasting earnings Example continued Suppose that the lab is housed in a warehouse space that the company could have otherwise rented out for $200,000 a year during the years 1-4. – will increase SG&A to $3 million @ t=1-4 Suppose that 25% of HomeNet’s sales come from customers who would have purchased an existing Linksys wireless router in HomeNet were not available. – Adoption of the project implies a reduction in existing revenues 12

13. Forecasting earnings Lets estimate the negative externality introduced by the project 25% of 100,000 = 25,000 units of existing Linksys router not sold. Existing router sells for wholesale price $100 Incremental sales are now $23 million It costs $60 to produce one unit of the existing router. Cost of goods sold reduced by $60 x 25,000 = $1.5 million 13

14. Forecasting earnings 14

15. Forecasting earnings Sunk costs are not affected by our decision and therefore they should not affect our decision The $300,000 spent already on the feasibility study cannot be recovered (whether the project is adopted or not!) This cost should not be included in our analysis and should not affect our decision 15

16. Forecasting earnings Other examples of sunk costs – Fixed overhead expenses – Past R&D expenses More realistic assumptions we abstract from for now. For example, – Annual sales are typically not flat overtime – Production costs may decline due to technology improvements overtime 16

17. Determining FCF We have an idea of future incremental earnings due to the adoption of the project To evaluate the project we need to consider free cash flows and not earnings! Remember…with earnings the firm cannot buy goods, pay investors, employees…for that it needs cash Lets learn how to adjust earnings to figure out the firm’s stream of expected free cash flows 17

18. Determining FCF Capital expenditures and depreciation – CAPEX is a cash out flow – Depreciation is not an actual payment made by the firm. It is a method used for accounting and tax purposes. To adjust for CAPEX and depreciation we need to – add back to earnings the depreciation expense for the lab equipment – subtract the actual CAPEX for the lab setup 18

19. Determining FCF 19

20. Determining FCF Working capital – Net working capital (NWC) is defined as the difference between Current Assets and Current Liabilities – NWC = Cash + Inventory + Receivables – Payables Expanding into a new project often requires changes to NWC. Potentially, – Increased cash holdings – Higher levels of inventory – The difference between Accounts receivables and Payables (known as trade credit) may increase 20

21. Determining FCF We can use this information to adjust earnings appropriately to calculate FCF Receivables Payables NWC 21

22. Determining FCF Suppose that HomeNet will have not cash or inventory requirements – Products will be shipped directly from the contract manufacturer to customers HomeNet will grant credit to its customers and as a result receivables related to HomeNet will account for 15% of annual sales HomeNet will receive credit from its suppliers and payables will account for 15% of annual cost of goods sold (COGS) 22

23. Determining FCF How does NWC affect the FCF from the project? To clarify…consider the cash component of NWC first in isolation from the rest The project requires higher level of NWC ($2.1 million in our example) @ t=1-4 In other words, the project requires – a cash outflow at time t=1 of $2.1 million – a cash inflow at time t=5 of $2.1 million 23

24. Determining FCF Formally, the annual increase in NWC is treated as a cash expenditure and is subtracted from earnings Thus we are interested in the change in NWC, ΔNWC t = NWC t – NWC t-1 Not to forget the recovery of NWC at the end of the life of the project - a reduction in NWC is equivalent to a cash inflow. 24

25. Determining FCF 25

26. Calculating FCF We have started from earnings since it is usually easier to forecast earnings and then derive the implied stream of cash flows It is also possible to calculate FCF directly using the formula 26

27. Calculating NPV With the FCF’s we can move onto the NPV calculation For now we assume that the project has the same risk as other projects in Cisco’s Linksys divisions with the appropriate discount rate of 12% Going back to the FCF time line we obtain 27

28. Choosing among alternatives We compared the NPV to zero since we faced the decision of either adopting or not without any other alternatives With alternative strategies we must compare the NPV of a project to that of the alternative mutually exclusive projects and choose the project with the highest NPV Back to our example, suppose that Cisco is considering an alternative manufacturing plan for the HomeNet product 28

29. Choosing among alternatives Under the current plan production is fully outsourced at cost of $110 per unit Cisco can alternatively produce the product in house for a cost of $95 per unit – Will require $5 million in upfront operating expenses – Cisco will need to maintain inventory equal to one month’s production. 29

30. Choosing among alternatives To address the outsourcing versus in-house- production decision we need to examine the incremental FCF’s 30

31. Choosing among alternatives Now consider EBIT 31

32. Further adjustments to FCF Depreciation schedule – We have assumed for simplicity the straight line depreciation method – Since depreciation reduces tax payments it is in the firm’s best interest to choose the most accelerated method of depreciation – MACRS is the most accelerated method approved by the IRS. For example for an asset with 3 year life span the schedule is 33.33%, 44.45%, 14.81%, 7.41% 32

33. Further adjustments to FCF Liquidation and Salvage value – Assets no longer needed often have a resale value – Some assets may even have a negative liquidation value – for example, if its parts need to be removed from the plant and disposed of – Capital gains (from selling the asset) are taxed Capital Gain = Sale price – Book value Book value = Purchase price – Accumulated Depreciation After tax CF from asset sale = Sale price – (Capital Gain)τ c After tax CF from asset sale = Sale price – (Capital Gain)τ c 33

34. Further adjustments to FCF Terminal or continuation value – Sometimes FCF’s are explicitly forecasts for a shorter horizon than the full horizon of the project (e.g., an expansion usually doesn’t have a specific life span) – Depending on the setting one should apply different methods for estimating the continuation value. For long lived projects it is common practice to cash flows grow at some constant rate beyond the forecast horizon. 34

35. Further adjustments to FCF Tax carryforwards and caryybacks – The tax code allows firms to take losses during a current year and offset them against gains in nearby years – The firm can offset losses during one year against income for the last tow years, or save the losses to be offset against income during the next 20 years 35

36. Analyzing the project The manager will choose the project with the highest NPV As we have seen, the NPV depends on the estimated FCF’s and the appropriate cost of capital There is considerable uncertainty regarding these estimates How can we make investment decisions when we are uncertain regarding the project’s future cash flows and its risk? 36

37. Analyzing the project When uncertain about an input it is useful to conduct the break-even analysis For example, consider the cost of capital of 12% we have assumed for the HomeNet project The question we will ask is “at what cost of capital will the HomeNet project have a zero NPV?” (the IRR of the project) 37

38. Analyzing the project Similarly we can calculate the breakeven point for other parameters of interest 38

39. Analyzing the project Another important tool is sensitivity analysis By examining the sensitivity of the NPV to changes in parameter values for which there is uncertainty we learn what assumptions are most important It also reveals what aspects of the project are most critical when managing the project 39

40. Analyzing the project 40

41. Analyzing the project 41

42. Assignments Chapter 7, questions 2, 6, 9 and Data Case 1-3