1. Example of capital budgeting
Forecasting earnings
Determining Free Cash Flow and NPV
Analyzing the project

2. Setup
Linksys, a division of Cisco Systems, is considering development of a wireless home networking appliance, HomeNet
Linksys has already conducted an intensive, $300,000 feasibility study to assess the attractiveness of the new product

3. Forecasting Earnings Revenue and cost estimates
Sales forecast: 100,000 units per year
Product will have a 4-year life
Wholesale price: $260 per unit
Cost of outsourcing production: $110 per unit
Engineering and design costs: $5 mln
Software engineering:
50 engineers needed
Cost of software engineer $200,000 per year
Will take one year to complete
Testing lab: $7.5 mln
Marketing and support: $2.8 mln per year

4. HomeNet’s Incremental Earnings Forecast (Spreadsheet)

5. Notes on the forecast spreadsheet
Capital expenditures and depreciation
$7.5 mln was invested in a lab
Assuming 5-year life for the lab and straight line depreciation we get $1.5 mln annual depreciation expense.
Interest is not included into calculation. Usually in capital budgeting we evaluate a project as if it is financed only through equity. Any adjustment for debt financing – in the discount rate (we discuss this in a few lectures). Hence we get Unlevered Net Income
Taxes = EBIT*(1-c)
You should use marginal tax rate
Don’t forget to add taxes when the project reduces the taxable income of your firm

6. Indirect effects on Incremental Earnings
Have we missed anything in our calculations?
Yes:
Opportunity costs
Project externalities (side effects)

7. Accounting for Opportunity Costs

8. Project Externalities
Suppose that 25% of HomeNet’s sales come from customers who would have purchased an existing Linksys appliance if HomeNet were not available.
Such reduction in sales of an existing product is called cannibalization.
We should account for it. It affects Sales and Costs of Goods Sold
Remark: project externalities can also be positive (synergies)

9. Accounting for Cannibalization
Assuming the existing appliance is sold for $100. So, the expected loss in sales:
25%  100,000 units  $100/unit = $2.5 mln
Assuming the cost of existing appliance is $60 per unit. So, the expected reduction in costs of goods sold:
25%  100,000 units  $60/unit = $1.5 mln

10. HomeNet’s Incremental Earnings Forecast Including Cannibalization and Lost Rent (Spreadsheet)

11. Sunk Costs
Why did not we include $300,000 spent on the feasibility study?
It’s sunk and should have no effect on our decision about the project
In reality managers sometimes tend to justify going on with a project on the ground that “we can’t give up after so much money has already been spent”

12. Determining Free Cash Flow
What is the relation between the Cash Flow to investors we computed in lecture 3 and Free Cash Flow?
Here it is in fact Cash Flow to investors, but as if the project is unlevered (hence, no interest, no differences in net borrowing)
Remember we had CF to investors = CF from operations – CF from investment – ΔCash + interest.
When the firm is unlevered: CF from operations = Unlevered Net Income + Depreciation – ΔNWC + ΔCash
CF from investment = CapEx
Hence, we obtain precisely the formula above

13. Calculation of HomeNet’s Free Cash Flow (Including Cannibalization and Lost Rent) (Spreadsheet)

14. Notes on FCF calculation
Depreciation – not a cash expense. Hence, must be added back
CapEx – money spent on the testing lab, $7.5 mln
NWC = Current Assets – Current Liabilities = Cash + Inventory + Receivables – Payables. Assume Cash = Inventory = 0, Receivables = 15% of annual sales, Payables = 15% of annual cost of goods sold. Note: we implicitly assume that NWC requirements for the cannibalized business of Cisco are the same. In reality, recevables for HomeNet = 15%  26 mln = 3.9 mln, but receivables of the cannibalized business fall by 15%  2.5 mln = mln. Hence, the net Receivables = mln. For Payables, cash and inventory – the same.

15. Note FCF can be rewritten as
The last term is called depreciation tax shield – tax savings resulting from the ability to deduct depreciation

16. Computing HomeNet’s NPV (Spreadsheet)

17. Choosing among alternatives
Assume instead of outsourcing production for $110 per unit Cisco could assemble the product in-house at a cost of $95 per unit. But this would require $5 mln of upfront operating expenses to reorganize the assembly facility. In addition, Cisco will need to maintain inventory equal to one month’s production.
We can exclude from calculations things that do not differ between the projects, and include only what differs

18. Cannibalization and lost rent effects do not change – exclude
Sales revenues do not change – exclude
Cost of sales (ignoring cannibalization) changes: $11 mln for outsourcing, $9.5 mln for in-house. In addition, in year 0, $5 mln in operating expenses appear for in-house. EBIT, Tax and Net Income change correspondingly.
CapEx do not change - exclude
NWC changes:
Change in the amount of Payables. Payables were 15%  $11 mln = $1.65 mln (ignoring cannibalization). Now they are 15%  $9.5 mln = $1.425 mln (ignoring cannibalization).
Now we have inventory requirement = $9.5 mln / 12 = $0.792 mln
Hence, ignoring Receivables that do not change:
For outsourcing, NWC = -$1.65 mln
For in-house production, NWC = Inventory – Payables = $0.792 mln - $1.425 mln = -$0.633 mln

19. Outsourced Assembly is better!
NPV Cost of Outsourced Versus In-House Assembly of HomeNet (Spreadsheet), using only cash flows that differ
Outsourced Assembly is better!

20. Accounting for liquidation (salvage) value
If you sell some assets at the end of the project this generates cash.
Imagine the salvage value of the lab’s equipment in the end of year 5 is $2 mln. It’s book value in the end of year 5 is $0 mln. We could sell the equipment for $2 mln, but we would have to pay taxes on capital gain:
c(Sale Price – Book Value) = 40% * $2 mln = $0.8 mln
Hence the cash from the sale = 2 – 0.8 = 1.2 mln
We would have to account for this cash in year 5.

21. Accounting for terminal (continuation) values
For long-lived projects sometimes cash flows are forecasted until year T and then certain assumption about the cash flow growth starting from T+1 is made.
That allows to compute a terminal value at T as if the project is finished is T and the cash equal to the terminal value is realized. Then this terminal value is used in NPV calculation

22. Example of accounting for continuation value

24. Accounting for inflation
Simply discount cash flows correctly:
If real values are used, use real R.
If nominal values – use nominal R.
1 + Rn = (1 + Rr)(1 + i)
Rr  Rn – i
CFrt = CFnt/(1 + i)t

25. Some things to remember
Use only incremental cash flows (i.e. the changes in the firm’s cash flows that occur as a consequence of the project)
Note: pay attention to side effects (like cannibalization and synergies)
Ignore sunk costs
Don’t ignore opportunity costs
Don’t forget working capital requirements
Don’t forget liquidation values (or costs) and terminal values
Be careful with inflation