Fundamentals of

Capital Budgeting

Chapter 8
Learning objectives
• Given the data of the problem, identify relevant cash
flows for a capital budgeting problem

• Explain why opportunity costs must be included in cash

flows, while sunk costs and interest expenses must not

• Calculate taxes that must be paid

• Calculate free cash flows for a given project

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Learning objectives

• Illustrate the impact of depreciation expense on

cash flows

• Describe the appropriate selection of discount

rate for a particular set of circumstances (more
on cost of capital later)

• Use breakeven analysis, sensitivity analysis, or

scenario analysis to evaluate project risk
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Some first definitions
• Capital Budgeting

• Process used to analyze alternate investments and decide which ones to accept

• There are several steps involved:

1) Forecast incremental earnings

2) Forecast working capital

3) Forecast incremental cash flows

4) Analyze (determine the NPV, IRR, etc.)

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Some first definitions

• Incremental earnings

• The amount by which the firm’s earnings are

expected to change as a result of the investment
decision

• Direct effects – revenues and expenses

• Indirect effects – opportunity costs and

externalities
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Reminder from Lecture 1
1 (+) Sales revenues
2 (−) Cost of sales ~ Variable costs
(=) Gross profit
3 (−) Selling, general, and administrative expenses
4 (−) R&D ~ Fixed costs
5 (−) Depreciation & Amortization
(=) Operating income
6 (+) Other income
7 (−) Other expenses
(=) Earnings before interest and taxes (EBIT)

The first objective is to populate forecasted incremental PNL

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An example of revenue and cost
estimates
• Linksys has completed a $300,000 feasibility study to
assess the attractiveness of a new product, HomeNet.
The project has an estimated life of four years

• Revenue Estimates

• Sales = 100,000 units/year

• Per Unit Wholesale Price = $260

• Per Unit Retail Price = $375

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An example of revenue and cost
estimates
• Cost Estimates

• Up-Front R&D = $15,000,000

• Design = $5 000 000

• Engineering = $10 000 000 ( 50 engineers * $200 000 / year = $10 000 000 )

• Up-Front New Equipment = $7,500,000

• Expected life of the new equipment is 5 years

• Housed in existing lab

• Annual Overhead = $2,800,000

• Per Unit Cost = $110

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Capital expenditures and
depreciation
• The $7.5 million in new equipment is a cash expense, but it is not
directly listed as an expense when calculating earnings

• Instead, the firm deducts a fraction of the cost of these items each year
as depreciation.

• One possible method: straight line depreciation

• The asset’s cost is divided equally over its life.

• Annual Depreciation = $7.5 million ÷ 5 years = $1.5 million/year

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(Financial) Interest expense

• In capital budgeting decisions, interest expense

is typically not included

• Why? Because the project should be judged on

its own operational ability to generate cash, not
on how it will be financed

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Taxes

• Marginal Corporate Tax Rate

• The tax rate on the marginal or incremental dollar of

pre-tax income. Note: A negative tax is equal to a tax
credit

Income Tax = EBIT  c

• Why incremental?

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Taxes (cont'd)

• First do not consider (passive) financial interests

and the corresponding tax shield:

• Unlevered Net Income Calculation

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An example of revenue and cost
estimates

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Incremental earnings and
opportunity cost
• Recall the concept of opportunity cost:

• The value a resource could have provided in its best alternative use

• In the calculation of the incremental earnings, do not forget to take

account for the opportunity cost of using a resource!

• HomeNet example: space will be required for the investment. Even

though the equipment will be housed in an existing lab, the opportunity
cost of not using the space in an alternative way (e.g., renting it out)
must be considered

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Incremental earnings and
opportunity cost

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Incremental earnings and
externalities
• Investing in a project may cause externalities

• Indirect effects of the project that may affect the

profits of other business activities of the firm

• An example of externality: cannibalization is when

sales of a new product displaces sales of an existing
product

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Incremental earnings and
externalities
• Follow up of the HomeNet:

• In the HomeNet project example, 25% of sales come from customers

who would have purchased an existing Linksys wireless router if
HomeNet were not available

• Because this reduction in sales of the existing wireless router is a

consequence of the decision to develop HomeNet, we must include it
when calculating HomeNet’s incremental earnings

• Wholesale price of the Old router = $100

• Cost of the Old router = $60

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Incremental earnings and
externalities
• Loss of sales from the cannibalization:

• 25% * 100 000 units * $100 / unit = $2.5 million

• Reduction of costs from the cannibalization:

• 25% * 100 000 units * $60 / unit = $1.5 million

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Incremental earnings and
externalities

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Incremental earnings and sunk
costs
• How to treat sunk costs in capital budgeting
decisions

• Sunk costs are costs that have been or will be

paid regardless of the decision whether or not
the investment is undertaken

• Sunk costs should not be included in the

incremental earnings analysis
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Incremental earnings and sunk
costs
• Examples of Sunk Costs:

• Fixed Overhead Expenses

• Typically they are fixed and not incremental to the project

• Past Research and Development Expenditures

• Money that has already been spent on R&D is a

sunk cost and therefore irrelevant. The decision to continue or
abandon a project should be based only on the incremental costs
and benefits of going forward

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Exercise 1
• The Weber-Decker Co. just paid $1 million in cash for a building, as part of a
new capital budgeting project. Assume straight-line depreciation over 20
years

• What is the relevant cash outflow at date 0 for capital budgeting purposes?
What are the relevant accounting expenses over time?

