Advanced Corporate Finance I

Valuation

Class 3
Capital Budgeting &
Project FCF Examples

Professor Janis Skrastins

 Outline

 Capital budgeting & project FCF examples

 Indirect Method vs. Direct Method
 Sales erosion, opportunity cost, and sunk cost
 A typical capital budgeting example

2 FIN 534 / Janis Skrastins

 Capital Budgeting &
Project FCF Examples

3 FIN 534 / Janis Skrastins

 Example 3.1(a): Project FCF

Consider a project, for which in the 1st year of the project:

 You expect sales to be equal to $3,000.
 Your operating expenses will be $2,500.
 You will incur interest expense of $30.
 The depreciation in the first year is $140.
 You make no capital expenditure in that year.
 The (operating) NWC increases by $150.
 Suppose your (marginal) tax rate equals 30%.

What’s the Project Free Cash Flow in year 1?

4 FIN 534 / Janis Skrastins

 Example 3.1(a): Indirect Method
Sales
(–) COGS/Operating Expenses
(–) Depreciation
(–) Interest Expenses
EBT
(–) Taxes @ 30%
Net Income
(+) Depreciation
(+) After-tax Interest Expenses
(–) CAPEX
(–) Change in NWC
Project Free Cash Flow
5 FIN 534 / Janis Skrastins
 Example 3.1(a): Indirect Method
Sales 3000
(–) COGS/Operating Expenses 2500
(–) Depreciation 140
(–) Interest Expenses 30
EBT 330
(–) Taxes @ 30% 99
Cancelled out
Net Income 231
(+) Depreciation 140
(+) After-tax Interest Expenses 21
(–) CAPEX 0
(–) Change in NWC 150
Project Free Cash Flow $242
6 FIN 534 / Janis Skrastins
 Example 3.1(a): Direct Method
Sales
(–) COGS/Operating Expenses
(–) Depreciation
EBIT (NOP)
(–) Operating Taxes @ 30%
NOPAT (Unlevered Net Income)
(+) Depreciation
(–) CAPEX
(–) Change in NWC
Project Free Cash Flow

Indirect Method and Direct Method must give us the same FCF!

7 FIN 534 / Janis Skrastins

 Example 3.1(a): Direct Method
Sales 3000
(–) COGS/Operating Expenses 2500
Does not subtract
(–) Depreciation 140
Interest Expenses
EBIT (NOP) 360
(–) Operating Taxes @ 30% No Interest 108
Tax Shield
NOPAT (Unlevered Net Income) 252
(+) Depreciation 140
Does not add back
(–) CAPEX 0
After-tax Interest
(–) Change in NWC Expenses 150
Project Free Cash Flow $242

Indirect Method and Direct Method must give us the same FCF!

8 FIN 534 / Janis Skrastins

 Example 3.1(b): Sales Erosion + Other Costs
Reconsider the earlier project in the 1st year:
 You expect sales to be equal to $3,000.
 Your operating expenses will be $2,500.
 You will incur interest expense of $30.
 The depreciation in the first year is $140
 The (operating) NWC increases by $150.
 Suppose your (marginal) tax rate equals 30%.
 You estimate sales erosion at 5% of project sales.
 There is an opportunity (sunk) cost of $100 ($100)

What’s the Project Free Cash Flow in year 1?

9 FIN 534 / Janis Skrastins

 Example 3.1(b): Sales Erosion
Direct Method

Sales (3000 – 5%*3000)

(–) COGS/Operating Expenses
(–) Depreciation
EBIT (NOP)
(–) Operating Taxes @ 30%
NOPAT (Unlevered Net Income)
(+) Depreciation
(–) CAPEX
(–) Change in NWC
Project Free Cash Flow
10 FIN 534 / Janis Skrastins
 Example 3.1(b): + Other Costs
Direct Method

Sales (3000 – 5%*3000) 2850

(–) COGS/Operating Expenses (incl. Opp. Cost 100) 2600
(–) Depreciation 140
Sunk cost of 100:
EBIT (NOP) 110
irrelevant
(–) Operating Taxes @ 30% 33
NOPAT (Unlevered Net Income) 77
(+) Depreciation 140
(–) CAPEX 0
(–) Change in NWC 150
Project Free Cash Flow $67
11 FIN 534 / Janis Skrastins
 Example 3.2: A Capital Budgeting Case
Olin Airlines’ Facility Project
 Olin Airlines is considering to build an aircraft maintenance facility.
The company estimates that the facility will help to generate sales of
$60,000 for the first year, and then $62,250 in year 2, $64,500 in year
3, $66,750 in year 4, $69,000 in year 5, and $71,250 in year 6.
 Note that all numbers in this case are in thousand dollars.
 [Capital spending] All required equipments such as machines, carts and
trucks cost in total of $18,000 and are 6-year MACRS property, and are
expected to have a salvage value of 10% of cost after 6 years.
 [Net working capital] It also needs a net working capital of $3,000 to
start. This amount is expected to grow at 5% per year. Injections of net
working capital are recovered in full at the end of the project.
 [Costs] Annual fixed operating costs are expected to be $53,000.
Variable costs, initially $3,000, are expected to grow at 5% per year.
 The tax rate is 15% and discount rate is 15%. There is no interest
income, nor expense. The facility is evaluated over a six-year life.

 Should Olin Airlines proceed with this project?

