Advanced Financial Management: Class 2 Capital Budgeting & Free Cash Flow Professor Janis Skrastins

Advanced Financial Management
Class 2
Capital Budgeting
& Free Cash Flow
Professor Janis Skrastins

Outline
 Capital budgeting methods

 The NPV, IRR, and Payback rules
 Mutually exclusive Investments
 Free Cash Flow (FCF)

 Concept and computation of FCF
 Incremental FCF for Projects
2 FIN 448 / Janis Skrastins

Capital Budgeting Methods

Motivation for Investment Decision Rules
 Only undertake investment opportunities that have

positive NPVs.
 Compare the PV of Benefits to the PV of the Costs
 In practice, however, firms rely on a multiplicity of

project selection criteria…

Project Evaluation Approaches
CFO Survey: Investment Evaluation Techniques
NPV, 75%
IRR, 75%
Payback, 50%
Book rate of
return, 20%
Profitability
Index, 12%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”
Journal of Financial Economics 61 (2001), pp. 187-243.

Major Project Evaluation Techniques
 Net Present Value (NPV)
 PV of project cash flows, discounted at the opportunity cost of capital, net
of capital outlay
 It is the wealth created in present dollars after accounting for the
opportunity cost of capital
 The NPV rule: Only take projects that have positive NPVs
 Internal Rate of Return (IRR)

 Determines the discount rate that sets NPV to $0
 The IRR rule: Only take projects with an IRR greater than the discount
rate (positive NPV)
 Payback Period (PP)

 Number of years required to recover project’s initial investment
 The Payback rule: Only take projects that repay the initial investment in
less than a set number of years

Example 2.1
 You are looking at a new project, and you have

estimated the following cash flows:
 Year 0: CF = –$165,000
 Year 1: CF = $63,120
 Year 2: CF = $70,800
 Year 3: CF = $91,080
 Your required rate of return for investments of this sort

of risk is 12%.

Computing NPV for the Project
 Using the formulas:

$63,120 $70,800 $91,080
𝑁𝑃𝑉 = −$165,000 + + 2
+ 3
1 + 12% 1 + 12% 1 + 12%
= $12,627.41
Do we accept or reject the project?

Payback Period
 How long does it take to get the initial cost back in a

nominal sense?
 Computation:
 Estimate the cash flows
 Subtract the future cash flows from the initial cost until
the initial investment has been recovered
 The Payback rule: Accept if the payback period is less

than some preset limit

Computing Payback for the Project
 Assume we will accept the project if it pays back within

two years.
 Year 1: $165,000 – $63,120 = $101,880 still to recover
 Year 2: $101,880 – $70,800 = $31,080 still to recover
 Year 3: $31,080 – $91,080 = –$60,000 project pays
back in year 3
Do we accept or reject the project?

Advantages and Disadvantages of Payback
Advantages Disadvantages
 Easy to understand  Ignores the time value of
 Adjusts for uncertainty of money
later cash flows  Requires an arbitrary
 Biased towards liquidity cutoff point
 “Rough” measure of risk  Ignores cash flows
beyond the cutoff date
 Biased against long-term
projects, e.g., research
and development, and
new projects

Anheuser-Busch (BUD) in China
 Acquisition of interests (up to 27%) in Tsingtao Brewery in the 90s
(sold after the InBev acquisition)
 Acquisition of Harbin Brewery in 2004, fully owned by Anheuser-
Busch InBev
 Currently, out of the 15 Anheuser-Busch breweries outside the

U.S., 14 are positioned in China.
 Budweiser is the 4th brand in the Chinese beer market.
 Commercials in China
https://www.youtube.com/watch?v=g0MgYnGaw6w
https://www.youtube.com/watch?v=n024O7EBRmI
https://www.youtube.com/watch?v=e-iMM-fBb4s
But it took over 10 year for BUD’s China project to break even!
Internal Rate of Return
 Most important alternative to NPV
 Often used in practice and is intuitively appealing
 Based entirely on the estimated cash flows and is

independent of interest rates found elsewhere
 Definition: IRR is the return (i.e., the discount rate) that

makes the NPV = 0
 The IRR rule: Accept the project if the IRR is greater

than the required return

Computing IRR for the Project
 If you do not have a financial calculator or spreadsheet,

then this becomes a trial and error process (i.e., make
an educated guess at the rate, and then ‘iterate’ to a
solution).
Our example:
 IRR = 16.13% > 12% required return
 Do we accept or reject the project?

