Chapter 8 Fundamentals of Capital Budgeting

Chapter Outline
Chapter 8 8.1 Forecasting Earnings

8.2 Determining Free Cash Flow and NPV
Fundamentals of
Capital Budgeting 8.3 Choosing Among Alternatives
8.4 Further Adjustments to Free Cash Flow
8.5 Analyzing the Project
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8.1 Forecasting Earnings Revenue and Cost Estimates
Capital Budget Example

Lists the investments that a company plans Linksys has completed a $300,000 feasibility
to undertake study to assess the attractiveness of a new
product, HomeNet. The project has an estimated
Capital Budgeting
life of four years.
Process used to analyze alternate investments
and decide which ones to accept Revenue Estimates
Sales = 100,000 units/year
Incremental Earnings Per Unit Price = $260
The amount by which the firms earnings are
expected to change as a result of the investment
decision
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Revenue and Cost Estimates Capital Expenditures and
(cont'd) Depreciation
Example The $7.5 million in new equipment is a cash

Cost Estimates expense, but it is not directly listed as an
Up-Front R&D = $15,000,000
expense when calculating earnings.
Up-Front New Equipment = $7,500,000 Instead, the firm deducts a fraction of the
Expected life of the new equipment is 5 years cost of these items each year as
Housed in existing lab
depreciation.
Annual Overhead = $2,800,000
Per Unit Cost = $110 Straight Line Depreciation
The assets cost is divided equally over its life.
Annual Depreciation = $7.5 million 5 years = $1.5
million/year
Interest Expense Taxes
In capital budgeting decisions, interest Marginal Corporate Tax Rate

expense is typically not included. The The tax rate on the marginal or incremental
rationale is that the project should be dollar of pre-tax income. Note: A negative tax is
judged on its own, not on how it will be equal to a tax credit.
financed.
Taxes (cont'd) Incremental Earnings Forecast
Unlevered Net Income Calculation Table 8.1 Spreadsheet HomeNets Incremental

Earnings Forecast
Textbook Example 8.1 Textbook Example 8.1 (cont'd)
Alternative Example 8.1 Alternative Example 8.1
Problem Problem (continued)

NRG, Inc. plans to launch a new line of energy drinks.
What will NRG owe in taxes next year without
The marketing expenses associated with launching the the new energy drinks?
new product will generate operating losses of $500 million
next year for the product. What will it owe with the new energy drinks?
NRG expects to earn pre-tax income of $7 billion from
operations other than the new energy drinks next year.
NRG pays a 39% tax rate on its pre-tax income.
Indirect Effects on Incremental
Alternative Example 8.1
Earnings
Solution Opportunity Cost

Without the new energy drinks, NRG will owe The value a resource could have provided in its
corporate taxes next year in the amount of: best alternative use
$7 billion 39% = $2.730 billion
In the HomeNet project example, space will be
With the new energy drinks, NRG will owe required for the investment. Even though the
corporate taxes next year in the amount of: equipment will be housed in an existing lab, the
$6.5 billion 39% = $2.535 billion opportunity cost of not using the space in an
Pre-Tax Income = $7 billion - $500 million = $6.5 billion
alternative way (e.g., renting it out) must be
Launching the new product reduces NRGs taxes considered.
next year by:
$2.730 billion $2.535 billion = $195 million.
Alternative Example 8.2 Alternative Example 8.2
Problem Solution
Suppose NRGs new energy drink line will be The opportunity cost of the factory is the
housed in a factory that the company could have forgone rent.
otherwise rented out for $900 million per year.
The opportunity cost would reduce NRGs
How would this opportunity cost affect NRGs incremental earnings next year by:
incremental earnings next year? $900 million (1 .39) = $549 million.
Indirect Effects on Incremental Indirect Effects on Incremental
Earnings (cont'd) Earnings (cont'd)
Project Externalities Project Externalities

Indirect effects of the project that may affect the In the HomeNet project example, 25% of sales
profits of other business activities of the firm. come from customers who would have
Cannibalization is when sales of a new product purchased an existing Linksys wireless router if
displaces sales of an existing product. 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
HomeNets incremental earnings.
Sunk Costs and Incremental Sunk Costs and Incremental
Earnings Earnings (cont'd)
Sunk costs are costs that have been or will Fixed Overhead Expenses
be paid regardless of the decision whether Typically overhead costs are fixed and not
or not the investment is undertaken. incremental to the project and should not be
Sunk costs should not be included in the included in the calculation of incremental
incremental earnings analysis. earnings.
Sunk Costs and Incremental Sunk Costs and Incremental
Earnings (cont'd) Earnings (cont'd)
Past Research and Development Unavoidable Competitive Effects

