Example of capital budgetingExample of capital budgeting

Forecasting earningsForecasting earnings

Determining Free Cash Flow and NPVDetermining Free Cash Flow and NPV

Analyzing the projectAnalyzing the project

SetupSetup

Linksys, a division of Cisco Systems, is Linksys, a division of Cisco Systems, is considering development of a wireless considering development of a wireless home networking appliance, HomeNethome networking appliance, HomeNet

Linksys has already conducted an Linksys has already conducted an intensive, $300,000 feasibility study to intensive, $300,000 feasibility study to assess the attractiveness of the new assess the attractiveness of the new productproduct

Forecasting EarningsForecasting Earnings

Revenue and cost estimatesRevenue and cost estimates Sales forecast: 100,000 units per yearSales forecast: 100,000 units per year Product will have a 4-year lifeProduct will have a 4-year life Wholesale price: $260 per unitWholesale price: $260 per unit Cost of outsourcing production: $110 per unitCost of outsourcing production: $110 per unit Engineering and design costs: $5 mlnEngineering and design costs: $5 mln Software engineering:Software engineering:

50 engineers needed50 engineers neededCost of software engineer $200,000 per yearCost of software engineer $200,000 per yearWill take one year to completeWill take one year to complete

Testing lab: $7.5 mlnTesting lab: $7.5 mln Marketing and support: $2.8 mln per yearMarketing and support: $2.8 mln per year

HomeNet’s Incremental Earnings HomeNet’s Incremental Earnings Forecast (Spreadsheet)Forecast (Spreadsheet)

Capital expenditures and depreciationCapital expenditures and depreciation $7.5 mln was invested in a lab$7.5 mln was invested in a lab Assuming 5-year life for the lab and straight line depreciation we Assuming 5-year life for the lab and straight line depreciation we

get $1.5 mln annual depreciation expense.get $1.5 mln annual depreciation expense.

Interest is Interest is not includednot included into calculation. Usually in capital into calculation. Usually in capital budgeting we evaluate a project budgeting we evaluate a project as ifas if it is financed only it is financed only through equity. Any adjustment for debt financing – in through equity. Any adjustment for debt financing – in the discount rate (we discuss this in a few lectures).the discount rate (we discuss this in a few lectures).Hence we get Hence we get UnleveredUnlevered Net Income Net Income

Taxes = EBIT*(1-Taxes = EBIT*(1-cc)) You should use You should use marginalmarginal tax rate tax rate Don’t forget to Don’t forget to addadd taxes when the project taxes when the project reducesreduces the taxable the taxable

income of your firmincome of your firm

Notes on the forecast spreadsheet Notes on the forecast spreadsheet

Indirect effects on Incremental Indirect effects on Incremental EarningsEarnings

Have we missed anything in our Have we missed anything in our calculations?calculations?

Yes:Yes: Opportunity costsOpportunity costs Project externalities (side effects)Project externalities (side effects)

Accounting for Opportunity CostsAccounting for Opportunity Costs

Project ExternalitiesProject Externalities

Suppose that 25% of HomeNet’s sales come Suppose that 25% of HomeNet’s sales come from customers who would have purchased an from customers who would have purchased an existing Linksys appliance if HomeNet were not existing Linksys appliance if HomeNet were not available.available.Such reduction in sales of an existing product is Such reduction in sales of an existing product is called called cannibalizationcannibalization..We should account for it. It affects Sales and We should account for it. It affects Sales and Costs of Goods SoldCosts of Goods SoldRemark: project externalities can also be Remark: project externalities can also be positive (synergies)positive (synergies)

Accounting for Cannibalization Accounting for Cannibalization

Assuming the existing appliance is sold for Assuming the existing appliance is sold for $100. So, the expected loss in sales:$100. So, the expected loss in sales:

25% 25% 100,000 units 100,000 units $100/unit = $2.5 $100/unit = $2.5 mlnmln

Assuming the cost of existing appliance is Assuming the cost of existing appliance is $60 per unit. So, the expected reduction in $60 per unit. So, the expected reduction in costs of goods sold:costs of goods sold:

25% 25% 100,000 units 100,000 units $60/unit = $1.5 mln $60/unit = $1.5 mln

HomeNet’s Incremental Earnings Forecast HomeNet’s Incremental Earnings Forecast Including Cannibalization and Lost Rent Including Cannibalization and Lost Rent

(Spreadsheet)(Spreadsheet)

Sunk CostsSunk Costs

Why did not we include $300,000 spent on Why did not we include $300,000 spent on the feasibility study?the feasibility study?

