Lecture 1

Chapter 8

Fundamentals of
Capital Budgeting

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 Chapter Outline

8.1 Forecasting Earnings

8.2 Determining Free Cash Flow and NPV
8.3 Choosing Among Alternatives
8.4 Further Adjustments to Free Cash Flow
8.5 Analyzing the Project
8.6 Discussion and Main Takeaways

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 8.1 & 8.2 Forecasting Earnings &
Determining Cash Flows
• 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

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 8.1 Revenue and Cost Estimates

• Example
– Linksys has completed a $300,000 feasibility
study to assess the attractiveness of a new
product, HomeNet. The project has an estimated
life of four years.
– Revenue Estimates
• Sales = 100,000 units/year
• Per Unit Price = $260

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 8.1 Revenue and Cost Estimates
(cont'd)
• Example
– Cost Estimates
• Up-Front R&D = $15,000,000
• Up-Front New Equipment = $7,500,000
– Expected life of the new equipment is five years.
– Housed in existing lab

• Annual Overhead = $2,800,000

• Per Unit Cost = $110

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 8.1 Incremental Earnings
Forecast
Table 8.1 Spreadsheet HomeNet’s Incremental
Earnings Forecast

What about $300,000 feasibility study?

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 8.1 Indirect Effects on
Incremental Earnings (cont'd)
Table 8.2 Spreadsheet HomeNet’s Incremental
Earnings Forecast Including Cannibalization and Lost
Rent 25% x #100,000 x $100 = $2.5m

25% x #100,000 x $60 = $1.5m

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 8.2 Calculating the Free Cash
Flow from Earnings
Table 8.4 Spreadsheet HomeNet’s Net Working
Capital Requirements

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 8.2 Calculating the Free Cash
Flow from Earnings (cont'd)
• Capital Expenditures and Depreciation
Table 8.3 Spreadsheet Calculation of HomeNet’s Free Cash Flow
(Including Cannibalization and Lost Rent)

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 8.2 Calculating Free Cash Flow
Directly
• Free Cash Flow
!""""""""" #"""""""""$
Unlevered Net Income

Free Cash Flow = (Revenues - Costs - Depreciation) ´ (1 - tc )

+ Depreciation - CapEx - DNWC

Free Cash Flow = (Revenues - Costs) ´ (1 - tc ) - CapEx - DNWC

+ tc ´ Depreciation

– The term tc Depreciation is called the

depreciation tax shield.

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 8.2 Calculating the NPV
FCFt 1
PV ( FCFt ) = = FCFt ´
(1 + r ) t
(1 + r )t
!"#" $
t = year discount factor

• HomeNet NPV (WACC = 12%)

NPV = - 16,500 + 4554 + 5740 + 5125 + 4576 + 1532
= 5027
Table 8.5 Spreadsheet Computing HomeNet’s NPV

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 8.3 Choosing Among Alternatives

• Launching the HomeNet project produces a

positive NPV, while not launching the
project produces a 0 NPV.

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 8.3 Choosing Among Alternatives
(cont'd)
• Evaluating Internalization vs.
Externalization Alternatives
– In the HomeNet example, assume the company
could produce each unit in-house for $95 if it
spends $5 million upfront to change the
assembly facility (versus $110 per unit if out-
house). The in-house manufacturing method
would also require an additional investment in
inventory equal to one month’s worth of
production.

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 8.3 Choosing Among Alternatives
(cont'd)
• Evaluating Manufacturing Alternatives
– Out-house
• Cost per unit = $110
• Investment in A/P = 15% of COGS
– COGS = 100,000 units $110 = $11 million
– Investment in A/P = 15% $11 million = $1.65 million
» ΔNWC = –$1.65 million in Year 1 and will increase by $1.65
million in Year 5
» NWC falls since this A/P is financed by suppliers

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 8.3 Choosing Among Alternatives
(cont'd)
• Evaluating Manufacturing Alternatives
– In-House
• Cost per unit = $95
• Up-front cost of $5,000,000
• Investment in A/P = 15% of COGS
– COGS = 100,000 units $95 = $9.5 million
– Investment in A/P = 15% $9.5 million = $1.425 million
– Investment in Inventory = $9.5 million / 12 = $0.792 million
– ΔNWC 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

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 8.3 Choosing Among Alternatives
(cont'd)
• Evaluating Manufacturing Alternatives
Table 8.6 Spreadsheet NPV Cost of Out-house Versus In-
House Assembly of HomeNet

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 8.3 Choosing Among Alternatives
(cont'd)
• Comparing Free Cash Flows
– Outsourcing is the less expensive alternative.

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 8.4 Further Adjustments
to Free Cash Flow
• Liquidation or Salvage Value

Capital Gain = Sale Price - Book Value

Book Value = Purchase Price - Accumulated Depreciation

After-Tax Cash Flow from Asset Sale = Sale Price - (tc ´ Capital Gain)

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 8.4 Further Adjustments
to Free Cash Flow (cont’d)

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 8.4 Further Adjustments
to Free Cash Flow (cont’d)

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 8.4 Further Adjustments
to Free Cash Flow (cont’d)
• Terminal or Continuation Value
– This amount represents the market value of the
free cash flow from the project at all future
dates and it can be a function of, for example,
the trailing EBIT

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 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.
– HomeNet IRR Calculation

Table 8.7 Spreadsheet HomeNet IRR Calculation

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 8.5 Analyzing the Project
(cont'd)
• Break-Even Analysis
– Break-Even Levels for HomeNet

Table 8.8 Break-Even Levels for HomeNet

– EBIT Break-Even of Sales

• Level of sales where EBIT equals zero

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 8.5 Analyzing the Project
(cont'd)
• Sensitivity Analysis shows how the NPV
varies with a change in one of the
assumptions, holding the other assumptions
constant.

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 8.5 Analyzing the Project
(cont'd)
Table 8.9 Best- and Worst-Case Parameter Assumptions
for HomeNet

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 8.5 Analyzing the Project
(cont'd)

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 8.5 Analyzing the Project
(cont'd)
• Scenario Analysis considers the effect
on the NPV of simultaneously changing
multiple assumptions.
Table 8.10 Scenario Analysis of Alternative Pricing
Strategies

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 8.6 Discussion and Main
Takeaways
• NPV(Internalization) vs.
NPV(Externalization)
• Innovation Finance:
– Knowledge-drive (asset specificity, nonexcludable,
nonrival) and intellectual property rights
– Internalize (set-up costs and attract private/venture
equity) or license (royalties)?
– Private/venture equity: appropriability, uncertainty and
asymmetric information (internalization)

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