1 - Project Selection I - V22

Corporate Finance
Fifth Edition, Global Edition
Chapter 8
Capital Budgeting and Investment

Projects’ selection I
TOPICS
I. Fundamentals of “Capital Budgeting”

Estimating Free Cash Flow and Net Present Value (NPV)
Analyzing the Project: Sensitivity and Scenario Analysis
Project-Based Cost of Capital
I. Fundamentals of“Capital Budgeting”
Estimating Free Cash Flows and NPV
Capital Budgeting and Investment Projects’ Selection

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 decision

Valuation of Investment Projects
The Key Variables
 The distinctive features of an investment project :

- it calls for a significant initial investment (-I0);
- It is expected to generate uncertain cash flows over a given time span
?
t
Initial Expected future cash flows
cash
outflows
Financial valuation methods

Calculating the NPV
The NPV of an investment project is equal to the present

value of all expected cash flows, net of the initial investment I0
CF1 CF2 CF3
-I0
NPV
t0 t1 t2 t3 tn
 The NPV depends on the project’s initial investment, on expected cash flows and on
the cost of capital r (the TRIAD of an investment project)
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 = $260

Revenue and Cost Estimates (Cont'd)
Example
Cost Estimates
 Up-Front R&D = $15,000,000
• (5KK Design&Engineering + 10KK software Development)
 Up-Front New Equipment (CAPEX) = $7,500,000
• Expected life of the new equipment is 5 years; Housed in existing lab
 Annual Overhead = $2,800,000
 Per Unit (production) Cost = $110

Incremental Earnings Forecast
Table 8.1 Spreadsheet HomeNet’s Incremental Earnings

Forecast

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/year

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.

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 credit.
Income Tax  EBIT  c

Taxes (Cont'd)
Unlevered Net Income Calculation
Unlevered Net Income  EBIT  (1  c )

 (Revenues  Costs  Depreciation)  (1   c )

Example 8.1

Example 8.1 (Cont'd)

Indirect Effects on Incremental Earnings
Opportunity Cost
 The value a resource could have provided in its best alternative use
 In the HomeNet project example, space will be required for the investment.
Even though the equipment will be housed in an existing lab, the
opportunity cost of not using the space in an alternative way (e.g.,
renting it out) must be considered.

Example 8.2

Example 8.2 (cont'd)

Indirect Effects on Incremental
Earnings (Cont'd)
Project Externalities
 Indirect effects of the project that may affect the profits of other business
activities of the firm. Cannibalization is when sales of a new product
displaces sales of an existing product.

Earnings (Cont'd)
Project Externalities
 In the HomeNet project example, 25% of sales come from customers
who would have purchased an existing Linksys wireless router if
HomeNet were not available. Because this reduction in sales of the
existing wireless router is a consequence of the decision to develop
HomeNet, we must include it when calculating HomeNet’s incremental
earnings.

Earnings (Cont'd)
Table 8.2 Spreadsheet HomeNet’s Incremental Earnings

Forecast Including Cannibalization and Lost Rent

Sunk Costs and Incremental Earnings
Sunk costs are costs that have been or will be paid regardless of the decision
whether or not the investment is undertaken.
 Sunk costs should not be included in the incremental earnings analysis.

Sunk Costs and Incremental
Earnings (Cont'd)
Fixed Overhead Expenses

 Typically overhead costs are fixed and not incremental to the project and
should not be included in the calculation of incremental earnings.

Earnings (Cont'd)
Past Research and Development Expenditures
 Money that has already been spent on R&D is a sunk cost 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.
Example: The company has already conducted a feasibility study, which

costs $300,000  Not to be included

Earnings (Cont'd)
Unavoidable Competitive Effects
 When developing a new product, firms may be concerned about the

cannibalization of existing products.
 However, if sales are likely to decline in any case as a result of new
products introduced by competitors, then these lost sales should be
considered a sunk cost (not to be included).

Real-World Complexities
Typically
 sales will change from year to year.
 the average selling price will vary over time.
 the average cost per unit will change over time.
The next 2 slides will show how to account for these effects

Example 8.3
 New Sales Volumes t1/t4

 New Sales Prices t1/t4
 New Sales t1/t4

25% * 125000= 31250

8.2 Determining Free Cash Flow and NPV
Free cash flow (Definition)
The incremental effect of a project on a firm’s available cash.

Calculating the Free Cash Flow from Earnings (Cont'd)
Table 8.3 Spreadsheet Calculation of HomeNet’s Free Cash Flow (Including

Cannibalization and Lost Rent). From “Unlevered Net Income” to “Free Cash
Flow”

How to compute the «Operational Cash Flow»
From NOPAT to Operational Cash Flow
Sales Revenue
- Cost of goods sold (COGS)
- Other operational costs
EBITDA
- Depreciation
-----------------------
EBIT
- Taxes (EBIT * Tc)
------------------------------
= Unlevered Net Income or NOPAT
+ Depreciation
+/- Changes in Net Working Capital (NWC)
(-/+)Investments/Disinvestments in fixed capital (CAPEX)
-------------------------------
Operational Cash flow (OCF) of YEAR t

Further Adjustments to Free Cash Flow (Cont'd)
Terminal or Continuation Value

• This amount represents the market value of the free cash flow from the
project at all future dates.

