Lectures 4-5

Corporate
Finance

Capital Lectures 4-5

Budgeting

Project
Corporate Finance
Analysis 2019

Theodosios Dimopoulos

HEC Lausanne
Swiss Finance Institute

October 8,15 2019

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 Capital Budgeting

Lectures 4-5

Corporate
Finance

Capital Capital Budgeting decision: What real assets should the

Budgeting
firm invest in?
Project
Analysis

Goal: identify opportunities to create streams of future

cash flows that are worth more to the financial markets
than the cost of creating them

How do we measure these benefits? Compute the NPV!

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 Computing NPV

Lectures 4-5

Corporate
Finance Steps:
Capital 1 Estimate future cash flows
Budgeting

Project
Analysis
E (C1 ), E (C2 ), . . . , E (Ct ), . . . , E (CT )

2 Estimate opportunity cost of capital

r ∗ = rf + β[E (rm ) − rf ]

3 Calculate
X E (Ct )
NPV = −I
t
(1 + r ∗ )t

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 What goes in the numerator?

Lectures 4-5

Corporate
Finance

Capital Incremental Cash Flow:

Budgeting

Project
Analysis
1 Incremental
What you learn in Business School: Think on the margin!

2 Cash
Much of what credit analysts, M&A analysts, etc., do is
undoing the accounting to recover the cash

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 Project Example

Lectures 4-5

Corporate
Finance Linksys has completed a $300,000 feasibility study to
Capital
assess the attractiveness of a new product, HomeNet.
Budgeting

Project
The project has an estimated life of four years.
Analysis
Revenue Estimates
- Sales = 100,000 units/year
- Per Unit Price = $260
- Cost Estimates
* Up-Front R&D = $15,000,000
* Up-Front New Equipment = $7,500,000
* Expected life of the new equipment is 5 years. Housed in
existing lab.
* Annual Overhead = $2,800,000
* Per Unit Cost = $110

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 Incremental Earnings Forecast

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 Valuing Projects

Lectures 4-5

Corporate a) Cash flows

Finance
b) Taxes
Capital
Budgeting c) Treatment of inflation
Project
Analysis d) Non-cash items
e) Sunk costs
f) Overhead
g) Opportunity costs
h) Project externalities
i) Working capital requirements
j) Liquidation
k) Continuation value

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 a) Cash Flows
Cash Flows vs. Earnings

Lectures 4-5
Cash flows: difference between cash received and cash
Corporate
Finance paid out
Capital
Budgeting
In finance, you must use cash flows rather than earnings.
Project
Analysis Indeed, you cannot spend earnings

Principles governing accounting earnings measurement:

Show revenues when products and services are sold or
provided, not when they are paid for
Show expenses associated with these revenues rather than
cash expenses
Only expenses associated with creating revenues in the
current period should be treated as operating expenses
Expenses that create benefits over several periods are
written off over multiple periods (depreciation)
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 a) Cash Flows
Forget Financing Costs!

Lectures 4-5

Corporate
Finance
X E (Ct )
Capital
NPV = −I
Budgeting
t
(1 + r ∗ )t
Project
Analysis

Ct is the after-tax operating cash flow

The cost of funds is the reason we discount

Including them in the numerator, in any form, is double

counting!

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 b) Taxes
Before or after tax?

Lectures 4-5

Corporate
Finance Market rates of return are earned on payoffs from
securities:
Capital
Budgeting

Project
Analysis
after corporate tax
before personal tax

When applying them in capital budgeting, discount

After-Corporate Tax Operating Cash Flows

Do not subtract personal taxes. That would be double

counting!

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 b) Taxes
The tax bill

Lectures 4-5

Corporate
Finance
Marginal Corporate Tax Rate
Capital
Budgeting
- The tax rate on the marginal or incremental dollar of
Project
Analysis pre-tax income. Note: A negative tax is equal to a tax
credit.

Income Tax=EBIT × τ
In real life, corporate taxes are a more complicated issue
Tax Carrybacks
Tax Carryforwards

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 b) Taxes
Carrybacks and Carryforwards

Lectures 4-5

Corporate Tax loss carryforwards and carrybacks allow corporations to take

Finance losses during its current year and offset them against gains in
Capital
nearby years.
Budgeting
When a firm can carry back losses, it receives in the current
Project
Analysis year a refund for taxes in previous years.
For example if the firm has paid a total of 50m. in taxes in the
previous two years and has pre-tax income of 70m. this year, it
will be taxed for 20m.
If the firm has exhausted its carryback then it can carryforward
any remaining losses to reduce future tax payments.
Until recently, in the US, firms could carry back losses for two
years and carry forward losses for 20 years.
The American Reinvestment Act (2009) extended the carryback
period to 5 years.

