Corporate Finance

Lecture: Fundamentals of Capital Budgeting

SHEN Tao （沈涛） Tsinghua University
Outline
1 The Capital Budgeting Process
2 Forecasting Incremental Earnings
3 Determining Incremental Free Cash Flow
4 Other Effects on Incremental Free Cash Flows
5 Analyzing the Project
6 Real Options in Capital Budgeting
Considerations in NPV Analysis
Now that we have established the superiority of NPV lets
revisit the steps involved in the Capital Budgeting Process.

 First - Estimate cash flows in the project.

 Second - Determine an opportunity cost of capital.
 Third - Apply NPV
 Fourth - Determine the selected alternative and implement.
=> We will now take a look at the first step
The Capital Budgeting Process
 A capital budget lists the projects and investments that a
company plans to undertake during future years. To create
this list, firms analyze alternate projects and decide which
ones to accept through a process called capital budgeting.
 Step 1: Forecast Incremental Earnings
 Step 2: Determine Incremental Free Cash Flow
Forecasting Incremental Earnings
 Incremental earnings: the amount by which the firm’s
earnings are expected to change as a result of the investment
decision.
 The incremental earnings forecast tells us how the decision
will affect the firm’s reported profits from an accounting
perspective.
 “Incremental” emphasize the additional sales and costs
generated by the project.
Discounted Cash Flow Issues for
NPV Analysis
 1. Only cash flow is relevant, not accounting profits.

 2. Only incremental cash flow matters.

 3. Recognize all cash flow effects.

 4. Recognize project interactions.

 5. Separate Investment and Financing Decisions.

Typical Project Cash Flows
Forecasting Incremental Earnings
 Introductory Problem:
Suppose you are considering whether to upgrade your
manufacturing plant and increase its capacity by purchasing a
new piece of equipment. The equipment cost $1 million, plus
an additional $20,000 to transport it and install it.You will also
spend $50,000 on engineering costs to redesign the plant to
accommodate the increased capacity. What are the initial
earning consequences of the decision?
Forecasting Incremental Earnings
 Operating Expenses vs. Capital Expenditure
• Operating Expenses: Marketing surveys, develop a prototype,
advertising campaign, etc.
• Capital Expenditure: Investment in plant, property, and
equipment.
 Capital Expenditure is actual cash expenses.
 Not directly listed as expenses in income statement
 Depreciation(Straight-line, MACRS), which is not actual cash outflow.
Forecasting Incremental Earnings
 Incremental Revenue and Cost Estimates
• Several factors to consider when estimating a project’s
revenues and costs:
1. A new product typically has lower sales initially
2. The average selling price of a product and its cost of
production will generally change over time
3. For most industries, competition tends to reduce profit
margins over time
Forecasting Incremental Earnings
 Incremental Revenue and Cost Estimates
• Taxes: Marginal Corporate tax rate, the tax rate it will pay on
an incremental dollar of pre-tax income.

Incremental Earnings
= EBIT- Taxes
= EBIT – EBIT  Tax Rate
= EBIT  (1 – Tax Rate)
= (Incremental Revenues – Incremental Costs –
Depreciation)  (1 – Tax Rate)
Forecasting Incremental Earnings
 Introductory Example (continued)
Assume after we installed the machine, the additional
capacity will generate incremental revenues of
$500,000 per year for five years, but also incur
$150,000 incremental costs per year. Also assume five
year straight-line depreciation is used, marginal tax
rate of 40%. What are the incremental earnings from
year 0 to year 5 for the taking this update?
 Forecasting Incremental Earnings
 Solution
Depreciation=$1,020,000/5=$204,000

Year 0 1 2 3 4 5
Incremental Revenues 500 500 500 500 500
Incremental Costs -50 -150 -150 -150 -150 -150
Depreciation -204 -204 -204 -204 -204
EBIT -50 146 146 146 146 146
Income Taxes @ 40% 20 -58.4 -58.4 -58.4 -58.4 -58.4
Incremental Earnings -30 87.6 87.6 87.6 87.6 87.6
Forecasting Incremental Earnings
 Note:
1. Pro Forma Statement: financials under a set of
hypothetical assumptions.
2. Taxes can be positive or negative. When
incremental EBIT<0, taxes>0, so it is tax savings.
3. We ignore the interest payment here, because by
assumption, the investment decision is independent
from financing decision . So when making capital
budgeting decisions, we treat net income as
unlevered net income.
Taxing Losses for Projects in Profitable
Companies
Problem:
 Kellogg Company plans to launch a new line of high-
fiber, zero-trans-fat breakfast pastries. The heavy
advertising expenses associated with the new product
launch will generate operating losses of $10 million next
year for the product. Kellogg expects to earn pre-tax
income of $320 million from operations other than the
new pastries next year. If Kellogg pays a 40% tax rate on
its pre-tax income, what will it owe in taxes next year
without the new pastry product? What will it owe with
the new pastries?
Taxing Losses for Projects in Profitable
Companies
Solution:
Plan:
 We need Kellogg’s pre-tax income with and without the new
product losses and its tax rate of 40%. We can then compute the
tax without the losses and compare it to the tax with the losses.
 Without the new pastries, Kellogg will owe $320 million  40%
= $128 million in corporate taxes next year. With the new
pastries, Kellogg’s pre-tax income next year will be only $320
million - $10 million = $310 million, and it will owe $310 million
 40% = $124 million in tax.
Determining Incremental Free CFs
 So far, we have discussed incremental earnings forecast of
taking a project.
 However, NPV rule is used to determine whether to take a
project or not. So we need one more step to calculate
incremental effect of the project on the firm’s available cash.
 This is the project’s incremental free cash flow.
 Determining Incremental Free CFs
 Introductory Example (Continued)

