Finance Chapter: Project Evaluation Techniques

Capital Budgeting Fundamentals

• Capital budgeting is the process of analyzing investment opportunities, ultimately deciding which ones to accept
• Goal is to maximize firm value
• NPV is the most accurate and reliable method for allocating resources
• Projects with positive NPV should be accepted
• Cash flows are crucial inputs for NPV calculation

Forecasting Earnings

• Capital budget lists projects and investments for the coming year
• Capital budgeting begins with forecasting future consequences
• Revenues and costs are identified and analyzed
• Goal determine NPV of cash flow consequences
• Earnings aren't cash flow; incremental earnings are crucial for forecasted cash flows
• Incremental earnings represent changes in earnings due to an investment
• Revenue and cost estimates are assessed for the target market
• Existing technologies can be adapted for new hardware
• Software applications are developed to provide control over the home
• Pre-existing equipment investments are required

Incremental Earnings Forecast

• Using revenue and cost estimates, incremental earnings are forecasted
• Sales occur over four years
• Production costs are $110 per unit
• Gross profit is calculated by subtracting production costs from sales
• Operating expenses such as marketing and support are included
• Research and development costs are one-time expenses
• Depreciation is an expense that is not a cash expense; it represents the allocation of asset cost over time
• Separate depreciation expenses, calculated using straight-line or other methods, are deducted
• Income tax is calculated at the firm's marginal corporate tax rate
• Unlevered net income = Earnings before interest and taxes × (1 - Marginal corporate tax rate)

Interest Expenses

• Firm's interest expenses are not factored in when deciding on capital budgeting
• Instead, the project is evaluated without considering the financing
• The appropriate cost of capital is incorporated into the NPV calculation
• Firm's treatment of capital expenditures for earnings is one reason earnings aren't a cash flow

Taxing Losses

• Corporate tax rates are considered
• Tax is calculated as Earnings before interest and taxes × Marginal corporate tax rate or EBIT × τ
• Tax saving from depreciation is called depreciation tax shield
• The tax rate used to compute depreciation expense is the marginal corporate tax rate
• Losses can be used to reduce current taxable income
• Tax loss carryforwards potentially reduce future taxable income

Project Externalities

• Some projects might have indirect effects on other business activities
• Some investments might displace sales of other products (called cannibalization)
• Any changes to other business activities should be included in incremental earnings
• Any changes in the costs, due to project externalities, should be considered as well

Taxes

• Firms use their marginal corporate tax rates
• Firms can deduct a portion of the project's purchase price when using MACRS (Modified Accelerated Cost Recovery System)
• The Tax Cut and Jobs Act of 2017 allows firms to deduct a full portion of the purchase price as bonus depreciation

Sunk Costs

• Sunk cost is any unrecoverable cost already incurred for which the firm is liable
• Sunk costs are not factored into capital budgeting analysis
• Sunk costs do not affect future cash flows, so they are irrelevant

Net Working Capital

• Net working capital (NWC) is calculated as current assets less current liabilities
• Components of NWC include cash, inventory, accounts receivable, and accounts payable
• NWC changes in a project affect free cash flows
• NWC changes should be included in free cash flow calculation

Free Cash Flow

• Free cash flow represents the incremental effect of the capital budgeting project on the company's available cash
• Free cash flow is calculated by adjusting earnings by removing non-cash expenses and including cash inflows
• Cash flows are adjusted for capital investments and changes in working capital

Project Valuation/Analysis

• NPV calculation calculates the difference between present value and the project cost
• Goal is to identify the factors that most impact the project's NPV
• Sensitivity and scenario analyses evaluate the impact of varying factors (i.e. costs, revenues) on the NPV
• Break-even levels for parameters (sales or prices) are calculated to determine when NPV becomes zero
• Different depreciation methods (MACRS, straight-line) impact NPV calculations as they affect the timing and magnitude of tax savings.
• Terminal value is the value of the project beyond the explicit forecast horizon

This quiz explores various project evaluation techniques in finance, focusing on outsourcing vs. in-house production, cash flow analysis, and the calculation of free cash flow. Assess your understanding of key concepts like NPV, cost of capital adjustments, and the importance of accurate cash flow estimation. Ideal for finance students looking to solidify their grasp on project evaluation methods.