Fundamentals of Capital Budgeting:

From Forecasting Earnings to Project

Cash Flows
Dr. Himanshu Joshi
FORE School of Management
 Tata Nano
• In July 2006, Ratan Tata, Chairman of Tata
Motors, announced to the shareholders at the
annual general body meeting that the
company would be launching a Tata Nano- A
car that would be sold for Rs. 1 Lakh only. He
said that the launch of the car would create a
new paradigm in low cost personal transport,
carve-out a new market segment, and reach a
broader base of pyramid.
 Tata Nano
• The decision of Tata Motors to launch Nano
represents the typical capital budgeting decision.
• How would the managers of the Tata Motors make a
decision about this investment?
• What will be the impact of this decision on the value
of the company and wealth of its shareholders?
• The managers of Tata Motors have to evaluates the
benefits and the costs of the Nano car project.
• We will discuss tools for evaluating projects such as
Tata Nano…
 FORE -casting Earnings
• A Capital Budget lists the project and investments that a
company plans to undertake during the coming year. To
determine this list, firm analyze alternate projects and
decide which one to accept through a process called capital
budgeting.
• This process begins with the forecasts of the project’s
future consequences for the firm.
• Some of the consequences will affect its revenues and
others will affect its costs.
• Our ultimate goal is to determine the effect of the decision
on the firm’s cash flows.
 Cash Flows Vs. Earnings..
• For the purpose of Project evaluation cash
flows are important not the earnings.
However, as a practical matter, to derive the
forecasted cash flows of the project, financial
managers often begin by determining the
incremental earnings of a project…
 Linksys..
• Linksys is a division of CISCO systems, a maker of consumer
networking hardware. Linksys is considering the development
of a wireless home networking appliance, called HomeNet, that
will provide both the hardware and the software necessary to
run an entire home from any internet connection. In addition to
the connecting PCs and Printers, Home Net will control new
internet capable stereos, digital video recorder, heating and air-
conditioning units, major appliances, telephone and security
systems, office equipment, and so on.
• Linksys has already conducted an intensive, $3,00,000 feasibility
study to assess the attractiveness of the new product.
 Linksys
• HomeNet’s target market is upscale residential “smart” homes
and home offices. Based on extensive marketing surveys, the
sales forecast for HomeNet is 1,00,000 units per year. Given the
pace of technological change, Linksys expects the product will
have a four year life. It will be sold through high end stereo and
electronics stores for a retail price of $375, with an expected
wholesale price of $260.
• Developing the new hardware will be relatively inexpensive, as
existing technologies can be repackaged in a newly designed,
home friendly box. Industrial design team will make the box and
packaging aesthetically pleasing to the residential market. Linksys
expect total engineering and design costs to amount to $5
million. Once the design is finalized, actual production will be
outsourced at a total cost (including packaging) of $110 per unit
 Linksys
• In addition to the hardware requirements, Linksys must build a new
software application to allow virtual control of home through web. This
software development project requires coordination with each of the
web appliance manufacturers and is expected to take a dedicated team
of 50 software engineers a full year to complete. The cost of a software
engineer (including benefits and related costs) is $2,00,000 per year.
• To verify the compatibility of new consumer-internet-ready appliances
with the HomeNet system as they become available, Linksys must also
build a new lab for testing purposes. The lab will occupy existing
facilities but will require $7.5 million of new equipment.
• The software and hardware design will be completed, and the lab will
be operational at the end of one year. At that time, HomeNet will be
ready to ship. Linksys expects to spend $2.8 million per year on
marketing and support for this project.
Incremental Earnings Forecast
 Capital Expenditure and Depreciation
• While investments in plant, equipment and
property are cash expenses, they are not directly
listed as expenses when calculating earnings.
Instead the firm deducts a fraction of the cost of
these items each year as depreciation.
• If we assume straight-line depreciation over a life
of five years for the lab equipment, HomeNet’s
depreciation expense is $1.5 million per year.
 Interest Expenses
• To compute the firm’s net income, we must first deduct
interest expenses from EBIT. When evaluating a capital
budgeting decision like the HomeNet project, however,
generally we do not include interest expense.
• Any incremental interest expenses will be related to the
firm’s decision regarding how to finance the project.
• Here we wish to evaluate the project on its own,
separate from financing decision.
• So we calculate unlevered income.
 Taxes
• The final expense we must account for is
corporate taxes. The correct tax rate to use is
the firm’s marginal corporate tax rate, which is
the tax rate it will pay on an incremental dollar
of pre-tax income.
• Incremental income tax = EBIT * Tc
• Where Tc is the firm’s marginal tax rate.
 Taxes
• In year 1, HomeNet will contribute an
additional $10.7 million to Cisco’s EBIT, which
will result in $10.7 million* 40% = $4.28
million in corporate tax that Cisco will owe.
• We deduct this amount to determine
HomeNet’s net income.
• In year 0, however, HomeNet’s EBIT is
negative. Are taxes relevant in this case?
 Taxes
• Yes HomeNet’s will reduce the Cisco’s taxable income
in year 0 by $15 million.
• As long as Cisco earns taxable income elsewhere in
year 0 against which it can offset HomeNet’s losses,
Cisco will owe $15 million* 40% = $6 million less in
taxes in year 0.
• The firm should credit this tax savings to the HomeNet
Project.
• A similar credit applies in year 5, when a firm claims
its final depreciation expense.
 Unlevered income calculation
• Unlevered Net Income = EBIT * (1-Tc)
• = (Revenues – Costs –Depreciation) * (1-Tc)
Indirect Effects on Incremental Earnings