It’s sunk and should have no effect on our It’s sunk and should have no effect on our decision about the projectdecision about the project In reality managers sometimes tend to justify In reality managers sometimes tend to justify

going on with a project on the ground that “we going on with a project on the ground that “we can’t give up after so much money has can’t give up after so much money has already been spent”already been spent”

Determining Free Cash FlowDetermining Free Cash Flow

What is the relation between the Cash Flow to investors What is the relation between the Cash Flow to investors we computed in lecture 3 and Free Cash Flow?we computed in lecture 3 and Free Cash Flow?

Here Here it isit is in fact Cash Flow to investors, but as if the project is in fact Cash Flow to investors, but as if the project is unlevered (hence, no interest, no differences in net borrowing)unlevered (hence, no interest, no differences in net borrowing)

Remember we had CF to investors = CF from operations – CF Remember we had CF to investors = CF from operations – CF from investment – from investment – ΔΔCash + interest.Cash + interest.

When the firm is unlevered: CF from operations = Unlevered Net When the firm is unlevered: CF from operations = Unlevered Net Income + Depreciation – Income + Depreciation – ΔΔNWC + NWC + ΔΔCashCash

CF from investment = CapExCF from investment = CapEx

Hence, we obtain precisely the formula aboveHence, we obtain precisely the formula above

Calculation of HomeNet’s Free Cash Flow Calculation of HomeNet’s Free Cash Flow (Including Cannibalization and Lost Rent) (Including Cannibalization and Lost Rent)

(Spreadsheet)(Spreadsheet)

Notes on FCF calculationNotes on FCF calculationDepreciation – not a cash expense. Hence, must be added backDepreciation – not a cash expense. Hence, must be added backCapEx – money spent on the testing lab, $7.5 mlnCapEx – money spent on the testing lab, $7.5 mlnNWC = Current Assets – Current Liabilities = Cash + Inventory + NWC = Current Assets – Current Liabilities = Cash + Inventory + Receivables – Payables.Receivables – Payables.Assume Cash = Inventory = 0, Receivables = 15% of annual sales, Assume Cash = Inventory = 0, Receivables = 15% of annual sales, Payables = 15% of annual cost of goods sold.Payables = 15% of annual cost of goods sold.Note: we implicitly assume that NWC requirements for the Note: we implicitly assume that NWC requirements for the cannibalized business of Cisco are the same. In reality, recevables cannibalized business of Cisco are the same. In reality, recevables for HomeNet = 15% for HomeNet = 15% 26 mln = 3.9 mln, but receivables of the 26 mln = 3.9 mln, but receivables of the cannibalized business fall by 15% cannibalized business fall by 15% 2.5 mln = 0.375 mln. Hence, 2.5 mln = 0.375 mln. Hence, the net Receivables = 3.525 mln. For Payables, cash and inventory the net Receivables = 3.525 mln. For Payables, cash and inventory – the same.– the same.

NoteNote

FCF can be rewritten asFCF can be rewritten as

The last term is called depreciation tax The last term is called depreciation tax shield – tax savings resulting from the shield – tax savings resulting from the ability to deduct depreciationability to deduct depreciation

Computing HomeNet’s NPV Computing HomeNet’s NPV (Spreadsheet)(Spreadsheet)

mln 027.5)1(

)(5

0

5

0

t

tt

tt r

FCFFCFPVNPV

factordiscount year - – )1(

1t

r t

Choosing among alternativesChoosing among alternatives

Assume instead of outsourcing production for $110 per Assume instead of outsourcing production for $110 per unit Cisco could assemble the product in-house at a cost unit Cisco could assemble the product in-house at a cost of $95 per unit. But this would require $5 mln of upfront of $95 per unit. But this would require $5 mln of upfront operating expenses to reorganize the assembly facility. operating expenses to reorganize the assembly facility. In addition, Cisco will need to maintain inventory equal to In addition, Cisco will need to maintain inventory equal to one month’s production.one month’s production.