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 b) Taxes
Tax Loss Carryforward: Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 b) Taxes
Tax Loss Carryforward: Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 c) Treatment of Inflation
Nominal or Real?

Lectures 4-5

Corporate
Finance
Inflation refers to the rise in the general price level as
Capital
Budgeting measured against a standard level of purchasing power
Project
Analysis
There is inflation (deflation) when the quantity of
consumption goods that a fixed amount of money can buy
decreases (increases) over time
Be consistent in your treatment of inflation!
Use a real discount rate to discount real cash flows
Use a nominal discount rate to discount nominal cash flows
The nominal approach is often preferable, since returns
from financial markets are nominal

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 c) Treatment of Inflation
What’s real?

Lectures 4-5
Real Measured in units of account with a constant
Corporate
Finance purchasing power
Capital Nominal Measured in units of account with purchasing
Budgeting
power that depends on inflation
Project
Analysis

Examples:

Lease: Nominal

Estimates of costs from an engineer: Often these will be

real

Tax savings from depreciation: Nominal

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 c) Treatment of Inflation
Relation between nominal and real cash flows

Lectures 4-5
i Inflation rate
Corporate
Finance CFtn Nominal cash flow at date t
Capital CFtr Real cash flow at date t
Budgeting

Project
rr Real discount rate
Analysis
rn Nominal discount rate

CFtn = CFtr (1 + i)t

Fisher’s formula:

1 + rn = (1 + rr )(1 + i)

or
rn ≈ rr + i
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 c) Treatment of Inflation
Example

Lectures 4-5

Corporate Inflation: 5%; Nominal discount rate: 12%

Finance
1. Nominal cash flows - Nominal discount rate
Capital
Budgeting
0 1 2
Project
Analysis -100 70 60

NPV at 12%: 10.33

2. Real cash flows - Real discount rate
0 1 2
-100 66.67 54.43

NPV at 6.67%: 10.33

Calculations: 66.67=70/1.05; 54.43=60/1.052 ;
1.0667=1.12/1.05

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 d) Non-Cash Items
Depreciation

Lectures 4-5

Corporate
Finance
Forget non-cash items (i.e., depreciation)
Capital
Budgeting ... but...
Project
Analysis
don’t forget the tax consequences of non-cash items

Depreciation is only important because it reduces taxable

income

Types of depreciation:
Straight-line depreciation
Accelerated depreciation (MACRS)

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 d) Non-Cash Items
Tax Implications

Lectures 4-5

Corporate
Finance Project generates:
Capital CtPT pre-tax operating cash flow at date t
Budgeting

Project Dt Depreciation charge at t

Analysis
τ Corporate tax rate
The after-tax cash flow at t will be:

CtPT − τ [CtPT − Dt ] = CtPT (1 − τ ) + τ Dt

= (CtPT − Dt )(1 − τ ) + Dt

Since we discount after-tax cash flows, when do you want the

depreciation?

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 d) Non-Cash Items
HomeNet Depreciation Example

Lectures 4-5 Year 0 1 2 3 4 5

Equipment cost (7500)
Corporate Straight line Depr. 20% 20% 20% 20% 20%
Finance Depr. Expense (1500) (1500) (1500) (1500) (1500)

Capital MACRS Depr. Rate 20% 32% 19.20% 11.52% 11.52% 5.76%
Budgeting Depr. Expense (1500) (2400) (1440) (864) (864) (432)

Project
Analysis Assume that cash flows occur at the end of each year.

Straight line depreciation: The asset’s cost, less of expected

salvage value, is divided equally over its estimated useful life

MACRS: Use table of depreciation rates. Tax code allows first

depreciation in year 0, as long as the equipment is put into use
by the end of year 0.

MACRS allows faster depreciation, therefore higher NPV of

project.

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 d) Non-Cash Items
MACRS depreciation

Lectures 4-5
only need for tax computation

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 e) Sunk Costs

Lectures 4-5
Forget sunk costs!
Corporate
Finance

Capital Past and irreversible outflows

Budgeting

Project Sunk costs are not incremental to the decision

Analysis
They have already been incurred
For some reason (behavioral?) people don’t get this: sunk
cost fallacy
Famous examples:
- Lockheed and the TriStar airplane
- Concorde
HomeNet Example: The cost of feasibility study
($300,000) is already paid. Should be irrelevant in the
investment decision.

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 f) Overhead
Overhead Often Not Incremental

Lectures 4-5

Corporate
Finance

Capital
Examples of overhead costs:
Budgeting Administrative staff in head office
Project
Analysis
Rent, heat, light...
Accountants want to find places and ways to allocate
overhead
Principle of incremental cash flows: include only the extra
expenses that would result from the project
A project may or may not generate extra overhead
expenses

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 g) Opportunity Costs

Lectures 4-5

Corporate
Finance

Capital
Budgeting
Opportunity costs: The value a resource could have
Project provided in its best alternative use
Analysis

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.

