Slide 1Chapter OutlineLearning ObjectivesLearning Objectives (continued)8.1 Forecasting EarningsRevenue and Cost EstimatesRevenue and Cost Estimates (continued)Incremental Earnings ForecastCapital Expenditures and DepreciationInterest ExpenseTaxesTaxes (continued)Textbook Example 8.1Textbook Example 8.1 (continued)Alternative Example 8.1Alternative Example 8.1Alternative Example 8.1Indirect Effects on Incremental EarningsTextbook Example 8.2Textbook Example 8.2 (continued)Alternative Example 8.2Alternative Example 8.2Indirect Effects on Incremental Earnings (continued)Indirect Effects on Incremental Earnings (continued)Indirect Effects on Incremental Earnings (continued)Sunk Costs and Incremental EarningsSunk Costs and Incremental Earnings (continued)Sunk Costs and Incremental Earnings (continued)Sunk Costs and Incremental Earnings (continued)Real-World ComplexitiesTextbook Example 8.3Textbook Example 8.3 (continued)8.2 Determining Free Cash Flow and NPVCalculating the Free Cash Flow from EarningsCalculating the Free Cash Flow from Earnings (continued)Calculating the Free Cash Flow from Earnings (continued)Calculating the Free Cash Flow from Earnings (cont'd)Textbook Example 8.4Textbook Example 8.4 (cont'd)Alternative Example 8.4Alternative Example 8.4 (cont’d)Calculating Free Cash Flow DirectlyCalculating the NPV8.3 Choosing Among Alternatives8.3 Choosing Among Alternatives (cont'd)8.3 Choosing Among Alternatives (cont'd)8.3 Choosing Among Alternatives (cont'd)8.3 Choosing Among Alternatives (cont'd)8.3 Choosing Among Alternatives (cont'd)8.4 Further Adjustments to Free Cash FlowTextbook Example 8.5Textbook Example 8.5 (cont'd)Alternative Example 8.5Alternative Example 8.5 (cont’d)Further Adjustments to Free Cash Flow (cont'd)Textbook Example 8.6Textbook Example 8.6 (cont'd)Further Adjustments to Free Cash Flow (cont'd)Textbook Example 8.7Textbook Example 8.7 (cont'd)Further Adjustments to Free Cash Flow (cont'd)Textbook Example 8.8Textbook Example 8.8 (cont'd)8.5 Analyzing the Project8.5 Analyzing the Project (cont'd)Sensitivity AnalysisSensitivity Analysis (cont'd)Slide 68Textbook Example 8.9Textbook Example 8.9 (cont'd)Alternative Example 8.9Alternative Example 8.9 (cont’d)Alternative Example 8.9 (cont’d)Alternative Example 8.9 (cont’d)Scenario AnalysisSlide 76Discussion of Data Case Key TopicChapter QuizChapter Quiz (cont’d)Slide 80Slide 81Chapter 8Fundamentals of Capital BudgetingCopyright ©2014 Pearson Education, Inc. All rights reserved.Chapter Outline8.1 Forecasting Earnings8.2 Determining Free Cash Flow and NPV8.3 Choosing Among Alternatives8.4 Further Adjustments to Free Cash Flow8.5 Analyzing the ProjectCopyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives1. Given a set of facts, identify relevant cash flows for a capital budgeting problem.2. Explain why opportunity costs must be included in cash flows, while sunk costs and interest expense must not.3. Calculate taxes that must be paid, including tax loss carryforwards and carrybacks.Copyright ©2014 Pearson Education, Inc. All rights reserved.Learning Objectives (continued)5. Calculate free cash flows for a given project.6. Illustrate the impact of depreciation expense on cash flows.7. Describe the appropriate selection of discount rate for a particular set of circumstances8. Use break-even analysis, sensitivity analysis, or scenario analysis to evaluate project risk.Copyright ©2014 Pearson Education, Inc. All rights reserved.8.1 Forecasting Earnings•Capital Budget–Lists the investments that a company plans to undertake•Capital Budgeting–Process used to analyze alternate investments and decide which ones to accept•Incremental Earnings–The amount by which the firm’s earnings are expected to change as a result of the investment decisionCopyright ©2014 Pearson Education, Inc. All rights reserved.Revenue and Cost Estimates•Example–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 Price = $260Copyright ©2014 Pearson Education, Inc. All rights reserved.Revenue and Cost Estimates (continued)•Example–Cost Estimates•Up-Front R&D = $15,000,000•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 = $110Copyright ©2014 Pearson Education, Inc. All rights reserved.Incremental Earnings ForecastTable 8.1 Spreadsheet HomeNet’s Incremental Earnings ForecastCopyright ©2014 Pearson Education, Inc. All rights reserved.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.•Straight Line Depreciation–The asset’s cost is divided equally over its life–Annual Depreciation = $7.5 million ÷ 5 years = $1.5 million/yearCopyright ©2014 Pearson Education, Inc. All rights reserved.Interest Expense•In capital budgeting decisions, interest expense is typically not included. The rationale is that the project should be judged on its own, not on how it will be financed.Copyright ©2014 Pearson Education, Inc. All rights reserved.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 creditCopyright ©2014 Pearson Education, Inc. All rights reserved.Taxes (continued)•Un-levered Net Income CalculationCopyright ©2014 Pearson Education, Inc. All rights reserved.Textbook Example 8.1Copyright ©2014 Pearson Education, Inc. All rights reserved.Textbook Example 8.1 (continued)Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Example 8.1•Problem–NRG, Inc. plans to launch a new line of energy drinks.–The marketing expenses associated with launching the new product will generate operating losses of $500 million next year for the product. –NRG expects to earn pre-tax income of $7 billion from operations other than the new energy drinks next year.–NRG pays a 39% tax rate on its pre-tax income.Copyright ©2014 Pearson Education, Inc. All rights reserved.Alternative Example 8.1•Problem (continued)–What will NRG owe in taxes next year without the new energy drinks? –What will it owe