Year 0 1 2 3 4 5
Incremental Revenues 500 500 500 500 500
Incremental Costs -50 -150 -150 -150 -150 -150
Depreciation -204 -204 -204 -204 -204
EBIT -50 146 146 146 146 146
Income Taxes @ 40% 20 -58.4 -58.4 -58.4 -58.4 -58.4
Incremental Earnings -30 87.6 87.6 87.6 87.6 87.6
Add Back Depreciation 204 204 204 204 204
Initial Capital Expenditure -1,020
Incremental Free CFs -1,050 291.6 291.6 291.6 291.6 291.6
Taxes
 Taxes are critical financial decision making, every dollar
paid in taxes enriches the government instead of the
shareholders.
 Corporate Taxes - Paid by the corporation out of profits
before shareholders are paid.
 Personal Taxes - Paid by the individuals from earned
income and earnings from capital assets held as
investments.
 System is progressive - Tax rate generally increases with
income.
 Marginal Tax Rate - Tax Rate on next dollar of income.
 Average Tax Rate - Taxes paid/Pretax income
 Marginal vs. Average Corporate Tax
Rates
Taxable Income Marginal Tax Cumulative Average
Rates Tax Liability Rates
$0 - 50,000 15% $7,500 15.00%
50,001 - 75,000 25% 13,750 18.33%
75,001 - 100,000 34% 22,250 22.25%
100,001 - 335,000 39% 113,900 34.00%
335,001 - 10 mil 34% 3.4 mil 34.00%
10 mil - 15 mil 35% 5,150,000 34.33%
15 mil - 18.33 mil 38% 6,416,667 35.00%
18.33 mil + 35% N/A 35.00%

Notice that, while marginal rates fluctuate and rise as high as

39%, average rates increase steadily with taxable income,
until the 35% level is reached.
 Depreciation Methods
• Depreciation is a non-cash expense and must be
added back to cash flows.
• Accelerated depreciation methods (e.g. MACRS)
reduce net income through the earlier recognition of
expenses than expense recognition under straight
line depreciation.
• MACRS Table on Page 326
• Cash flows actually increase because the tax
reduction from depreciation (depreciation tax shield)
is realized earlier.
• Normal practice is to allow only ½ of the first year of
depreciation in the year the asset is acquired.
• (We will ignore this when not using MACRS.)
MACRS Example $100,000 Asset
35% Tax Bracket
Year MACRS Annual Tax Straight Tax
5 Year % Depr. Savings Line Savings
1 20% $20,000 $7,000 $10,000 $3,500
2 32% $32,000 $11,200 $20,000 $7,000
3 19.2% $19,200 $6,720 $20,000 $7,000

4 11.52% $11,520 $4,032 $20,000 $7,000

5 11.52% $11,520 $4,032 $20,000 $7,000

6 5.76% $5,760 $2,016 $10,000 $3,500

PV of Tax $24,156 PV of Tax $21,935
Savings Savings
@ 15 % @ 15 %

Difference in Tax Savings $2,221

 Net Working Capital Effects
 Often new projects require increased investment in Net Working
Capital (e.g. inventory or receivables)
 Project termination will release Working Capital committed to the
project.
 Net Working Capital (NWC)
Net Working Capital = Current Assets - Current Liabilities
= Cash + Inventory + Receivables - Payables
• A increase in NWC means additional investment in working capital, hence
a reduction in cash flow.

