Fundamentals of Capital Budgeting:
From Forecasting Earnings to Project
Dr. Himanshu Joshi
FORE School of Management
• In July 2006, Ratan Tata, Chairman of Tata
Motors, announced to the shareholders at the
annual general body meeting that the
company would be launching a Tata Nano- A
car that would be sold for Rs. 1 Lakh only. He
said that the launch of the car would create a
new paradigm in low cost personal transport,
carve-out a new market segment, and reach a
broader base of pyramid.
• The decision of Tata Motors to launch Nano
represents the typical capital budgeting decision.
• How would the managers of the Tata Motors
make a decision about this investment?
• What will be the impact of this decision on the
value of the company and wealth of its
• The managers of Tata Motors have to evaluates
the benefits and the costs of the Nano car
• We will discuss tools for evaluating projects such
as Tata Nano…
FORE -casting Earnings
• A Capital Budget lists the project and investments
that a company plans to undertake during the
coming year. To determine this list, firm analyze
alternate projects and decide which one to
accept through a process called capital budgeting.
• This process begins with the forecasts of the
project’s future consequences for the firm.
• Some of the consequences will affect its revenues
and others will affect its costs.
• Our ultimate goal is to determine the effect of
the decision on the firm’s cash flows.
Cash Flows Vs. Earnings..
• For the purpose of Project evaluation cash
flows are important not the earnings.
However, as a practical matter, to derive the
forecasted cash flows of the project, financial
managers often begin by determining the
incremental earnings of a project…
• Linksys is a division of CISCO systems, a maker of consumer
networking hardware. Linksys is considering the
development of a wireless home networking appliance,
called HomeNet, that will provide both the hardware and
the software necessary to run an entire home from any
internet connection. In addition to the connecting PCs and
Printers, Home Net will control new internet capable
stereos, digital video recorder, heating and air-conditioning
units, major appliances, telephone and security systems,
office equipment, and so on.
• Linksys has already conducted an intensive, $3,00,000
feasibility study to assess the attractiveness of the new
• HomeNet’s target market is upscale residential “smart”
homes and home offices. Based on extensive marketing
surveys, the sales forecast for HomeNet is 1,00,000 units
per year. Given the pace of technological change, Linksys
expects the product will have a four year life. It will be sold
through high end stereo and electronics stores for a retail
price of $375, with an expected wholesale price of $260.
• Developing the new hardware will be relatively
inexpensive, as existing technologies can be repackaged in
a newly designed, home friendly box. Industrial design
team will make the box and packaging aesthetically
pleasing to the residential market. Linksys expect total
engineering and design costs to amount to $5 million.
Once the design is finalized, actual production will be
outsourced at a total cost (including packaging) of $110 per
• In addition to the hardware requirements, Linksys must build a new
software application to allow virtual control of home through web.
This software development project requires coordination with each
of the web appliance manufacturers and is expected to take a
dedicated team of 50 software engineers a full year to complete.
The cost of a software engineer (including benefits and related
costs) is $2,00,000 per year.
• To verify the compatibility of new consumer-internet-ready
appliances with the HomeNet system as they become available,
Linksys must also build a new lab for testing purposes. The lab will
occupy existing facilities but will require $7.5 million of new
• The software and hardware design will be completed, and the lab
will be operational at the end of one year. At that time, HomeNet
will be ready to ship. Linksys expects to spend $2.8 million per year
on marketing and support for this project.
Incremental Earnings Forecast
Capital Expenditure and Depreciation
• While investments in plant, equipment and
property are cash expenses, they are not directly
listed as expenses when calculating earnings.
Instead the firm deducts a fraction of the cost of
these items each year as depreciation.
• If we assume straight-line depreciation over a life
of five years for the lab equipment, HomeNet’s
depreciation expense is $1.5 million per year.
• To compute the firm’s net income, we must first
deduct interest expenses from EBIT. When
evaluating a capital budgeting decision like the
HomeNet project, however, generally we do not
include interest expense.
• Any incremental interest expenses will be related
to the firm’s decision regarding how to finance
• Here we wish to evaluate the project on its own,
separate from financing decision.
• So we calculate unlevered income.
• The final expense we must account for is
corporate taxes. The correct tax rate to use is
the firm’s marginal corporate tax rate, which is
the tax rate it will pay on an incremental dollar
of pre-tax income.
• Incremental income tax = EBIT * Tc
• Where Tc is the firm’s marginal tax rate.
• In year 1, HomeNet will contribute an
additional $10.7 million to Cisco’s EBIT, which
will result in $10.7 million* 40% = $4.28
million in corporate tax that Cisco will owe.
• We deduct this amount to determine
HomeNet’s net income.
• In year 0, however, HomeNet’s EBIT is
negative. Are taxes relevant in this case?
• Yes HomeNet’s will reduce the Cisco’s taxable
income in year 0 by $15 million.
• As long as Cisco earns taxable income elsewhere
in year 0 against which it can offset HomeNet’s
losses, Cisco will owe $15 million* 40% = $6
million less in taxes in year 0.
• The firm should credit this tax savings to the
• A similar credit applies in year 5, when a firm
claims its final depreciation expense.
Unlevered income calculation
• Unlevered Net Income = EBIT * (1-Tc)
• = (Revenues – Costs –Depreciation) * (1-Tc)
Indirect Effects on Incremental
• All changes between the firm’s earnings with
project Versus firm’s earnings without the
• Thus far we have analyzed only the direct
effects of HomeNet project.