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 g) Opportunity Costs
HomeNet Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 h) Project Externalities

Lectures 4-5
Externalities are indirect effects of the project that may
Corporate
Finance
affect the profits of other business activities of the firm.
Capital
Budgeting Example: Cannibalization,i.e. a new product displacing
Project sales of an existing product.
Analysis
HomeNet Example:
25% of sales come from customers who would have
purchased an existing Linksys wireless router if HomeNet
were not available.
This reduction in sales of the existing wireless router is a
consequence of the decision to develop HomeNet
The following table takes into account both the
opportunity costs (in SG&A) and the cannibalization effect
(Sales).
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 Opportunity costs &Externalities
HomeNet Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 i) Working Capital Requirements

Lectures 4-5

Corporate
Finance Working capital: difference between short term assets and
Capital
liabilities
Budgeting
Principal short term assets: accounts receivable and
Project
Analysis
inventories of raw materials and finished goods
Principal short term liabilities: accounts payable
Don’t forget added working capital!
Classic mistake for small business
Working capital is a permanent investment in your
business, as long as you expect it to operate
If you expect the business to grow, additional investments
in working capital will be required

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 i) Working Capital Requirements
HomeNet Example

Lectures 4-5

Corporate
Finance
Assume that Sales are as in the ”Opportunity Costs &
Capital Externalities” slide.
Budgeting

Project Further assume that 15% of HomeNet’s sales and

Analysis
purchases from suppliers will not be paid immediately.
How can we forecast net working capital?

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 Free Cash Flows

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis Free Cash Flow=(Revenue-Cost-Depreciation)× (1 − τ )
+Depreciation-Capex-∆NWC
Free Cash Flow= (Revenue-Cost)× (1 − τ )
-Capex+τ ×Depreciation-∆NWC

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 Free Cash Flows
HomeNet Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 j) Liquidation

Lectures 4-5

Corporate
Finance
At the end of their life, projects may generate cash flows
Capital
Budgeting from selling equipment and other assets.
Project
Analysis Those cash flows generate a liquidation or salvage value.
In some cases these can be negative (e.g. cost of
scrapping obsolete equipment).
Capital Gain=Sale Price - Book value, where
Book value=Purchase Price- Accumulated depreciation
After tax cash flow= Sale Price-τ × Capital Gain

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 i) Liquidation
HomeNet Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 j) Liquidation
HomeNet Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 k) Continuation value

Lectures 4-5

Corporate
Finance
Projects may have an infinite maturity
Capital
Budgeting
In this case, the practice is to forecast cash flows up to a
Project
Analysis
year and then project cash flows into the future using an
assumption (e.g. constant growth).
That means we need to find the terminal value of the
project and discount it to present
We will return to this subject later
For now let’s see a simple example

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 k) Continuation value
Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 k) Continuation value
Example

Lectures 4-5

Corporate
Finance

Capital
Budgeting

Project
Analysis

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 Summary

Lectures 4-5
Only Cash Flow is relevant
Corporate
Finance Always estimate cash flows on an incremental basis
Capital Do not include non-cash expenses (depreciation, amortization,
Budgeting
etc.)
Project
Analysis Do include the corresponding cash flows (capex, changes in WC,
etc.)
Do include the tax gains from non-cash expenses
Do not include financing flows such as interests, nor their
associated tax deduction
Do not subtract personal taxes
Be consistent with the treatment of inflation
Forget sunk costs, beware of overhead costs
Account for opportunity costs and externalities
Include the liquidation or continuation value
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 Project Analysis

Lectures 4-5

Corporate
Finance
“A project is not a black box”
Capital
Budgeting What are the crucial assumptions in project valuation?
Project
Analysis
‘What if’ techniques:
i. Sensitivity analysis: what is the effect of a change in one
of the variables (sales, costs, etc.) on project’s NPV?
ii. Scenario analysis: effect on project NPV of changing
several variables at a time.
iii. Break-even analysis: Analysis of the level of sales (or other
variable) at which the company breaks even.
iv. Monte Carlo simulation: Estimation of the probabilities of
different possible outcomes.

