CAPITAL BUDGETINGCapital 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 flow s 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 anew project on the firm’s cash flows?Figure Cash Flows in a Typical ProjectSome 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, ev aluate 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 steps1. Calculate incremental earnings2. Make adjustments to get incremental cash flows3. Discount all cash flows at the cost of capital to get the NPV1. 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 incomeExample: 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 HomeNetproject?Example: Incremental Earnings• We need four items to calculate incremental earnings: 1. incremental revenues2. incremental costs3. depreciation4. the marginal tax rate• Incremental Revenues are: o additional units sold  price = 50,000  $260 = $13,000,000 per year• Incremental Production Costs are: o additional units sold  production costs = 50,000  $110 = $5,500,000 per year• Incr. Selling, General and Administrative Costs: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 tax es and interest• Why positive eff ect from tax es 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 tak e into account:—Capital Expenditures—Depreciation—Changes in Net Working Capital—Terminal valuesCapital 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 flow s actually happenExample: 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 eff ect on cash flows when it is eventually freed upExample: Changes in Net Working Capital•