2. Capital Budgeting Process Chap 9

• Chapter focuses on capital budgeting, forecasting incremental earnings, determining free cash flow, analyzing the project, and real options.

The Capital Budgeting Process

• Capital budget is a list of projects a firm plans to undertake.
• Capital budgeting encompasses the process a firm uses to analyze projects and decide which ones to undertake.
• Incremental earnings refer to the change in earnings expected from an investment decision.

Forecasting Incremental Earnings

• Estimating incremental revenue and costs are vital to this process.
• Initially, a new product typically experiences lower sales.
• Over time, the average selling price and production costs tend to fluctuate.
• Profit margins tend to decrease over time in most industries due to competition.
• The aim is to evaluate how the project will alter the firm's cash flows. A focus on incremental revenues and costs is most important.
• Operating expenses are distinct from capital expenditures. Capital expenditures are not initially listed as an expense, but as depreciation or capital cost allowance (CCA).
• CCA has the required amount for tax purposes.
• Incremental Earnings Before Interest and Taxes (EBIT) is calculated as Incremental Revenue minus Incremental Costs and Depreciation.
• Income Tax = EBIT multiplied by the firm's marginal corporate tax rate.
• Need to determine the marginal corporate tax rate a firm will pay on an incremental dollar of pre-tax income.

Incremental Earnings Example, HomeNet Project

• HomeNet aims to control a variety of Internet-capable devices, facing major competition from Brandt-Quigley Corporation.
• Sales forecasts estimate 50,000 units per year for HomeNet, and the product's life span is expected to be four years with a wholesale price of $260 per unit ($110 per unit outsourced).
• A new lab is necessary to verify the compatibility of new consumer Internet-ready appliances.
• A $7.5 million investment in new equipment is needed which will be depreciated using the straight-line method over five years, the marginal tax rate is 40%.
• The company is also forecasted to spend $2.8 million per year on the lab space rental, marketing, and support.
• To calculate incremental earnings, it's essential to determine: incremental revenues, incremental costs, depreciation, and the marginal tax rate.
  • Incremental Revenues: 50,000 units sold multiplied by $260 = $13,000,000
  • Incremental Costs: 50,000 units sold multiplied by $110 = $5,500,000
• Selling, general, and administrative expenses amount to $2,800,000 for rent, marketing, and support.
• Depreciation is calculated as: $7,500,000 (Depreciable basis) divided by 5 (Depreciable Life) = $1,500,000
• The length of the project is four years but the equipment has a 5 year life and a final depreciation charge is applicable in year 5.

Taxes

• These incremental earnings are an intermediate step in calculating the incremental cash flows for the HomeNet analysis.
• Equipment costs influence earnings over five years through depreciation, not immediately.
• Depreciable life of an asset may differ from its economic life.
• Incremental earnings are forecasted using a pro forma statement and hypothetical assumptions.
• Taxes and negative EBIT reduce taxable income.
• Interest expense is excluded and treated as a separate financial decision.
• Unlevered net income assumes the company is not leveraging debt.

Taxing Losses Example, Kellogg

• Kellogg plans to introduce high-fiber, gluten-free breakfast pastries, resulting in a $15 million operating loss in the first year due to advertising.
• Without the pastries, $460 million would be earned from pretax income and the company would owe $184 million in corporate taxes (40% tax rate).
• With the new product, pretax income will be $445 million, resulting in $178 million in taxes with losses.
• Launching the new product reduces the firms taxes by a total of $6 million.
• Losses make the new product have a tax bill of negative $6 million.

Determining Incremental Free Cash Flow

• Converting from earnings to free cash flow is the process to determine the project's value.
• Free cash flow is the incremental effect of a project on a firm's available cash.
• Capital expenditures and the capital cost allowance (CCA) should also be factored into these calculations.