Expenditures When developing a new product, firms may be
Money that has already been spent on R&D is a concerned about the cannibalization of existing
sunk cost and therefore irrelevant. The decision products.
to continue or abandon a project should be However, if sales are likely to decline in any case
based only on the incremental costs and benefits as a result of new products introduced by
of the product going forward. competitors, then these lost sales should be
considered a sunk cost.
Indirect Effects on Incremental
Real-World Complexities
Earnings (cont'd)
Table 8.2 Spreadsheet HomeNets Incremental Typically,
Earnings Forecast Including Cannibalization and Lost
Rent sales will change from year to year.
the average selling price will vary over time.
the average cost per unit will change over time.
8.2 Determining Free Cash Flow Calculating the Free Cash Flow
and NPV from Earnings
The incremental effect of a project on a Capital Expenditures and Depreciation

firms available cash is its free cash flow. Capital Expenditures are the actual cash
outflows when an asset is purchased. These
FCF = Unlevered NI cash outflows are included in calculating free
+ Depreciation cash flow.
- Capital Expenditures
Depreciation is a non-cash expense. The free
- Increments in Net Working Capital
cash flow estimate is adjusted for this non-cash
expense.
Calculating the Free Cash Flow Calculating the Free Cash Flow
from Earnings (cont'd) from Earnings (cont'd)
Net Working Capital (NWC) Table 8.4 Spreadsheet HomeNets Net Working
Capital Requirements
Most projects will require an investment in net

working capital.
Trade credit is the difference between receivables
and payables.
The increase in net working capital is defined as:
Calculating the Free Cash Flow
Textbook Example 8.4
from Earnings (cont'd)
Capital Expenditures and Depreciation

Table 8.3 Spreadsheet Calculation of HomeNets Free Cash Flow
(Including Cannibalization and Lost Rent)
Textbook Example 8.4 (cont'd) Alternative Example 8.4
Problem
Rising Star Inc is forecasting that their sales will
increase by $250,000 next year, $275,000 the
following year, and $300,000 in the third year.
The company estimates that additional cash
requirements will be 5% of the change in sales,
inventory will increase by 7% of the change in
sales, receivables will increase by 10% of the
change in sales, and payables will increase by
8% of the increase in sales. Forecast the
increase in net working capital for Rising Star
over the next three years.
Alternative Example 8.4 (contd) Calculating the NPV
HomeNet NPV (WACC = 12%)

Solution
The required increase in net working capital is
shown below:
Table 8.5 Spreadsheet Computing HomeNets NPV
8.3 Choosing Among Alternatives
8.3 Choosing Among Alternatives
(cont'd)
Launching the HomeNet project produces a Evaluating Manufacturing Alternatives

positive NPV, while not launching the In the HomeNet example, assume the company
project produces a 0 NPV. could produce each unit in-house for $95 if it
spends $5 million upfront to change the
Evaluating Manufacturing Alternatives assembly facility (versus $110 per unit if
outsourced). The in-house manufacturing
method would also require an additional
investment in inventory equal to one months
worth of production.
8.3 Choosing Among Alternatives 8.3 Choosing Among Alternatives
(cont'd) (cont'd)
Evaluating Manufacturing Alternatives Evaluating Manufacturing Alternatives

Outsource In-House
Cost per unit = $110 Cost per unit = $95
Investment in A/P = 15% of COGS Up-front cost of $5,000,000
COGS = 100,000 units $110 = $11 million
Investment in A/P = 15% of COGS
Investment in A/P = 15% $11 million = $1.65 million
NWC = $1.65 million in Year 1 and will increase by $1.65 COGS = 100,000 units $95 = $9.5 million
million in Year 5 Investment in A/P = 15% $9.5 million = $1.425 million
NWC falls since this A/P is financed by suppliers Investment in Inventory = $9.5 million / 12 = $0.792 million
NWC in Year 1 = $0.792 million $1.425 million =
$0.633 million
NWC will fall by $0.633 million in Year 1 and increase by
$0.633 million in Year 5
8.3 Choosing Among Alternatives 8.3 Choosing Among Alternatives
(cont'd) (cont'd)
Evaluating Manufacturing Alternatives
Comparing Free Cash Flows Ciscos
Table 8.6 Spreadsheet NPV Cost of Outsourced Versus Alternatives
In-House Assembly of HomeNet Outsourcing is the less expensive alternative.
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
Problem
Canyon Molding is considering purchasing a new
machine to manufacture finished plastic
products. The machine will cost $50,000 and
falls into the MACRS 3-year asset class. What
depreciation deduction would be allowed for the
machine using the MACRS method, assuming
the equipment is put into use in year 0?
Further Adjustments
Alternative Example 8.5 (contd)
to Free Cash Flow (cont'd)
Solution Liquidation or Salvage Value

