Fundamentals of capital budgeting

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					Fundamentals of Capital Budgeting:
From Forecasting Earnings to Project
           Cash Flows
          Dr. Himanshu Joshi
      FORE School of Management
                 Tata Nano
• 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.
                  Tata Nano
• 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.
             Interest Expenses
• 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
  the project.
• 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
  HomeNet Project.
• 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
             Opportunity Costs.
• 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
  HomeNet Project??
   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
• 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.
Table 2
 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
  its analysis.
• 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
•   Competition
 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
  year 0.
          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
  month’s production.
Evaluating Manufacturing Alternatives
• When comparing between these two
  alternatives, we compute the free cash flows
  associated with each choice and Compare
  their NPV.
• 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?