CAPITAL BUDGETING Capital budgeting Capital Budgeting Process of analyzing investment opportunities and deciding which ones to accept Tool the NPV rule by now we all know how to use the NPV rule But to use NPV we need cash flows of a project What is Cash Flow NOT accounting earnings We are interested in actual cash flows that accrue to investors Why might these be different We also only care about how a project will incrementally change the cash flows of the firm Today s goal how to figure out the incremental effect of a new project on the firm s cash flows Figure Cash Flows in a Typical Project Some Capital Budgeting Rules Four basic ingredients in cash flows are Revenues costs investments taxes Depreciation is NOT a cash flow But it does affect taxes Interest expense is NOT a cash flow for now We want to separate the investment and financing decisions So for now evaluate projects as if they are all equity financed Include only cash flows that are incremental Ignore sunk costs Don t forget opportunity costs E g real estate own time Three steps 1 Calculate incremental earnings 2 Make adjustments to get incremental cash flows 3 Discount all cash flows at the cost of capital to get the NPV 1 Forecasting Incremental Earnings Incremental Earnings Before Interest and Taxes EBIT Incr Revenues Incr Cost Incr Depreciation Incremental Earnings after taxes Incr Revenues Incr Costs Incr Depreciation 1 Marginal Tax Rate Marginal Corporate Tax Rate The tax rate a firm will pay on an incremental dollar of pre tax income Example Incremental Earnings Linksys is considering developing a new wireless home networking gadget HomeNet Sales and cost forecasts Annual sales of 50 000 units per year Four year life Wholesale price of 260 Unit production costs of 110 The project also requires A new testing and support lab which will cost 2 8 million per year rent personnel costs etc Purchasing new equipment for 7 5 million Will be depreciated straight line over a 5 year life Linksys marginal tax rate is 40 HomeNet would be ready to ship in one year What are the forecasted incremental earnings from the HomeNet project Example Incremental Earnings We need four items to calculate incremental earnings 1 2 3 4 incremental revenues incremental costs depreciation the marginal tax rate Incremental Revenues are Incremental Production Costs are Incr Selling General and Administrative Costs o additional units sold price 50 000 260 13 000 000 per year o additional units sold production costs 50 000 110 5 500 000 per year o 2 800 000 per year Depreciation is o Depreciable basis Depreciable Life 7 500 000 5 1 500 000 per year over five years Marginal Tax Rate o 40 Example Incremental Earnings Note Even though the project lasts for 4 years the equipment has a 5 year life so we must account for the final depreciation charge in the 5th year The cost of the equipment does not affect earnings in the year it is purchased year 0 but does so through the depreciation expense in the following five years Note on taxes and interest Why positive effect from taxes in the fifth year Negative EBIT provides a tax credit Leads to lower taxes on the firm s other projects as long as the firm is profitable otherwise i e a positive incremental impact on cash flows Interest expenses For now we ignore financing Why 2 Converting from Earnings to Free Cash Flow Need to take into account Capital Expenditures Depreciation Changes in Net Working Capital Terminal values Capital Expenditures and Depreciation Capital expenditures are cash flows but are not captured in incremental earnings when they happen Instead capital expenditures are recognized in earnings as depreciation over time But depreciation expenses do not correspond to actual cash outflows We need to adjust incremental earnings for capital expenditures and depreciation to accurately capture when the cash flows actually happen Example Capital expenditures and depreciation In the HomeNet example We recognize the 7 5 million cash outflow associated with the equipment purchase in year 0 Add back the 1 5 million depreciation expenses from year 1 to 5 as these are not actually cash outflows Why first subtract depreciation and then add it back Can t we instead just ignore depreciation Changes in Net Working capital Net Working Capital NWC Current Assets Current Liabilities Cash Inventory Receivables Payables An increase in NWC ties up cash For example if the project requires inventory or if it leads to higher receivables if the firm s customers don t pay immediately Effect on cash flows Negative effect on cash flows when additional NWC is tied up Positive effect on cash flows when it is eventually freed up Example Changes in Net Working Capital Suppose receivables related to HomeNet are expected to account for 15 of annual sales 1 95 million and payables are expected to be 15 of the annual cost of goods sold 825 000 And suppose no inventory is required HomeNet s net working capital requirements are shown in the following table How does this affect the project s free cash flows Example Changes in Net Working Capital In year 1 NWC increases by 1 125 million 1 950 million of the firm s sales and 0 825 million of its costs have not yet been paid for in year 1 Negative 1 125 million effect on cash flows In years 2 4 net working capital does not change No effect on cash flows In year 5 when the project is shut down net working capital falls by 1 125 million The payments of the last customers are received and the final bills are paid Positive 1 125 million effect on cash flows Example Changes in Net Working Capital Bringing everything so far together we see that incremental Free Cash Flows are different from Incremental Earnings because of Capital Expenditures and Depreciation Changes in NWC Calculating Free Cash Flow Directly Free Cash Flow Revenues Costs Investments Taxes This is equal to the way we calculated FCF in the previous slides i e EBIT 1 taxrate Depreciation Investments To see this Free Cash Flow Revenues Costs Investments Taxes Revenues Costs Investments taxrate Revenues Costs Depreciation 1 taxrate Revenues Costs Investments taxrate Depreciation 1 taxrate Revenues Costs Depreciation Investments taxrate Depreciation 1 taxrate Depreciation EBIT 1 tc Depreciation Investments Note EBIT Revenues Costs Depreciation Tax Rate x Depreciation Depreciation Tax Shield Investments here include e g Capital Expenditures Change in NWC etc 3 Calculating the NPV To compute the project s NPV we must