“Change” in NWC in t = NWCt – NWCt-1

• Whenever a project causes a change in NWC, that change must be
subtracted from incremental earning
Determining Incremental Free CFs
 For example, consider a three-year project that causes the
firm to build up initial inventory by $20,000 at year 0 and
maintain that level of inventory in year 1 and year 2, before
drawing it down as the project ends at year 3. The
incremental free cash flows are:

1 Year 0 1 2 3

2 Net Working Capital 20,000 20,000 20,000 0

3 Change in NWC 20,000 0 0 - 20,000

4 Cash Flow Effect -20,000 0 0 20,000

 Determining Incremental Free CFs
 Calculating Free CF directly

Unlevered Net Income

Free Cash Flow  (Revenues  Costs  Depreciation)  (1  tax rate)
 Depreciation  CapEx  Changein NWC

Free Cash Flow = (Revenues – Costs) ×(1 – tax rate)

- CapEx – Change in NWC + tax rate ×Depreciation
The last term “tax rate × Depreciation” is called
depreciation tax shield.
 Determining Incremental Free CFs
 Calculating the NPV
 Introductory Example (Continued)
Year 0 1 2 3 4 5
Incremental Free CFs -1,050 291.6 291.6 291.6 291.6 291.6

Assume the discount rate is 10%, are you going to take this
upgrade?
Answer: NPV  1050  291.6 (1  1 5 )  55.39  0
0.1 1.1
So yes, you should take this upgrade.
Only Incremental Cash Flows Matter
 Definition of Incremental Cash Flow
 CF with the Project – CF without the Project

 Include All Incidental or Indirect Effects

 Will project help or hurt existing projects

 Forget Sunk Costs

 Earlier decisions can’t be reversed today

 Include Opportunity Costs

 Value alternative uses of existing assets (market value)
Considerations in NPV Analysis
Project Interactions
 Cannibalization
 New product will decrease sales of existing products.

 Incremental Benefits
 New product will increase sales of related accessories.
Project Interaction Example
 Calculate the NPV of the Gillette New Razor Project
 Should the Company Take On the Project?

 Recalculate the NPV including the new assumptions of

cannibalization of the existing products.
 Should the Company Take On the Project?

 What do we learn from this analysis.

Other Effects on Incremental Free CFs
 Opportunity Cost
• The opportunity cost of using a resource is the value it could
have provided in its best alternative use.
• It should be included in the incremental cost of the project.
• Even if you own the resource, or the resource is currently idle,
there is an opportunity cost.
Other Effects on Incremental Free CFs
 Accelerated Deprecation
• Depreciation increases firm’s cash flows through depreciation
tax shields.
• Due to time value of money, firms would prefer the most
accelerated method of depreciation, so that the NPV of these
depreciation tax shields.
• The most accelerated depreciation method is Modified
Accelerated Cost Recovery System (or MACRS).
 Other Effects on Incremental Free CFs
 Liquidation or Salvage Value
• Assets that are no longer needed often have a resale value or
salvage value.
• But only part of this resale is taxable: capital gain, the
difference between this value and the book value of the asset.

Capital Gain = Sale Price - Book Value

Book Value = Purchase Price - Accumulated Depreciation

 Other Effects on Incremental Free CFs
 Liquidation or Salvage Value
So the total cash flow effect of a liquidation is going to be

After-Tax Cash Flow from Asset Sale

= Sale Price - Tax Rate  Capital Gain
= Sale Price –Tax Rate  (Sale Price - Book Value)
= Sale Price  (1- Tax Rate) + Book Value  Tax Rate
 Other Effects on Incremental Free CFs
 Replacement Example
You are trying to decide whether to replace a machine on your
production line. The new machine will cost $1 million, but will
be more efficient than the old machine, reducing costs by
$500,000 per year.Your old machine is fully depreciated, but you
could sell it for $50,000.You would depreciate the new machine
over a 5-year life using MACRS. The new machine will not change
your working capital needs.Your tax rate is 35%, and the cost of
capital is 10%.

Year 0 1 2 3 4 5
Depreciation Rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
Other Effects on Incremental Free CFs
 Solution
• Depreciation schedule

• Capital Gain on salvage = $50,000 - $0= $50,000

• Cash flow from salvage value:
+50,000 – (50,000)(.35) = 32,500
Analyzing the Project
 The most difficult part of capital budgeting is deciding how
to estimate the cash flows and cost of capital. The following
are methods that assess the importance of this uncertainty
and identify the drivers of value in the project:
 Sensitivity Analysis
 Break-Even Analysis
 Scenario Analysis
Analyzing the Project
 Sensitivity analysis breaks the NPV calculation into its
component assumptions and shows how the NPV varies
as the underlying assumptions change. In this way, sensitivity
analysis allows us to explore the effects of errors in our NPV
estimates for the project.
Analyzing the Project
 Example
Analyzing the Project
Analyzing the Project
 Scenario Analysis
• Sensitivity analysis consider the consequence of varying only
one parameter a time, by keeping other parameters constant.
• Scenario analysis considers the effect on NPV of
changing multiple parameters.
• For example, we can use scenario analysis to evaluate alternative
pricing strategies.
Analyzing the Project
 Break-Even Analysis
• Analysis of the level of sales (or other variable) at which the
company “breaks even.”
• Accounting Break-Even focuses on the point where Net
Income becomes positive.
• Economic Break-Even focuses on the point where NPV is
greater than zero.
 Analyzing the Project
 Accounting Break-Even Analysis
• Projects have sales, variable costs and fixed Costs.
• The objective is to find the level of a parameter that make the
incremental earning equal to zero.
• Since earning is required to be zero, tax liability is also zero (Tax rate
does not matter). It is equivalent to pretax earning being zero.