NPV Profile for the Project
70,000
60,000
50,000
40,000
30,000
NPV
20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
-20,000
Discount Rate

Conflicts Between NPV and IRR
 NPV directly measures the increase in value to the firm.
 Whenever there is a conflict between NPV and another

decision rule, you should always use NPV.
 IRR is unreliable in the following situations:

 Non-conventional cash flows
 Mutually exclusive projects

Non-conventional Cash Flows
 The IRR rule is only guaranteed to work for a stand-

alone project if all of the project’s negative cash flows
precede its positive cash flows. If not, the IRR rule can
lead to incorrect decisions.
Example 2.2:
A publisher’s offer on writing a book
(a) Delayed Investments
(b) Multiple IRRs
(c) Nonexistent IRR

Example 2.2(a): Delayed Investments
 CF0 = $1 million (upfront), CF1 = CF2 = CF3 = –$500K (costs)
 Estimated opportunity cost = 10%
 When the benefits of an investment occur before the costs, the

NPV is an increasing function of the discount rate.
Example 2.2(b): Multiple IRRs
 CF0 = $550K (advance), CF1 = CF2 = CF3 = –$500K (costs), CF4 =
$1 million; estimated opportunity cost = 10%
 With more than one IRR, the IRR rule cannot be applied.
Example 2.2(c): Nonexistent IRR
 CF0 = $750K (advance), CF1 = CF2 = CF3 = –$500K (costs), CF4 =
$1 million; estimated opportunity cost = 10%
 No IRR exists because the NPV is positive for all values of

the discount rate. Thus, the IRR rule cannot be used.
Mutually Exclusive Projects
 When you must choose only one project among several

possible projects, the choice is mutually exclusive.
The NPV rule:

 Select the project with the highest NPV
The IRR rule:

 Select the project with the highest IRR
 May lead to mistakes

Differences in Scale
 If a project’s size is doubled, its NPV will double. This is not the
case with IRR. Thus, the IRR rule cannot be used to compare
projects of different scales.
Example 2.3 Bookstore Coffee Shop

Initial Investment $300,000 $400,000
Cash FlowYear 1 $63,000 $80,000
Annual Growth Rate 3% 3%
Cost of Capital 8% 8%
IRR 24% 23%
NPV $960,000 $1,200,000

Review: Present Value Formulas
Annuity
Perpetuity
CF1   1  
n
PVP0 
CF1 PVA0  1    
r r   1  r  
The General
Formula
CF1 CF2 CFn

PV0    ... 
1  r1  1  r2 2 1  rn n
Growing
Growing
Annuity
Perpetuity
CF1   1  g  
n
CF1
PVP0  PVA0  1    
rg r  g   1  r  

Free Cash Flow (FCF)

Capital Budgeting: NPV Approach
Estimate
Financial analysis
project cash flows Project Project Review
and
and Implementation Post Audit
Project selection
cost of capital
Only Free Cash Flow (FCF) and Time Value of Money matter:
 FCF matters, not accounting profit or loss like Net Income
 FCF must be relevant and incremental to the new project:
 Does FCF occur when project is accepted or rejected?
 Common pitfalls: Sunk Costs, Opportunity Costs, Side Effects
 Size, Risk, and Timing of FCF must be identified
 In discounting FCF, treat inflation consistently

Concept of Free Cash Flow
 Free cash flow is the finance view of cash flow.
 Free cash flow equals the cash flow generated by normal,

continuing operations.
 Free cash flow is available (“free”) for distribution to all

suppliers of capital, i.e., security holders such as
equityholders, bondholders, convertible bondholders.
 Free cash flow does not relate to:

 How the firm finances its operations (e.g., borrowing, issuing
stock, repaying debt, interest expense or income)
 Investments that are not related to normal business activity

Deriving Net Income (I)
Sales
– Cost of goods sold (COGS)
– Selling, general &
administrative costs (SG&A)
– Interest expense (INT EXP)
– Taxes (T × EBT)
= Net Income (NI)
NI = (Sales – COGS - SG&A - INT EXP) × (1 – T)

Free Cash Flow vs. Net Income
 Does Net Income = Free Cash Flow?