Example 8.7
Continuation Valuet4 = FCFt5/r-g
Constant-Growth Perpetuity


Further Adjustments to Free Cash Flow (Cont'd)
Tax Carryforwards/Carrybacks
• Tax loss carryforwards and carrybacks allow corporations to take
(current) losses during its current year and offset them against gains in
nearby years.
• In the USA
o firms can offset losses at t0 against income for the last 2 yrs
(getting a tax credit at t0); OR
o Save losses at t0 against income of the next 20 yrs (no taxes will be
paid in the future until the carryforwards are exhausted).

Example 8.8


Calculating the Free Cash Flow From Earnings
Capital Expenditures 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. The free cash flow estimate is
adjusted for this non-cash expense (D is added back).

Net Working Capital (NWC)
 Most projects will require an investment in net working capital.

• Trade credit is the difference between receivables and payables.
 The increase in net working capital is defined as:

Table 8.4 Spreadsheet HomeNet’s Net Working Capital Requirements
COGS Cost of Goods Sold

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

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

Calculating the NPV
NPV   16,500  4554  5740  5125  4576  1532

 5027
Table 8.5 Spreadsheet Computing HomeNet’s NPV (WACC = 12%)

Applying the NPV Rule to Select Projects
 A practical rule :
If NPV > 0 accept the project
If NPV < 0 reject the project

Analyzing the project
Sensitivity Analysis

8.5 Analyzing the Project
Break-Even Analysis
• The break-even level of an input is the level that causes the NPV of the
investment to equal zero.
• HomeNet IRR Calculation
Table 8.7 Spreadsheet HomeNet IRR Calculation

8.5 Analyzing the Project (Cont'd)
Break-Even Analysis
 Break-Even Levels for HomeNet (that drive EBIT down to
zero)
Table 8.8 Break-Even Levels for HomeNet
 EBIT Break-Even of Sales

• Level of sales where EBIT equals zero

Sensitivity Analysis
Sensitivity Analysis shows how the NPV varies with a change in one of the
assumptions, holding the other assumptions constant.
“Point Estimates” vs “Confidence Interval Estimates”(Range of variation of a

given parameter)

Sensitivity Analysis (Cont'd)
Table 8.9 Best- and Worst-Case Parameter Assumptions for HomeNet
Impact on the project’s NPV? See following slide

Figure 8.1 Homenet’s NPV Under Best and Worst-case
Parameter Assumptions
Break-even levels for each variable

Example 8.9


Scenario Analysis
Scenario Analysis considers the effect on the NPV of simultaneously

changing multiple assumptions.
Table 8.10 Scenario Analysis of Alternative Pricing Strategies (Price/Units Sold)

Figure 8.2 Price and Volume Combinations
for Homenet with Equivalent NPV
Scenario Analysis

Alternative Example 8.9
Problem
• Assume NRG originally forecasted its marketing and support costs at
$500,000 per year during years 1 – 3. Suppose the marking and support
costs could be as low as $200,000 or as high as $900,000 per year. How
would these changes impact the NPV of the proposed energy drink project?
Recall, NRG pays a 39% tax rate on its pre-tax income. Assume their cost
of capital is 9%.

Alternative Example 8.9 (Cont’d)
Solution.
• We can answer the question by computing the NPV of the resulting free
cash flow, given the change in marketing and support costs.

Solution.
• A $300,000 decrease in marketing and support costs will increase NRG’s
EBIT by $300,000 and will, therefore increase NRG’s free cash flow by an
after-tax amount of:$300,000 x ( 1 – 0.39) = $183,000
• The present value of this increase is:
$183,000 $183,000 $183,000

PV=  2
 3
 $463, 227
1.09 1.09 1.09
• thus, the NPV of the project would rise by $463,227.

Solution.
• A $400,000 increase in marketing and support costs will decrease NRG’s
EBIT by $400,000 and will, therefore decrease NRG’s free cash flow by an
after-tax amount of:
$400,000 x ( 1 – 0.39) = $244,000
• The present value of this decrease is:
-$244,000 -$244,000 -$244,000

PV=  2
 3
 $617, 636
1.09 1.09 1.09
thus, the NPV of the project would fall by $617,636.

NPV and Shareholder Value
 Example: Io = -1
PVo= 3
NPV= 2 Delta Equity
BEFORE INVESTMENT AFTER INVESTMENT
Delta NPV=2
PVo=3 Equity
Cash=1
Value Created for
Equity=10 Shareholders =
Equity=10 A+PVo-E = PVo-Io=NPV
Asset=9 Asset=9
NPV is the increase in Equity

created by the project (value
for Shareholders)
A=10 E=10 A=12 E=12

Capital Budgeting and Investment Projects’ Selection II

Project-Based Cost of Capital

18.5 Project-based Costs Of Capital
In the real world, a specific project may have different market risk than the
average project for the firm.
In addition, different projects may vary in the amount of leverage they will
support.