12 FIN 534 / Janis Skrastins

 Example 3.2: Facility Project (I)

 Step 1. Projecting NOPAT

 Project revenues
 Project costs

Variable Fixed Book

Year Costs Costs Depreciation MACRS % Value
0 $18,000
1 3,000 53,000 3,600 20% 14,400
2 3,150 53,000 5,760 32% 8,640
3 3,308 53,000 3,456 19.20% 5,184
4 3,473 53,000 2,074 11.52% 3,110
5 3,647 53,000 2,074 11.52% 1,037
6 3,829 53,000 1,037 5.76% 0
$18,000
13 FIN 534 / Janis Skrastins
 Example 3.2: Facility Project (II)

 Step 1 (continued)
 Projecting NOPAT

Revenues 60,000 62,250 64,500 66,750 69,000 71,250

Variable Costs 3,000 3,150 3,308 3,473 3,647 3,829
Fixed Costs 53,000 53,000 53,000 53,000 53,000 53,000
Depreciation 3,600 5,760 3,456 2,074 2,074 1,037
EBIT 400 340 4,737 8,204 10,280 13,384
Operating Taxes 60 51 710 1,231 1,542 2,008
NOPAT 340 289 4,026 6,973 8,738 11,377

14 FIN 534 / Janis Skrastins

 Example 3.2: Facility Project (III)
 Step 2. Estimate changes in NWC and CAPEX
Initial NWC 3,000
Projected NWC 3,150 3,308 3,473 3,647 3,829 0
Change in NWC 3,000 150 158 165 174 182 -3,829

CAPEX
Initial outlay 18,000
18000

-1530
After tax salvage -1,530
CAPEX 18,000
18000 -1,530
-1530

 Recover NWC: –(3,000+150+158+165+174+182) = –3,829

 After-Tax Salvage Value: –(0.118,000)(1–0.15) = –1,530

15 FIN 534 / Janis Skrastins

 Example 3.2: Facility Project (IV)

 Step 3. Estimate project FCF

Year 0 1 2 3 4 5 6
NOPAT 0 340 289 4,026 6,973 8,738 11,377
+ Depreciation 0 3,600 5,760 3,456 2,074 2,074 1,036
- Change in NWC 3,000 150 158 165 174 182 -3,829
- CAPEX 18,000 0 0 0 0 0 -1,530
Project FCF -21,000 3,790 5,892 7,317 8,873 10,629 17,772

 Step 4. Compute NPV at 15% discount rate

 NPV = $9,602

16 FIN 534 / Janis Skrastins

 Example 3.2: Capital Budgeting Case Summary
Olin Airlines’ Facility Project

 Discussion of the new Facility Project

 Analysis:
 Step 1. Projecting NOPAT
 Project revenues
 Project costs
 Project depreciation
 Step 2. Estimate changes in NWC and CAPEX
 Depreciation = (Cost – BV of Salvage)  Depre. Rate
 After-Tax Value = Market Value (MV) of Machine
– [MV – Book Value (BV)]  Tax Rate
 Step 3. Estimate project FCF
 Step 4. Compute NPV of the project by discounting
 Conclusion

17 FIN 534 / Janis Skrastins

 Example 3.3:
Considering Replacing an Assembly Line
 Old line:  New line:
 Operating expenses: $510k  Operating expenses: $200k
annually annually from year 1.
 installed 3 years ago at a cost of  Requires investment of $1
$500k million.
 Depreciated straight line over 5  Depreciated using MACRS over
years, 6 years (same as earlier
example), no salvage value.
 It will last 6 more years, with no
salvage thereafter.  One-time increase in working
capital of $20k
 It could be sold now for $40k
 Tax rate 35%
 Discount Rate: 16%
 Q1: Should we invest in the new line?
 Q2: At what price would we be indifferent?

18 FIN 448 / Janis Skrastins

 About Case #1: Hansson Private Label

19 FIN 448 / Janis Skrastins

 More on Net Working Capital:
Cash Conversion Cycle = DI + DSO – DPO

Recall:

20 FIN 448 / Janis Skrastins

 More on Net Working Capital:
Cash Conversion Cycle = DI + DSO – DPO

 Days in Inventory (DI): Number of days you have items tied

up in inventory
 DI = Inventory / Average Daily COGS

 Days Sales Outstanding (DSO): Number of days it takes to

collect from your customers
 DSO = Accounts Receivable / Average Daily Sales Revenue

 Days Payables Outstanding (DPO): Number of days it takes

you to pay your suppliers
 DPO = Accounts Payable / Average Daily COGS

21 FIN 448 / Janis Skrastins

 Some WACC Formulas

𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑅𝐸 + 𝑅𝐷 (1 − 𝜏𝐶 )
𝑉 𝑉

𝐷
𝑅𝐸 = 𝑅𝐴 + 𝑅𝐴 − 𝑅𝐷 1 − 𝜏𝐶
𝐸

𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 )(1 − 𝜏𝐶 )
𝐸

22 FIN 448 / Janis Skrastins

 Expansion and Risk at Hansson Private Label, Inc.

 A good exercise on FCF, NPV, and capital budgeting decision

 A starting discussion on WACC as the discount rate
 Need a solid grip on the concepts and computation

 Deliverable:
 Each group will submit a 3 page memorandum of analysis and
recommendations covering the case study questions plus any
accompanying tables you wish to include as appendices.
 Both one electronic copy (by 1pm of due date) and one hard
copy (in class).
 I will provide hard copies after the case discussion.
23 FIN 448 / Janis Skrastins