 NO!
 How do the two differ?

 Net Income includes non-cash expenses and
revenues (Example: ?)
 Net Income includes non-operating expenses and
income (Example: ?)

Deriving Net Income (II)
Sales
 Sales on credit, revenue earned but not received
- Cost of goods sold
 Include non-cash items such as depreciation & amortization
 Expenses owed but not yet paid
 Inventory expensed when sold not when paid
- Selling, general and administrative costs
 Include non-cash items such as depreciation & amortization
 Expenses owed but not yet paid
 May purchase fixed assets, capitalized not expensed
- Interest expense
- Taxes
 Taxes paid do not equal tax expense
= Net Income
How Do We Calculate Free Cash Flow?
 Indirect Method
 Starts with Net Income and adjusts for non-cash
charges included in Net Income.
 This is the method most people know/use.
 Direct Method
 Begins with Cash Sales and restates the Income
Statement to include only cash charges and
operating cash flows.
 Both methods yield the same free cash flow
(~ bottom-up vs. top-down approach).
FCF Calculation: Indirect Method
 The indirect method starts with Net Income and makes

appropriate adjustments to arrive at Free Cash Flow.
 The adjustments include:

 Operational adjustments
 Adjustments for depreciation & other non-cash expense
 Adjustments for changes in Net Working Capital (NWC)
 Adjustments for investment in new Fixed Assets
 Financial adjustments
 Adjustments of after-tax interest expenses and incomes

General Areas of Adjustments
Operating Adjustment
Net Income
+ Non-cash charges
Depreciation Operating Adjustment
Amortization
± Change in Net Working Capital (NWC) EXCLUDING Cash, Marketable
Securities, or Short-Term Borrowing
Account Receivable
Inventories
Other Current Assets/Liabilities
Operating Adjustment
Account Payable
± Proceeds for sale of or payment for Fixed Assets
Financial Adjustment
+ After-tax portion of Interest Expense
 After-tax portion of Interest Income
= Free Cash Flow

Typical Items of Adjustments
Net Income
+ Non-cash expenses: Depreciation (before tax)
± Income not yet collected: Accounts Receivables (A/R)
± Operating Items paid for but not expensed: Inventory
± Expenses not yet paid: Accounts Payable (A/P)
± Non-operating income/expenses: Interest (after tax)
 Net expenditures on operating assets (Change in PPE)
= Free Cash Flow
This is not an exhaustive list. Items vary as much as firms’ statements.

 Increases in assets are cash outflows (i.e. decrease FCF).
 Decrease in assets are cash inflows (i.e. increase FCF).

Motivation for Understanding FCF
in Capital Budgeting
 With all the tools in place, we now begin to apply them

to real corporate investment decisions.
 We need to develop the discounted cash flow (DCF)

valuation method for resource allocation decisions
within a firm.
 NPV of a project is the PV of the Incremental Free Cash

Flows (FCF) minus the initial investment.

The Big Picture
 What’s a project worth to a firm’s owners?
 The answer depends on how much cash the project

uses up and how much cash it generates.
 Free Cash Flow measures this net difference in cash

generation and cash usage.
 NPV just puts it all in terms of today’s $$$.

Incremental FCF
Cash flows included in our analysis are:

 Required investment (capital outlay)
 Direct cash flows
 Increase in sales
 Increase in costs
 Indirect cash flows
 Change in Net Working Capital
 Opportunity costs
 Side effects/Synergies

Incremental FCF
Cash Generation Cash Usage

Increase in Revenue Increase in COGS
Costs Avoided Increase in SG&A
Costs Savings Increase in Tax
Assets Recovered New Investments in Fixed Assets
Assets Sold New Investments in NWC
Free Cash Flow

Indirect Cash Flows (I):
Net Working Capital (NWC)
 Definition: Current assets minus current liabilities.