A. 1M, 1M

B. 50k, 1M

C. 1M, 50k

D. 50k, 50k

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Solution to Exercise 1: C

• For capital budgeting purposes, the relevant

cash outflow at date 0 is the full $1 million
(CapEx)

• Assuming straight-line depreciation over 20

years, only $50,000 ($1 million/20 years) are
considered accounting expenses starting year 1

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Exercise 2
• The General Milk Company is currently evaluating the
NPV of establishing a line of chocolate milk. As part of
the evaluation the company had paid a consulting firm
$100,000 to perform a test-marketing analysis. This
expenditure was made last year. Is this cost relevant for
the capital budgeting decision now confronting the
management? (Yes or NO, explain)

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Solution to Exercise 2: No
• The $100,000 is not recoverable, so the $100,000
expenditure is a sunk cost

• Of course, the decision to spend $100,000 for a

marketing analysis was a capital budgeting decision itself
and was perfectly relevant before it was sunk

• Once the company incurred the expense, the cost

became irrelevant for any future decision

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Exercise 3
• Suppose the Innovative Motors Corporation (IMC) is determining the NPV of
a new convertible sports car. 50% of the customers who would purchase
this new car would have bought of IMC’s compact sedan (old car). The
Gross Profit of the new car (excluding erosion from cannibalization) is
currently estimated at $100m

• What is the true Gross Profit of the new car if the plan is to sell 12,000 units
of new cars and sedans (old cars) are currently produced at a cost of
$15,000 and their sales price is $40,000?

A. −140m C. +150m

B. +190m D. −50m

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Solution to Exercise 3: D
• Loss of sales:

• 50% x 12,000units x $40,000 = −$240m

• Reduction of cost:

• 50% x 12,000units x $15,000 = $90m

• True Gross Profit:

• $100m − $150m = −$50m

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Steps (reminder)

• There are several steps involved:

1) Forecast incremental earnings

2) Forecast working capital

Free cash flows
calculation
3) Forecast incremental cash flows

4) Analyze (determine the NPV, IRR, etc.)

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Determining Free Cash Flow
• The incremental effect of a project on a firm’s available cash is its
free cash flow

• How to calculate the free cash flow starting from earnings:

• Capital Expenditures and Depreciation

• Capital Expenditures are the actual cash outflows when an asset is

purchased. These cash outflows are included in calculating free cash flow

• Depreciation is a non-cash expense. The free cash flow estimate is

adjusted for this non-cash expense

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Net working capital (NWC)
• (N)WC is generically defined as Current assets less Current liabilities
Net Working Capital = Current Assets − Current Liabilities
= Cash + Inventory + Receivables − Payables
• However, we often exclude cash from this

• Most projects will require an investment in net

working capital

• The increase in net working capital is defined as:

NWCt = NWCt − NWCt − 1

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An example of calculation of the
NWC
• Rising Star Inc is forecasting that their sales will increase by $250,000 next year,
$275,000 the following year, and $300,000 in the third year

• The company estimates that

• additional cash requirements will be 5% of the change in sales,

• inventory will increase by 7% of the change in sales,

• receivables will increase by 10% of the change in sales,

• payables will increase by 8% of the increase in sales.

• Forecast the increase in net working capital for Rising Star over the next three years

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An example of calculation of the
NWC

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Calculating the Free Cash Flow
from earnings: NWC

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 Exercise 4
• Castle View Games would like to invest in a division to develop software for video
games. To evaluate this decision, the firm first attempts to project the working capital
needs for this operation. Its chief financial officer has developed the following
estimates (in million of dollars)

• Assuming that Castle View currently does not have any working capital invested in this
division, calculate the cash flows associated with changes in working capital for the
first five years of this investment

Year 1 Year 2 Year 3 Year 4 Year 5

Cash required 4 12 14 16 14
Accounts Receivable 20 22 24 25 26
Inventory 6 9 12 13 15
Accounts Payable 17 20 25 25 33
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Solution to Exercise 4
• Net working capital: Cash + Inventory + Receivables – Payables

NWCt = NWCt − NWCt − 1

• Change in NWC:

• Change in working capital for year 1: $ 13 million

• Change in working capital for year 2: $ 10 million

• Change in working capital for year 3: $ 2 million

• Change in working capital for year 4: $ 4 million

• Change in working capital for year 5: $ -7 million

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Calculating Free Cash Flow

• Free Cash Flow:

Unlevered Net Income

Free Cash Flow = (Revenues − Costs − Depreciation)  (1 − c )

+ Depreciation − CapEx − NWC

• The term 𝜏c × Depreciation is called the

depreciation tax shield
Free Cash Flow = (Revenues − Costs)  (1 − c ) − CapEx − NWC
+ c  Depreciation

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Calculating Free Cash Flow

• Interpretation of the depreciation tax shield:

• Lower taxes paid due to an accounting cost

• Reminder: the treatment of financial costs does

not enter in the Free Cash Flow

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Determining Free Cash Flow
and NPV

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Exercise 5
• Elmdale Enterprises is deciding whether to expand its production
facilities. Although long-term cash flows are difficult to estimate,
management has projected the following cash flows for the first two
years (in million of dollars). What are the incremental earnings and
free cash flows in each year?
Year 1 Year 2
Revenues 101,6 163,5
COGS & Op. Expenses 36,1 41,1
Depreciation 23,3 34,8
Increase in NWC 4,3 8,3
CAPEX 34,3 42,9
Marginal Corporate Tax Rate 34% 34%

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Solution to Exercise 5
• Incremental earnings calculation:

(Revenues − COGS − Depreciation) × (1 − T)

• Incremental earnings for year 1: $27.9 m

• Incremental earnings for year 2: $57.8 m

• Free cash flow calculation:

• Unl. Net Income + Depr. − CAPEX − 𝚫NWC

• Free cash for for year 1: $12.6 m

• Free cash for for year 2: $41.4 m

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Steps (reminder)

• There are several steps involved:

1) Forecast incremental earnings

2) Forecast working capital

3) Forecast incremental cash flows

4) Analyze (determine the NPV, IRR, etc.)

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Calculating the NPV

FCFt 1
PV ( FCFt ) = = FCFt 
(1 + r ) t
(1 + r )t
t = year discount factor

• HomeNet NPV (r = 12%)

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Further adjustments to Free
Cash Flow
• Other Non-cash Items (e.g. Amortization of intangible assets)

• Timing of Cash Flows (Seasonality)

• Cash flows are often spread throughout the year

• Accelerated Depreciation

• Modified Accelerated Cost Recovery System

(MACRS) depreciation

• Maybe interesting for tax advantages (from the depreciation tax shield)

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Further adjustments to Free
Cash Flow
• Liquidation or Salvage Value

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Further adjustments to Free Cash
Flow – continuation Value
• Terminal or continuation value

• This amount represents the market value of the free cash flow
from the project at all future dates.

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Continuation Value: an Example

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Exercise 7
• Bay Properties is considering starting a commercial real estate
division.

• It has prepared the following four-year forecast of free cash flows for
this division
Year 1 Year 2 Year 3 Year 4
Free Cash Flow −$168,000 −$5,000 $100,000 $174,000

• Compute the continuation value assuming that after year 4 cash

flows will grow at a constant growth rate of 3% and that the
opportunity cost is 18%.

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Solution to Exercise 7

• Continuation value calculation:

FCF(4) x (1 + g) / (r − g) =

= $174,000 x (1.03) / (0.18 – 0.03)

= $ 1,194,800

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Exercise 8
• Your firm would like to evaluate a proposed new operating division. You have
forecasted cash flows for this division for the next five years and have estimated that
the cost of capital is 13%. You would like to estimate a continuation value. You have
made the following forecasts for the last year of your five-year forecasting horizon (in
million of dollars)

• You forecast that future cash flows after year 5 will grow at 5% per year, forever.
Estimate the continuation value in year 5, using the growing perpetuity formula

Year 5
Revenues $ 209
Operating income $ 71
Net income $ 46
Free cash flows $ 116
Book value of equity $ 267
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Solution to Exercise 8

• PV(growing perp.) = FCF(5) x (1 + g) / (r − g)

= $ 116 x (1.05) / (0.13 − 0.05)

= $ 1,523

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Analyzing the project

• Break-Even Analysis

• The break-even level of an input is the level that

causes the NPV of the investment to equal zero

• Sensitivity Analysis

• Sensitivity Analysis shows how the NPV varies with a

change in one of the assumptions, holding the other
assumptions constant

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Sensitivity Analysis - Example

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HomeNet’s NPV Under Best- and
Worst-Case Assumptions

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Takeaways
• To understand whether the investment project is worth investing into,
we need to forecast its cash flows and compute the NPV

• This requires a careful forecasting of incremental earnings

• Earnings are not cash flows hence non-cash items and movements
in the working capital need consideration

• Investment analysis can involve simple measures like NPV/IRR/etc.

but also more complex sensitivity/scenario/Monte-Carlo analyses as
well

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