Based on the percentages in Table 8A.1, the
allowable depreciation expense for the lab
equipment is shown below:
Further Adjustments
Terminal or Continuation Value

This amount represents the market value of the
free cash flow from the project at all future
dates.
Further Adjustments
Textbook Example 8.7 (cont'd)
Tax Carryforwards
Tax loss carryforwards and carrybacks allow
corporations to take losses during its current
year and offset them against gains in nearby
years.
(cont'd)
Break-Even Analysis Break-Even Analysis

The break-even level of an input is the level Break-Even Levels for HomeNet
that causes the NPV of the investment to equal
zero. Table 8.8 Break-Even Levels for HomeNet
HomeNet IRR Calculation
Table 8.7 Spreadsheet HomeNet IRR Calculation
EBIT Break-Even of Sales

Level of sales where EBIT equals zero
Sensitivity Analysis Sensitivity Analysis (cont'd)
Sensitivity Analysis shows how the NPV Table 8.9 Best- and Worst-Case Parameter Assumptions
varies with a change in one of the for HomeNet
assumptions, holding the other assumptions
constant.
Figure 8.1 HomeNets NPV Under Best-
and Worst-Case Parameter Assumptions
Problem
Assume NRG originally forecasted its marketing
and support costs at $500,000 per year during
years 1 3. Suppose the marking and support
costs could be as low as $200,000 or as high as
$900,000 per year. How would these changes
impact the NPV of the proposed energy drink
project? Recall, NRG pays a 39% tax rate on its
pre-tax income. Assume their cost of capital is
9%.
Alternative Example 8.9 (contd) Alternative Example 8.9 (contd)
Solution. Solution.
We can answer the question by computing the A $300,000 decrease in marketing and support
NPV of the resulting free cash flow, given the costs will increase NRGs EBIT by $300,000 and
change in marketing and support costs. will, therefore increase NRGs free cash flow by
an after-tax amount of:
$300,000 x ( 1 0.39) = $183,000
The present value of this increase is:
thus, the NPV of the project would rise by

$463,227.
Alternative Example 8.9 (contd) Scenario Analysis
Solution. Scenario Analysis considers the effect

A $400,000 increase in marketing and support on the NPV of simultaneously changing
costs will decrease NRGs EBIT by $400,000 and multiple assumptions.
will, therefore decrease NRGs free cash flow by
an after-tax amount of: Table 8.10 Scenario Analysis of Alternative Pricing
Strategies
$400,000 x ( 1 0.39) = $244,000
The present value of this decrease is:
thus, the NPV of the project would fall by

