Tutorial 07

The document provides an overview of capital budgeting fundamentals from a finance textbook. It includes sample questions and answers about key concepts like incremental earnings and determining free cash flow. The document is intended to help students review topics related to capital investment decisions.

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Tutorial 07

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FINA2203

Spring 2022‐23

Tutorial 7

Topic Review
• Chapter 9: Fundamentals of Capital Budgeting

1
9.1 The Capital Budgeting Process
Question 1
Which of the following best defines incremental earnings?

A) Cash flows arising from a particular investment decision.

B) The amount by which a firm's earnings are expected to change as
a result of an investment decision.
C) The earnings arising from all projects that a company plans to
undertake in a fixed time span.
D) The net present value (NPV) of cash flow that a firm is expected to
receive as the result of an investment decision.

9.1 The Capital Budgeting Process

Incremental earning means that we should only be looking at the
additional revenues and costs for a project. A firm's earnings
(Revenues – Costs) are expected to change as a result of an
investment decision.

• Option A is wrong. Earnings are not actual cash flow. (E.g.

Depreciation)
• Option C is wrong. It should be a chosen project, not ALL projects.
• Option D is wrong. NPV includes all cash items, but earnings are
subject to depreciation which is a non‐cash item.

Answer: B

2
9.2 Forecasting Incremental Earnings
Question 2
CathFoods will release a new range of candies which contain anti‐oxidants.
New equipment to manufacture the candy will cost $4 million, which will be
depreciated by straight‐line depreciation over six years. In addition, there
will be $5 million spent upfront on promoting the new candy line. It is
expected that the range of candies will bring in revenues of $6 million per
year for five years with production and support costs of $1.5 million per
year. If CathFoods’ marginal tax rate is 35%, what are the incremental
earnings in the second year of this project?

A) $2.492 million
B) $2.100 million
C) $3.833 million
D) $1.342 million

9.2 Forecasting Incremental Earnings

• Incremental Revenue per year: $6 million

• Incremental Cost per year: $1.5 million
• Depreciation per year: $4 million/6 years = $0.667 million
• Earnings before interest and tax (EBIT):
$6 million – $1.5 million – $0.667 million = $3.833 million
• With marginal tax rate 35%, incremental earnings in second year:
$3.833 million × (1 – 35%) = $2.492 million

Answer: A

3
9.3 Determining Incremental FCF
Question 3
Bubba Ho‐Tep Company reported net income of $290 million for the
most recent fiscal year. The firm had depreciation expenses of $100
million and capital expenditures of $150 million. Although it had no
interest expense, the firm did have an increase in net working capital
of $30 million. What is Bubba Ho‐Tep's free cash flow?

A) $10 million
B) $210 million
C) $270 million
D) $570 million