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 Example

Lectures 4-5

Corporate Expected cash flow forecasts for Otobai Company’s Motor

Finance
Scooter project:
Capital
Budgeting

Project
Analysis

Cost of capital of 10%

P10 3
NPV = −15 + t=1 (1.1)10 = 3.43 billion Yen

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 i. Sensitivity Analysis

Lectures 4-5

Corporate How does the NPV of the project changes if one of the
Finance
cash flow components changes?
Capital
Budgeting Possible outcomes:
Project
Analysis

NPVs:

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 ii. Scenario Analysis

Lectures 4-5

Corporate
What would be the effect of a sharp rise in oil prices on the NPV of
Finance the project?
Capital
This would affect several variables at the same time.
Budgeting

Project
Analysis

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 iii. Break-Even Analysis

Lectures 4-5
Point at which NPV=0 is the break even point.
Corporate
Finance Otobai Motors has a breakeven point of 85,000 units sold.

Capital
Budgeting

Project
Analysis

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 iv. Monte Carlo Simulation

Lectures 4-5

Corporate
Finance
Scenario analysis considers the effect of a limited number
Capital
Budgeting of plausible combinations of variables.
Project
Analysis
MC enables to inspect the entire distribution of project
outcomes.

Modeling process:
Step 1: Modeling the Project
Step 2: Specifying Probabilities
Step 3: Simulate the Cash Flows

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 iv. Monte Carlo Simulation

Lectures 4-5
- To analyze the effect of future decisions to the present value
Corporate
Finance today, one needs to integrate out uncertainty, which is usually
done by Monte Carlo Simulation
Capital
Budgeting

Project
Analysis - The modern version of the Monte Carlo method was invented in
the late 1940s by Stanislaw Ulam, while he was working on
nuclear weapon projects at the Los Alamos National Laboratory.

- It was named by Nicholas Metropolis, after the Monte Carlo

Casino, where Ulam’s uncle often gambled.

- Shortly, von Neumann understood its importance and

programmed the ENIAC computer to carry out Monte Carlo
calculations.
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 iv. Monte Carlo Simulation

Lectures 4-5
- Monte-Carlo Simulation is a technique for computing
Corporate
Finance probabilities and statistical moments

Capital
- Imagine that x ∼ N (0, 1) with density φ(x) and that you want
Budgeting to compute E (h(x))
Project
Analysis - If h(x) = x, this is easily done analytically
- If h(x) = cos(x(exp(sin(x − log (4 + x))))) then... good luck
- Still numerical integration techniques could provide an accurate
method for evaluating integrals
- Assume a real valued function g (x) : [a, b] → R
- The numerical methods devise a sequence of quadrature points
xk ∈ [a, b] , k = 1, .., n and associated weights wk such that
Pn Rb
k=1 wk g (xk ) u a g (x)dx
- Setting g (x) = h(x)φ(x), we can approximate the value of the
expectation E (h(x))
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 iv. Monte Carlo Simulation

Lectures 4-5

Corporate - However numerical integration methods become quickly

Finance
burdensome once more than 2-3 variables of integration are
Capital
Budgeting
introduced
Project - Instead Monte-Carlo methods can easily handle thousands of
Analysis
variables of integration
- This will allow us to incorporate multiple sources of uncertainty
- How can that be?
- It is a straightforward consequence of the idea of Monte-Carlo
sampling:
- Rather than using integrals, just generate random numbers
according to the assumed distribution and compute sample
statistics on the generated data

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 iv. Monte Carlo Simulation

Lectures 4-5

Corporate
Finance

Capital - Assume h(x) : R k → R and an associated pdf, f (x)

Budgeting
n
Project
- Given a random sample (xk )k=1 , where xk ∼ f (.),
Analysis
Pn Z
k=1 h(xk )
u h(x)f (x)dx
n Rn

- This means that a multidimensional integral can be

approximated with a simple average over a random sample
realization, provided that the number of observations is large
enough

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 iv. Monte Carlo Simulation

Lectures 4-5

Corporate Question: How can we generate random data according to a cdf

Finance
distribution FX (.)?
Capital
Budgeting
Answer:
Project - Begin by drawing random numbers ui from the uniform
Analysis
distribution U[0, 1]
- Use the probability integral transform theorem:
“Suppose that a random variable X has continuous cdf FX .
Then Y = FX (X ) ∼ U[0, 1]”
- This implies that xi = FX−1 (ui ) will have cdf FX
- Indeed
Pr (xi < x) = Pr (FX−1 (ui ) < x) = Pr (ui < FX (xi )) = FX (xi )

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 iv. Monte Carlo Simulation

Lectures 4-5
Useful Excel Commands: RAND(), NORMINV()
Corporate
Finance
Example
Capital
Budgeting Simulate
Project
Analysis
- a N (1, 2) random variable
- the autoregressive process xt+1 = 0.5xt + 0.8εt+1 , x1 = 1 where
εt+1 ∼ N (0, 1)
 
1
- a trivariate normal with mean  2 
3
 
1 0.3 −0.1
and covariance matrix  0.3 2 −0.4 
−0.1 −0.4 3
See file Simulation Guide.xlsx

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