Incremental Earning
= Annual Revenues – Variable Costs - Fixed Costs -Depr. =
0
Analyzing the Project
 Example: 5-year project to produce printers:
• Revenue $100 per unit for a Printer .
• Variable Costs $70 per unit.
• Fixed Costs $300,000.
• $1,500,000 Investment, Straight-line Depr.
• Taxes 35%
Question: What is the accounting break-even
number of units to be sold?
Analyzing the Project

 Revenues ($100/unit)
Expenses ($70/unit)
Actual Gross Profit ($30/unit)
Gross Profit Required
Fixed Costs - 300,000
Depreciation - 300,000
Pretax profit 0
 Analyzing the Project
 Solution:
Gross Profit Required
= Fixed Cost + Depreciation
= $300,000 + $1,500,000/5 = $600,000
= Actual Gross Profit
= $30/unit  Number of Units
So break-even Units= $600,000/$30 = 20,000 units
Analyzing the Project
 Note to Accounting Break Even
1. Accounting Break-Even results in cash flows equal
to depreciation.
2. Break-Even generates cash flows sufficient to
recover the initial investment over the life of the
project. ($300,000 x 5 = $1,500,000)
3. As a result, Accounting Break-Even always results
in a Negative NPV.
4. Investors will not be happy if the company simply
returns their original investment over time.
 Analyzing the Project
 Economic Break-Even Analysis
• Positive NPVs require that the PV of cash inflows exceed the PV of
the Investment Required.
• The objective is to find the level of a parameter that make the
incremental NPV equal to zero.
• Since earning is not zero any more, tax liability is not zero. Tax rate
MATTERs!
• To calculate, start with cash flows and go backward.
Analyzing the Project
 Example (revisited): 5-year project to produce printers:
 Revenue $100 per unit for a Printer
 Variable Costs $70 per unit.
 Fixed Costs $300,000
 Initial Investment $1,500,000, straightly-line depr.
 Taxes 35%
 Required Return on Investment = 10%
Question: What is the economic break-even
number of units to be sold?
 Analyzing the Project
Solution:
• The first step is to calculate the required cash flow each period to
equate NPV to 0.
• Note the CF0 is -$1,500,000, and cash flows from year 1 through
year 5 are the same.
Year 0 1 2 3 4 5
Cash Flows -1,500,000 CF CF CF CF CF

So

We have the required cash flow CF= $395,696

Analyzing the Project
Revenues ($100/unit)
Expenses ($70/unit)
Actual Gross Profit ($30/unit)
Gross Profit Required
Fixed Costs - 300,000
Depreciation - 300,000
Pretax profit
Tax @ 35%
Profit after tax
+ Depreciation +300,000
Required Cash Flow 395,696
 Analyzing the Project
 Solution (Continued)
• Profit after tax= 395,696- 300,000 = 95,696
• Pretax profit= 95,696/(1-35%) = 147,224.62
• Gross Profit Required
= 147,224.62+300,000+300,000 = 747,224.62
• Economic Break-Even number of units required is
747,224.62/30 = 24,907.49
• Note this number required is bigger than the accounting break-even,
20,000.
Real Option
 We assumed that our forecast of the project’s expected
future cash flows already incorporated the effect of
future decisions that would be made. In truth, most
projects contain real options. A real option is the
right, but not the obligation, to take a particular
business action.
 Common types of real options in capital budgeting
• Option to delay
• Option to expand
• Option to abandon
Common Real Options
Timing Option (Option to Delay)
The option to delay commitment (the option to time the
investment) is almost always present.
A company would only choose to delay if doing so would
increase the NPV of the project by more than the cost of
capital over the time of delay.

Abandonment Option
An abandonment option is the option to walk away.
Abandonment options can add value to a project because a
firm can drop a project if it turns out to be unsuccessful.
Common Real Options
Option to Expand
The option to expand, is the option to start with limited
production and expand only if a product is successful.
A company could, instead, test market the product in
limited release before committing fully to it. It is
possible that by reducing its upfront commitment, and
only choosing to expand if a product is successful, that an
increase the NPV of the product could result.