Net Working Capital = Current Assets – Current Liabilities
= (Cash + Inventory + Receivable) – Payables
Note that we include cash only if it is required for operation.
Also, note that an increase in NWC is cash outflow, and a decrease in
NWC is cash inflow.
 Most projects will require an investment in net working

capital. As we look at incremental effects (changes), we
include the changes in NWC from year to year, but not the
overall level.
NWCt = NWCt – NWCt–1
 At the end of a project, the investment in NWC is often

recovered either in whole or in part.

The Cash and Operating Cycle for a Firm

Indirect Cash Flows (II):
Opportunity Costs
 When existing assets are used for a new project, the costs of
these assets are included as incremental cash flows even if
no money changes hands.
 Since these existing assets can be sold, leased, or used

elsewhere in the business, you need to consider the
potentially lost revenue from alternative uses.
 These lost revenues should be treated as costs.
 They are called opportunity costs because, by taking on the

new project, the firm forgoes opportunities for using the
assets elsewhere.

Indirect Cash Flows (III):
Side Effects/Synergies
 An important negative side effect is erosion.

 Erosion is the cash flow transferred to a new project from
customers and sales of other products of the firm.
Examples: … ?
 It should be treated as a cost to the new project.
 A positive side effect, e.g., synergy, occurs when a new

project increases the revenues of an existing product.
Examples: … ?
 Also called “project externalities”

Cash Flows to Exclude (I):
Sunk Costs
 Sunk costs are costs that have been or will be paid

regardless of the decision whether or not the investment is
undertaken.
 Already occurred and cannot be removed, hence, should not be
included in incremental cash flows
Examples:
 Fixed Overhead Expenses
 Often fixed and not incremental to the project and should not
be included in the calculation of incremental earnings
 Past Research and Development Expenditures
 Already spent on R&D and therefore irrelevant; the decision to
continue or abandon a project should be based only on the
incremental costs and benefits of the product going forward

Cash Flows to Exclude (II):
Financing Costs
 In capital budgeting decisions, financing costs such as

interest expense is not included. The rationale is that
the project should be judged on its own, not on how it
will be financed.
 In addition, the discount rate (i.e., the project’s WACC)

will handle the costs and benefits of financing.

Further Adjustment for Project FCF (I):
Capital Expenditure and Depreciation
 Capital Expenditures (CAPEX) 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, but affects taxes.

The free cash flow estimate is adjusted for this non-
cash expense.

Further Adjustment for Project FCF (II):
Liquidation or Salvage Value of Fixed Assets
 Definition:
Capital Gain = Sale Price – Book Value
Book Value = Purchase Price
– Accumulated Depreciation
 Add back the after-tax cash flows to the terminal year of

the project:
After-tax Cash Flow from Asset Sale
= Sale Price – (c × Capital Gain)
where c is the marginal corporate tax rate
Calculating Project FCF Indirectly
 Bottom-up Approach of Free Cash Flow:

 We will first project incremental net income from the
project and then do the following adjustments:
Net Income
+ Depreciation
+ After-Tax Net Interest Exp.
 Capital Expenditures (CAPEX)
 Increase in Operating NWC
 At the end of the project’s life, recover salvage/resale

value of project (after tax) and possibly some NWC.

Calculating Project FCF directly
 Top-down Approach of Free Cash Flow:

 We will calculate FCF directly from revenues:
Unlevered Net Income
Free Cash Flow  (Revenues  Costs  Depreciation)  (1  c )

 Depreciation  CapEx  NWC
Free Cash Flow  (Revenues  Costs)  (1  c )  CapEx  NWC

 c  Depreciation
The term c × Depreciation is called the depreciation tax shield.

Incremental FCF: Problem 1
Introduce a new product, which is expected to reduce cash flow
of existing product (cannibalize) to the extent of $500,000.
Should this loss be included in the FCF?
Incremental FCF =
Cash flows “with” investment - Cash flows “without” investment
• Cash flows “with” investment: Less by $500,000
• Cash flows “without” investment?