Estimating the Unlevered Cost of Capital
Suppose Avco launches a new plastics manufacturing division that faces

different market risks than its main packaging business.
 The unlevered cost of capital for the plastics division can be estimated
by (using “comparables”) looking at other single-division plastics
firms that have similar business risks.

Estimating the Unlevered Cost of Capital (cont'd)
Assume two firms are comparable to the plastics division and have
the following characteristics:

Assuming that both firms maintain a target leverage ratio, the unlevered
cost of capital for each competitor (rU) can be estimated by calculating their
pretax WACC.

Based on these comparable firms, we estimate an unlevered cost of capital for

the plastics division is approximately 9.5%.
With this rate in hand we can now use the APV approach (Compute the
project’s VU and then add PV of ITS).
To use WACC or FTE methods we need to estimate the project’s equity cost
of capital, which depends on the incremental debt the company will take on as a
result of the project.

Project Leverage and the Equity Cost Of Capital
A project’s equity cost of capital may differ from the firm’s equity cost of
capital if the project uses a target leverage ratio that is different than the
firm’s. The project’s equity cost of capital can be calculated as:
D
rE  rU  ( rU  rD )
E
“Re(De)levering” of rE

Project Leverage and the Equity Cost of Capital (Cont’d)
The division’s WACC can now be estimated to be:
rWACC  0,50  13,0%  0,50  6,0%  (1  0,40)  8,3%
An alternative method for calculating the division’s WACC is:
rwacc  rU  d c rD
rwacc  9,5%  0,50  0,40  6%  8,3%

Project Leverage and the Equity Cost of Capital (Cont’d)
Now assume that Avco plans to maintain an equal mix of debt and equity
financing as it expands into plastics manufacturing, and it expects its
borrowing cost to be 6%.
 Given the unlevered cost of capital estimate of 9.5%, the plastics division’s
equity cost of capital is estimated to be:
0.50
rE  9.5%  (9.5%  6%)  13.0%
0.50

Example 18.5


Determining the Incremental Leverage of a Project
To determine the equity or weighted average cost of capital for a project,

the incremental financing that results if the firm takes on the project needs to
be calculated.

Determining the Incremental Leverage of a Project (Cont'd)
In other words, what is the change in the firm’s total debt (net of cash) with
the project versus without the project.
• Note: The incremental financing of a project need not correspond to the

financing that is directly tied to the project.

Determining the Incremental Leverage of a Project (Cont'd)
The following important concepts should be considered when determining a

project’s incremental financing.
 Cash Is Negative Debt
 A Fixed Payout Policy Implies 100% Debt Financing
 Optimal Leverage Depends on Project and Firm Characteristics
 Safe Cash Flows Can Be 100% Debt Financed

Example 18.6


Alternative Example 18.6
Problem
 F5 Networks (FFIV) ended their fiscal year 2012 with approximately
$532 million in cash and securities and no debt. Consider a project with
an unlevered cost of capital of rU = 18%. Suppose F5 Networks’ payout
policy is completely fixed during the life of this project, so that the free cash
flow from the project will affect only F5 Networks’ cash balance.

Problem
 If F5 Networks earns 1.1% interest on its cash holdings and pays a 36%
corporate tax rate, what cost of capital should F5 Networks use to
evaluate the project?

Solution
 Because the inflows and outflows of the project change F5 Networks’ cash
balance, the project’s debt-to-value ratio is 100%; that is, d = 1. The
appropriate cost of capital for the project is
rwacc = rU - τcrD = 18% - 36% * 1.1% = 17.6%
• Note that the project is effectively 100% debt financed, because even
though F5 Networks itself had no debt, if the cash had not been used to
finance the project, F5 Networks would have had to pay taxes on the
interest the cash earned.

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Corporate Finance

Fifth Edition, Global Edition

Capital Budgeting and Investment

I. Fundamentals of “Capital Budgeting”

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

 The distinctive features of an investment project :

Financial valuation methods

The NPV of an investment project is equal to the present

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Table 8.1 Spreadsheet HomeNet’s Incremental Earnings

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

In capital budgeting decisions, interest expense is typically not included. The

Capital Budgeting and Investment Projects’ Selection

Marginal Corporate Tax Rate

Income Tax  EBIT  c

Capital Budgeting and Investment Projects’ Selection

Unlevered Net Income Calculation

Unlevered Net Income  EBIT  (1  c )

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Table 8.2 Spreadsheet HomeNet’s Incremental Earnings

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Fixed Overhead Expenses

Capital Budgeting and Investment Projects’ Selection

Past Research and Development Expenditures

Example: The company has already conducted a feasibility study, which

Capital Budgeting and Investment Projects’ Selection

Unavoidable Competitive Effects

 When developing a new product, firms may be concerned about the

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

 New Sales Volumes t1/t4

Capital Budgeting and Investment Projects’ Selection

25% * 125000= 31250

Free cash flow (Definition)

The incremental effect of a project on a firm’s available cash.

Capital Budgeting and Investment Projects’ Selection

Table 8.3 Spreadsheet Calculation of HomeNet’s Free Cash Flow (Including

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Terminal or Continuation Value

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Budgeting and Investment Projects’ Selection

Capital Expenditures and Depreciation