• All changes between the firm’s earnings with

project Versus firm’s earnings without the
project.
• Thus far we have analyzed only the direct
effects of HomeNet project.
• It may also have indirect effects on Cisco’s
earnings.
 Opportunity Costs.
• Many projects use a resource that company already owns.
Because the firm does not need to pay cash to acquire this
resource for a new project, it is tempting to assume that the
resource is available for free.
• The opportunity cost of using a resource is the value it could
have provided in its best alternative use.
• Because this value is lost when the resource is used by the
another project, we should include the opportunity cost as an
incremental cost of the project.
• Is there any opportunity cost in case of
HomeNet Project??
 Opportunity Costs in HomeNet
• Space will be required for the new lab. Even
though the lab will be housed in an existing
facility, we must include opportunity cost of not
using the space in an alternative way.
• Suppose HomeNet’s lab will be housed in
warehouse space that the company would have
otherwise rented out for $2,00,000 per year
during 1-4 years. How does this opportunity
cost affect HomeNet’s incremental earnings.
 Project externalities
• Project externalities are indirect effects of the
project that may increase or decrease the
profits of other business activities of the firm.
This is called cannibalization.
• Suppose that 25% of HomeNet’s sales come
from customers who would have purchased an
existing Linksys wireless router (wholesale
price $100 per unit and unit cost $60 ) if
HomeNet were not available.
Table 2
 Sunk Costs and External Earnings
• A sunk cost is any unrecoverable cost for which firm
is already liable. Sunk cost have been or will be paid
regardless of the decision whether or not to proceed
with the project.
• Therefore they are not incremental with respect to
current decision and should not be included in its
analysis.
• For this reason we did not include in our analysis the
$3,00,000 already expended on marketing and
feasibility studies.
 Other Sunk costs
• Fixed Overhead Expenses
• Past Research and Development Expenses.
 Real- World Complexities
• Unit sold.
• Price changes.
• Manufacturing cost
• Competition
 Determining Free Cash Flow and NPV
• Calculating Free Cash Flows from Earnings.
• Capital Expenditure and Depreciation: Depreciation
is not a cash expense paid by the firm. Rather it is a
method used for accounting and tax purposes to
allocate the original cost of asset over its life. So it
should be added back to determine the free cash
flows.
• Capital Expenditure we have to subtract the original
cost of the equipment $7.5 million in the year 0.
 Net Working Capital
• Net W. Capital = Current Assets – Current Liab.
• = cash + inventory + receivables – payables
• The difference between receivables and payables is
called trade deficit.
• Suppose that HomeNet will have no incremental cash or
inventory requirements
(products will be shipped directly from the contract
manufacturer to customers). However receivables
related to HomeNet are expected to account for 15% of
sales, and the payables are expected to be 15% of COGS.
HomeNet’s Net W.C Requirement
HomeNet’s Free Cash Flows
 Calculating Free Cash Flows Directly

• Free Cash Flows = (Revenues – Costs –

Depreciation) (1-Tc) + Depreciation – Capex –
∆ Net Working Capital

Free Cash Flow = (Revenues – Costs)* (1-Tc) –

Capex - ∆ Net Working Capital + Depreciation*
(Tc)
 Depreciation Tax Shield
• Depreciation Tax Shield = Depreciation * Tc
• Often firms report a different depreciation
expense for accounting and for tax purposes.
• Because only tax consequences of
depreciation expense are relevant for free
cash flows, we should use depreciation
charged by the firm for tax purposes only.
 Calculating NPV of HomeNet
• “= NPV(r, FCF1:FCF5) + FCF0”
 Choosing Among Alternatives
• Because not launching HomeNet produces an
additional NPV of zero for the firm, launching
HomeNet is the best decision for the firm if its
NPV is positive.
• It is a choice between launching HomeNet or
Not Launching HomeNet.
 Evaluating Manufacturing Alternatives

• Suppose Cisco is considering an alternative

manufacturing plan for the HomeNet product.
It could assemble the product in house at a
cost of $95 per unit. however, it will require $5
million in upfront operating expenses to
recognize the assembly facility and Cisco will
need to maintain inventory equal to one
month’s production.
 Evaluating Manufacturing Alternatives

• When comparing between these two

alternatives, we compute the free cash flows
associated with each choice and Compare
their NPV.
• We need to compare only those cash flows
that differ between them.
• As we can ignore HomeNet’s revenue as it
continue to be same in both the case.
 Timing of Cash Flows
• For simplicity, we have treated cash flows for
HomeNet as if they occur at annual interval. In
reality cash flows will spread through out the
year.
• We can forecast cash flows on quarterly,
monthly, or even on continues basis.
 Liquidation or Salvage Value
• Some assets may have some salvage value when they are no
longer needed.
• However, some assets may have negative salvage value.
• In the calculation of free cash flows, we include the
liquidation value of any assets that are no longer needed and
may be disposed of.
• When an asset is liquidated, any capital gain is taxed as
income.
• Capital Gain = Sale Price – Book Value
• Book Value = Assets Original Cost – Accumulated
Depreciation.
 Liquidation or Salvage Value
• We must adjust the project’s free cash flows
to account for the after-tax cash flows that
would result from an asset sale:
• After tax cash flow from sale of asset = Sale
Price – (Tc*Capital Gain)
 HomeNet
• Suppose that in addition to $7.5 million in new
equipment required for HomeNet’s lab, another
equipment will be transferred to the lab from another
Linksys facility.
• This equipment has a resale value of $2 million and a
book value of $1 million. If the equipment is kept rather
than sold, its remaining value can be depreciated next
year. when the lab is shut down in year 5, the equipment
will have a salvage value of $8,00,000. what adjustment
we must make to HomeNet’s free cash flows in this case?