1. Existing product would have continued its sales growth, no loss of $500,000.
2. Competitor may introduce a new product and result in a loss of $500,000.
If (1), then $500,000 should be included in project cash flows as a cost

for negative side effect, otherwise no.

Build a factory on land already owned by the company.
Should the cost of land be included in the FCF?
• Cash flows “with” investment: No extra cash flow from land.

1. Could have sold the land for $X.
2. No effective alternate use for land as it is in the middle of our
facilities.
If (1), then land cost should be included as equal to $X as an

opportunity cost.
– Need to identify mutually exclusive alternatives to identify
opportunity costs.

Should we invest $1 million in a project which has already
cost $5 million with projected cash flows of $2 million?
• Cash flows “with” investment: –1 + 2 = $1 million

1. Abandon project and realize zero value.
2. Scrap project and recover $2 million.
If (1), then it may make sense to throw in the new money,
otherwise no.
– Ignore sunk costs; do not confuse average with incremental!

Key Points
 To value a project, we:

 Calculate the incremental free cash flows!!!
 Required investment (capital outlay)
 Direct cash flows – change in sales and costs
 Indirect cash flows
 Change in NWC
 Opportunity costs
 Side effects/Synergies
 Accept all positive NPV projects (if possible)

 Mutually exclusive projects: Project with the highest NPV

Advanced Financial Management: Class 2 Capital Budgeting & Free Cash Flow Professor Janis Skrastins

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Advanced Financial Management

Professor Janis Skrastins

 Capital budgeting methods

 Free Cash Flow (FCF)

2 FIN 448 / Janis Skrastins

3 FIN 448 / Janis Skrastins

 Only undertake investment opportunities that have

 In practice, however, firms rely on a multiplicity of

4 FIN 448 / Janis Skrastins

5 FIN 448 / Janis Skrastins

 Internal Rate of Return (IRR)

 Payback Period (PP)

6 FIN 448 / Janis Skrastins

 You are looking at a new project, and you have

 Your required rate of return for investments of this sort

7 FIN 448 / Janis Skrastins

 Using the formulas:

Do we accept or reject the project?

8 FIN 448 / Janis Skrastins

 How long does it take to get the initial cost back in a

 The Payback rule: Accept if the payback period is less

9 FIN 448 / Janis Skrastins

 Assume we will accept the project if it pays back within

Do we accept or reject the project?

10 FIN 448 / Janis Skrastins

11 FIN 448 / Janis Skrastins

 Currently, out of the 15 Anheuser-Busch breweries outside the

 Most important alternative to NPV

 Often used in practice and is intuitively appealing

 Based entirely on the estimated cash flows and is

 Definition: IRR is the return (i.e., the discount rate) that

 The IRR rule: Accept the project if the IRR is greater

13 FIN 448 / Janis Skrastins

 If you do not have a financial calculator or spreadsheet,

 Do we accept or reject the project?

14 FIN 448 / Janis Skrastins

15 FIN 448 / Janis Skrastins

 NPV directly measures the increase in value to the firm.

 Whenever there is a conflict between NPV and another

 IRR is unreliable in the following situations:

16 FIN 448 / Janis Skrastins

 The IRR rule is only guaranteed to work for a stand-

17 FIN 448 / Janis Skrastins

 When the benefits of an investment occur before the costs, the

 No IRR exists because the NPV is positive for all values of

 When you must choose only one project among several

The NPV rule:

The IRR rule:

21 FIN 448 / Janis Skrastins

Example 2.3 Bookstore Coffee Shop

22 FIN 448 / Janis Skrastins

CF1 CF2 CFn

23 FIN 448 / Janis Skrastins

24 FIN 448 / Janis Skrastins

25 FIN 448 / Janis Skrastins

 Free cash flow is the finance view of cash flow.

 Free cash flow equals the cash flow generated by normal,

 Free cash flow is available (“free”) for distribution to all

 Free cash flow does not relate to:

26 FIN 448 / Janis Skrastins

NI = (Sales – COGS - SG&A - INT EXP) × (1 – T)

 Does Net Income = Free Cash Flow?