• It may also have indirect effects on Cisco’s
• Many projects use a resource that company already
owns. Because the firm does not need to pay cash to
acquire this resource for a new project, it is tempting
to assume that the resource is available for free.
• The opportunity cost of using a resource is the value it
could have provided in its best alternative use.
• Because this value is lost when the resource is used by
the another project, we should include the opportunity
cost as an incremental cost of the project.
• Is there any opportunity cost in case of
Opportunity Costs in HomeNet
• Space will be required for the new lab. Even
though the lab will be housed in an existing
facility, we must include opportunity cost of not
using the space in an alternative way.
• Suppose HomeNet’s lab will be housed in
warehouse space that the company would have
otherwise rented out for $2,00,000 per year
during 1-4 years. How does this opportunity cost
affect HomeNet’s incremental earnings.
• Project externalities are indirect effects of the
project that may increase or decrease the
profits of other business activities of the firm.
This is called cannibalization.
• Suppose that 25% of HomeNet’s sales come
from customers who would have purchased
an existing Linksys wireless router (wholesale
price $100 per unit and unit cost $60 ) if
HomeNet were not available.
Sunk Costs and External Earnings
• A sunk cost is any unrecoverable cost for which
firm is already liable. Sunk cost have been or will
be paid regardless of the decision whether or not
to proceed with the project.
• Therefore they are not incremental with respect
to current decision and should not be included in
• For this reason we did not include in our analysis
the $3,00,000 already expended on marketing
and feasibility studies.
Other Sunk costs
• Fixed Overhead Expenses
• Past Research and Development Expenses.
Real- World Complexities
• Unit sold.
• Price changes.
• Manufacturing cost
Determining Free Cash Flow and NPV
• Calculating Free Cash Flows from Earnings.
• Capital Expenditure and Depreciation:
Depreciation is not a cash expense paid by the
firm. Rather it is a method used for accounting
and tax purposes to allocate the original cost of
asset over its life. So it should be added back to
determine the free cash flows.
• Capital Expenditure we have to subtract the
original cost of the equipment $7.5 million in the
Net Working Capital
• Net W. Capital = Current Assets – Current Liab.
• = cash + inventory + receivables – payables
• The difference between receivables and payables
is called trade deficit.
• Suppose that HomeNet will have no incremental
cash or inventory requirements
(products will be shipped directly from the
contract manufacturer to customers). However
receivables related to HomeNet are expected to
account for 15% of sales, and the payables are
expected to be 15% of COGS.
HomeNet’s Net W.C Requirement
HomeNet’s Free Cash Flows
Calculating Free Cash Flows Directly
• Free Cash Flows = (Revenues – Costs –
Depreciation) (1-Tc) + Depreciation – Capex –
∆ Net Working Capital
Free Cash Flow = (Revenues – Costs)* (1-Tc) –
Capex - ∆ Net Working Capital + Depreciation*
Depreciation Tax Shield
• Depreciation Tax Shield = Depreciation * Tc
• Often firms report a different depreciation
expense for accounting and for tax purposes.
• Because only tax consequences of
depreciation expense are relevant for free
cash flows, we should use depreciation
charged by the firm for tax purposes only.
Calculating NPV of HomeNet
• “= NPV(r, FCF1:FCF5) + FCF0”
Choosing Among Alternatives
• Because not launching HomeNet produces an
additional NPV of zero for the firm, launching
HomeNet is the best decision for the firm if its
NPV is positive.
• It is a choice between launching HomeNet or
Not Launching HomeNet.
Evaluating Manufacturing Alternatives
• Suppose Cisco is considering an alternative
manufacturing plan for the HomeNet product.
It could assemble the product in house at a
cost of $95 per unit. however, it will require $5
million in upfront operating expenses to
recognize the assembly facility and Cisco will
need to maintain inventory equal to one
Evaluating Manufacturing Alternatives
• When comparing between these two
alternatives, we compute the free cash flows
associated with each choice and Compare
• We need to compare only those cash flows
that differ between them.
• As we can ignore HomeNet’s revenue as it
continue to be same in both the case.
Timing of Cash Flows
• For simplicity, we have treated cash flows for
HomeNet as if they occur at annual interval. In
reality cash flows will spread through out the
• We can forecast cash flows on quarterly,
monthly, or even on continues basis.
Liquidation or Salvage Value
• Some assets may have some salvage value when they
are no longer needed.
• However, some assets may have negative salvage
• In the calculation of free cash flows, we include the
liquidation value of any assets that are no longer
needed and may be disposed of.
• When an asset is liquidated, any capital gain is taxed as
• Capital Gain = Sale Price – Book Value
• Book Value = Assets Original Cost – Accumulated
Liquidation or Salvage Value
• We must adjust the project’s free cash flows
to account for the after-tax cash flows that
would result from an asset sale:
• After tax cash flow from sale of asset = Sale
Price – (Tc*Capital Gain)
• Suppose that in addition to $7.5 million in new
equipment required for HomeNet’s lab, another
equipment will be transferred to the lab from
another Linksys facility.
• This equipment has a resale value of $2 million
and a book value of $1 million. If the equipment
is kept rather than sold, its remaining value can
be depreciated next year. when the lab is shut
down in year 5, the equipment will have a salvage
value of $8,00,000. what adjustment we must
make to HomeNet’s free cash flows in this case?