We can exclude from calculations things that do not We can exclude from calculations things that do not differ between the projects, and include only what differsdiffer between the projects, and include only what differs

Cannibalization and lost rent effects do not change – Cannibalization and lost rent effects do not change – excludeexcludeSales revenues do not change – excludeSales revenues do not change – excludeCost of sales (ignoring cannibalization) changes: $11 Cost of sales (ignoring cannibalization) changes: $11 mln for outsourcing, $9.5 mln for in-house. In addition, in mln for outsourcing, $9.5 mln for in-house. In addition, in year 0, $5 mln in operating expenses appear for in-year 0, $5 mln in operating expenses appear for in-house. EBIT, Tax and Net Income change house. EBIT, Tax and Net Income change correspondingly.correspondingly.CapEx do not change - excludeCapEx do not change - excludeNWC changes:NWC changes:

Change in the amount of Payables. Payables were 15% Change in the amount of Payables. Payables were 15% $11 $11 mln = $1.65 mln (ignoring cannibalization). Now they are 15% mln = $1.65 mln (ignoring cannibalization). Now they are 15% $9.5 mln = $1.425 mln (ignoring cannibalization).$9.5 mln = $1.425 mln (ignoring cannibalization).

Now we have inventory requirement = $9.5 mln / 12 = $0.792 Now we have inventory requirement = $9.5 mln / 12 = $0.792 mlnmln

Hence, ignoring Receivables that do not change:Hence, ignoring Receivables that do not change:For outsourcing, NWC = -$1.65 mlnFor outsourcing, NWC = -$1.65 mlnFor in-house production, NWC = Inventory – Payables = $0.792 mln For in-house production, NWC = Inventory – Payables = $0.792 mln - $1.425 mln = -$0.633 mln- $1.425 mln = -$0.633 mln

NPV Cost of Outsourced Versus In-House NPV Cost of Outsourced Versus In-House Assembly of HomeNet (Spreadsheet), using only Assembly of HomeNet (Spreadsheet), using only

cash flows that differcash flows that differ

Outsourced Assembly is better!Outsourced Assembly is better!

Accounting for liquidation (salvage) Accounting for liquidation (salvage) valuevalue

If you sell some assets at the end of the project If you sell some assets at the end of the project this generates cash.this generates cash.Imagine the salvage value of the lab’s Imagine the salvage value of the lab’s equipment in the end of year 5 is $2 mln. It’s equipment in the end of year 5 is $2 mln. It’s book value in the end of year 5 is $0 mln. We book value in the end of year 5 is $0 mln. We could sell the equipment for $2 mln, but we could sell the equipment for $2 mln, but we would have to pay taxes on capital gain:would have to pay taxes on capital gain: cc(Sale Price – Book Value) = 40% * $2 mln = $0.8 (Sale Price – Book Value) = 40% * $2 mln = $0.8

mlnmln Hence the cash from the sale = 2 – 0.8 = 1.2 mlnHence the cash from the sale = 2 – 0.8 = 1.2 mln We would have to account for this cash in year 5.We would have to account for this cash in year 5.

Accounting for terminal Accounting for terminal (continuation) values(continuation) values

For long-lived projects sometimes cash For long-lived projects sometimes cash flows are forecasted until year T and then flows are forecasted until year T and then certain assumption about the cash flow certain assumption about the cash flow growth starting from T+1 is made.growth starting from T+1 is made.That allows to compute a That allows to compute a terminal valueterminal value at at T T as ifas if the project is finished is T and the the project is finished is T and the cash equal to the terminal value is cash equal to the terminal value is realized. Then this terminal value is used realized. Then this terminal value is used in NPV calculationin NPV calculation

Example of accounting for Example of accounting for continuation valuecontinuation value

Accounting for inflationAccounting for inflation

Simply discount cash flows correctly:Simply discount cash flows correctly: If real values are used, use real R.If real values are used, use real R. If nominal values – use nominal R.If nominal values – use nominal R.

1 + Rn = (1 + Rr)(1 + i)1 + Rn = (1 + Rr)(1 + i)

Rr Rr Rn – i Rn – i

CFrCFrtt = CFn = CFntt/(1 + i)/(1 + i)tt

Some things to rememberSome things to remember

Use only Use only incrementalincremental cash flows (i.e. the cash flows (i.e. the changes in the firm’s cash flows that occur as a changes in the firm’s cash flows that occur as a consequence of the project)consequence of the project) Note: pay attention to side effects (like cannibalization Note: pay attention to side effects (like cannibalization

and synergies)and synergies)

Ignore sunk costsIgnore sunk costsDon’t ignore opportunity costsDon’t ignore opportunity costsDon’t forget working capital requirementsDon’t forget working capital requirementsDon’t forget liquidation values (or costs) and Don’t forget liquidation values (or costs) and terminal valuesterminal valuesBe careful with inflationBe careful with inflation