$617,636.
Figure 8.2 Price and Volume Combinations for
HomeNet with Equivalent NPV Chapter HW
1. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will
be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be
$20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that
40% will come from customers who switch to the new, healthier pizza instead of buying the original
version.
a. Assume customers will spend the same amount on either version. What level of incremental
sales is associated with introducing the new pizza?
b. Suppose that 50% of the customers who will switch from Pisa Pizzas original pizza to its
healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza.
What level of incremental sales is associated with introducing the new pizza in this case?
2. Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the
Mini Mochi Munch. Kokomochi plans to spend $5 million on TV, radio, and print advertising this
year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million
this year and by $7 million next year. In addition, the company expects that new consumers who try
the Mini Mochi Munch will be more likely to try Kokomochis other products. As a result, sales of
other products are expected to rise by $2 million each year.
Kokomochis gross profit margin for the Mini Mochi Munch is 35%, and its gross profit margin
averages 25% for all other products. The companys marginal corporate tax rate is 35% both this
year and next year. What are the incremental earnings associated with the advertising campaign?
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Chapter HW Chapter HW
3. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and 5. Cellular Access, Inc. is a cellular telephone service provider that reported net income of $250 million
South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail
for the most recent fiscal year. The firm had depreciation expenses of $100 million, capital
outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last
month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the expenditures of $200 million, and no interest expenses. Working capital increased by $10 million.
new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should Calculate the free cash flow for Cellular Access for the most recent fiscal year.
be included as part of the incremental earnings for the proposed new retail store?
a. The cost of the land where the store will be located.
b. The cost of demolishing the abandoned warehouse and clearing the lot. 6. Castle View Games would like to invest in a division to develop software for video games. To evaluate
c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing
this decision, the firm first attempts to project the working capital needs for this operation. Its chief
outlet become customers of the new store instead. financial officer has developed the following estimates (in millions of dollars):
d. The $10,000 in market research spent to evaluate customer demand.
e. Construction costs for the new store. Assuming that Castle View currently does not have any working capital invested in this division,
calculate the cash flows associated with changes in working capital for the first five years of this investment.
f. The value of the land if sold.
g. Interest expense on the debt borrowed to pay the construction costs.
4. Hyperion, Inc. currently sells its latest high-speed color printer, the Hyper 500, for $350. It plans to lower the price to $300
next year. Its cost of goods sold for the Hyper 500 is $200 per unit, and this years sales are expected to be 20,000 units.
a. Suppose that if Hyperion drops the price to $300 immediately, it can increase this years sales by 25% to 25,000
units. What would be the incremental impact on this years EBIT of such a price drop?
b. Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink cartridges for the next
three years, and Hyperion has a gross profit margin of 70% on ink cartridges. What is the incremental impact on
EBIT for the next three years of a price drop this year?
Copyright 2011 Pearson Prentice Hall. All rights reserved. 7-75 Copyright 2011 Pearson Prentice Hall. All rights reserved. 7-76
Chapter HW Chapter HW
8. You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into
7. Elmdale Enterprises is deciding whether to expand its production facilities. Although your office, drops a consultants report on your desk, and complains, We owe these consultants $1 million for this report, and I am not sure
long-term cash flows are difficult to estimate, management has projected the following cash their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion.
You open the report and find the following estimates (in thousands of dollars):
flows for the first two years (in millions of dollars):
All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be
purchased today (year 0), which is what the accounting department recommended. The report concludes that because the project will increase
a. What are the incremental earnings for this project for years 1 and 2? earnings by $4.875 million per year for 10 years, the project is worth $48.75 million. You think back to your halcyon days in finance class and
realize there is more work to be done!
b. What are the free cash flows for this project for the first two years?
First, you note that the consultants have not factored in the fact that the project will require $10 million in working capital upfront (year 0),
which will be fully recovered in year 10. Next, you see they have attributed $2 million of selling, general and administrative expenses to the
project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that
accounting earnings are not the right thing to focus on!
a. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed
project?
b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project?
Copyright 2011 Pearson Prentice Hall. All rights reserved. 7-77 Copyright 2011 Pearson Prentice Hall. All rights reserved. 7-78
Chapter HW
9. One year ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available
that offers many advantages; you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over 10 years, after
which it has no salvage value. You expect that the new machine will produce EBITDA (earning before interest, taxes, depreciation, and
amortization) of $40,000 per year for the next 10 years. The current machine is expected to produce EBITDA of $20,000 per year. The
current machine is being depreciated on a straight-line basis over a useful life of 11 years, after which it will have no salvage value, so
depreciation expense for the current machine is $10,000 per year. All other expenses of the two machines are identical. The market value
today of the current machine is $50,000. Your companys tax rate is 45%, and the opportunity cost of capital for this type of equipment is
10%. Is it profitable to replace the year-old machine?
10. Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows for this division for the next five
years, and have estimated that the cost of capital is 12%. You would like to estimate a continuation value. You have made the following
forecasts for the last year of your five-year forecasting horizon (in millions of dollars):
a. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate the continuation value in year
5, using the perpetuity with growth formula.
b. You have identified several firms in the same industry as your operating division. The average P/E ratio for these firms is 30.
Estimate the continuation value assuming the P/E ratio for your division in year 5 will be the same as the average P/E ratio for the
comparable firms today.
c. The average market/book ratio for the comparable firms is 4.0. Estimate the continuation value using the market/book ratio.
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Chapter 8 Fundamentals of Capital Budgeting

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Chapter 8 Fundamentals of Capital Budgeting

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Chapter Outline

Chapter 8 8.1 Forecasting Earnings

Copyright 2014 Pearson Education, Inc. All rights reserved. 8-2

Capital Budget Example

Example The $7.5 million in new equipment is a cash

In capital budgeting decisions, interest Marginal Corporate Tax Rate

Unlevered Net Income Calculation Table 8.1 Spreadsheet HomeNets Incremental

Problem Problem (continued)

Solution Opportunity Cost

Project Externalities Project Externalities

Past Research and Development Unavoidable Competitive Effects

The incremental effect of a project on a Capital Expenditures and Depreciation

Most projects will require an investment in net

Capital Expenditures and Depreciation

HomeNet NPV (WACC = 12%)

Table 8.5 Spreadsheet Computing HomeNets NPV

Launching the HomeNet project produces a Evaluating Manufacturing Alternatives

Evaluating Manufacturing Alternatives Evaluating Manufacturing Alternatives

Other Non-cash Items

Timing of Cash Flows

Solution Liquidation or Salvage Value

Terminal or Continuation Value

Break-Even Analysis Break-Even Analysis

Table 8.7 Spreadsheet HomeNet IRR Calculation

EBIT Break-Even of Sales

thus, the NPV of the project would rise by

Solution. Scenario Analysis considers the effect

thus, the NPV of the project would fall by

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