Incremental Free Cash Flow Example, HomeNet Project

• Need to recognize the $7.5 million outflow to determine if Cisco should invest in the HomeNet project.
• This examples free cash flow will depend on the $7.5 outlay of cash.
• The $1.5 million depreciation expenses should be added back from years 1-5, as these are non-cash outflows.
• Recognizing the $7.5 million outflow leaves $7.5 million left from the firm.
• Depreciation expenses from years 1-5 must be added back to accurately estimate depreciation, which is a non cash flow.

Net Working Capital

• Net Working Capital = Current Assets − Current Liabilities = Cash + Inventory + Receivables  Payables
• The difference between receivables and payables is the firm's capital consumption from credit transactions.
• Change in NWC in Year t = NWCt  NWCt  1

Net Working Capital Example

• HomeNet will have no incremental cash, with direct shipment from the contract manufacturer to customers.
• Receivables are 15% and payables are also 15% related to COGS, with annual Net Working Capital requirements shown in a table.

Net Working Capital Impacts

• Any increase to Net Working Capital reduces cash flow for the firm.
• Reduction of free cash flow occurs as cash outflow, corresponding to the sales a firm earns not yet paid.
• In years 2-4, net working capital does not change, so no contributions are needed.
• For year 5 capital falls by $1.125, then this is added to free cash flow in year 5 as the payments of the last customers are received and the final bills are paid.
• The cash flows for the net free income result in the cash flow effects of capital expenditures on equipment, depreciation, as well as changes in working capital.
• During the first year, free cash flow is lower than unlevered net income, reflecting the up-front investment in equipment.
• In later years free cash flow exceeds unlevered net income because depreciation is not a cash expense.
• In the last year, the firm ultimately recovers the investment in net working capital, further boosting the free cash flow.

Free Cash Flow Equation

• Free Cash Flow = (Revenues - Costs - Depreciation) x (1 – Tax Rate) + Depreciation - CapEx - Change in NWC
• Free Cash Flow = Unlevered Net Income + Depreciation - CapEx - Change in NWC
• Free Cash Flow = (Revenues - Costs) x (1- Tax Rate) - CapEx - Change in NWC + Tax Rate × Depreciation

Net Present Value

• To compute a project's NPV, one must discount its free cash flow at the appropriate cost of capital.
• Discounted cash flows (DCF) is a method to use forecasts of free cash flow to find the value of a specific project.
• PV(FCF) = FCFt / (1 + r)t = FCFt × 1 / (1 + r)t (t-year discount factor)

Calculating NPV Example

• Managers believe that the costs of HomeNet project are similar to its existing portfolio and has a cost of 12%.
• Sum the HomeNet cash flow values, noting year 0 outflow is already in the present.
• Based on estimates, HomeNet's NPV is $2.862 million.
• HomeNet's upfront cost is $7.5 million, but the present value the firm receives totals 10.362 million.
• Taking HomeNet project is equivalent to Cisco having an extra $2.862 million in the bank today.

Analyzing a Project

• Sensitivity analysis is a capital budgeting tool where we can determine how NPV changes as we change a single underlying assumption.
• Best- and worst-case assumptions for project HomeNet include:
  • Units Sold: 50,000 (Initial), 35,000 (Worst), 65,000 (Best)
  • Sales Price: $260, $240, $280
  • COGS: $110, $120, $100
  • Net Working Capital: $1125, $1525, $725
  • Cost of Capital: 12%, 15%, 10%

Break-Even Analysis

• Break-Even includes a parameter for which there is an NPV of zero.
• Accounting Break-Even represents an EBIT Break-Even.
• EBIT is a level for which the project's EBIT is equal to zero.
  • Units Sold × (Sale Price − Cost per Unit) − SG&A − Depreciation = 0

Scenario Analysis

• Scenario analysis involves varying many underlying assumptions simultaneously.
• Scenario analysis of alternative pricing strategies
  • Current Strategy
    • $260 Price
    • 50,000 Expected Units Sold
    • NPV = $2862 million
  • Price Reduction
    • $245 Price
    • 55,000 Expected Units Sold
    • NPV = $2729 million
  • Price Increase
    • $275 Price
    • 45,000 Expected Units Sold
    • NPV = $2729 million