FINA 5120

FINA 5120
Corporate Finance
Veronique LAFON-VINAIS
Associate Professor of Business Education, Dept of
Finance
Fall 2022
FUNDAMENTALS OF CAPITAL
BUDGETING
IN THIS CHAPTER…
We will learn about:
• The capital budgeting process
• Forecasting incremental earnings
• Forecasting incremental free cash flows
• Continuation (terminal) value
• Analyzing the project
FINA 5120 – Capital Budgeting

The Capital Budgeting Process
• Capital Budget
– A capital budget lists the projects and investments that a
company plans to undertake during the next period
• Capital Budgeting
– The process of analyzing projects and investment
opportunities and deciding which ones to accept
• Incremental Earnings
– The amount by which a firm’s earnings are expected to
change as a result of an investment decision
– Ultimately we use the incremental earnings to forecast the
actual cash flows of the project
Copyright ©2015 Pearson Education, Inc. All rights reserved.
FINA 5120 – Capital Budgeting Process

Operating Expenses Versus Capital Expenditures
• Operating Expenses (opex) = surveys, prototypes, ad

campaigns…
• Capital Expenditures (capex) = investment in PP&E
(property, plant and equipment)
– Such expenditures are not directly listed as expenses when
calculating earnings (i.e. they are not reported in the income
statement directly)
– Instead, the firm deducts a fraction of the cost of these items
each year as depreciation
– The accounting and tax treatment of capex is one of the key
reasons why earnings are not an accurate representation of
cash flows
FINA 5120 – Forecasting Incremental Earnings

Depreciation
• Depreciation
– Depreciation expenses do not correspond to actual cash outflows
– There are different methods of depreciation, in particular straight

line depreciation and accelerated depreciation
• Straight-Line Depreciation:
– the cost of the asset is divided equally over its depreciable life
– The justification of this accounting method is to match the cost of

acquiring the machine to the timing of the revenues it generates

Incremental Revenue and Cost Estimates
• Factors to consider when estimating a project’s revenues
and costs:
1. Life cycle of products: A new product typically has lower sales
initially, as customers gradually become aware of the product.
Sales will accelerate, plateau and eventually decline as the
product faces obsolescence or increased competition (example:
iPhone)
2. The average selling price of a product and its cost of production
will generally change over time as a result of inflation,
decreased costs as technology improves (example: microchips)
3. For most industries, competition tends to reduce profit margins
over time

• The evaluation is on how the project will change the
cash flows of the firm
• Our revenue and cost estimates should be
incremental, meaning that we only account for the
additional sales and costs generated by the project
– Thus, focus is on incremental revenues and costs
Incremental Earnings Before Interest and Taxes (EBIT) = Incremental Revenue –

Incremental Costs – Depreciation

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

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

Application: Example 1
• We are considering upgrading our manufacturing plant to
increase its capacity by purchasing a new piece of
equipment. What are the initial consequences of this
decision on earnings?
• The machine costs $1 million, plus $20,000 to transport
and install it
• An additional $50,000- in engineering costs is needed to
redesign the plant to accommodate the new capacity.
• The additional capacity will allow us to generate $500,000 in
additional revenues per year for 5 years

• The cost of $1 Million of the new equipment and the

associated installation and transportation costs ($20,000)
are capital expenditure (capex); this will be depreciated
over the depreciable life of the equipment
• The $50,000 engineering costs are operating expenses
• The additional costs to operate the new machine are

$150,000 per year

• Assuming the equipment has a 5 year depreciable
life and we use the straight-line method,
• we can expense: $1,020,000/5 = 204,000 per year
for 5 years as depreciation expense

• The new machine allows us to generate $500,000
additional revenues per year for 5 years
• There was a $50,000 engineering cost at installation

• Incremental Earnings Forecast
Incremental Earnings = (Incremental Revenues – Incremental Costs – Depreciation)  (1

– Tax Rate)

Illustration: HomeNet part 1
• Based on extensive marketing surveys, the sales forecast for HomeNet
is 40,000 units per year. Given the pace of technological change,
Linksys expects the product will have a four-year life and an expected
wholesale price of $200 (the price Linksys will receive from stores).
Actual production will be outsourced at a cost (including packaging) of
$90 per unit.
• To verify the compatibility of new consumer Internet-ready appliances
with the HomeNet system as they become available, Linksys must also
establish a new lab for testing purposes. They will rent the lab space,
but will need to purchase $6.5 million of new equipment. The
equipment will be depreciated using the straight-line method over a 5-
year life.

Illustration: HomeNet part 1
• The lab will be operational at the end of one year.
• At that time, HomeNet will be ready to ship.
• Linksys expects to spend $2.0 million per year on rental costs for the
lab space, as well as marketing and support for this product.
• Forecast the incremental earnings from the HomeNet project.
• Assume 40% marginal tax rate
• What are the incremental earnings in year 3?

SPREADSHEET Spreadsheet HomeNet Example

1 Year 1 2 3 4 5 Assumptions
2 Revenues 8,000 8,000 8,000 8,000 Units Sold (thousands) 40
3 Cost of Goods Sold -3,600 -3,600 -3,600 -3,600 Sale price ($/unit) 200
4 Gross Profit 4,400 4,400 4,400 4,400 Cost of goods ($/unit) 90

Selling, General and
5 Admin -2,000 -2,000 -2,000 -2,000 NWC ($ thousands) 660
Selling, General and Admin
6 Depreciation -1,300 -1,300 -1,300 -1,300 -1,300 ($ thousands) 2,000
7 EBIT 1,100 1,100 1,100 1,100 -1,300 Depreciation ($ thousands) 1,300
8 Income Tax at 40% -440 -440 -440 -440 520 Income Tax Rate 40%
Incremental Earnings
9 (Unlevered Net Income) 660 660 660 660 -780 Cost of purchase in year 0 6,500

Forecasting Incremental Earnings
• Incremental Earnings Forecast
– Pro Forma Statement
• The table calculating incremental earnings that we have
produced in the preceding examples is often referred to as
proforma statement, because it is based on a set of
assumptions rather than actual data
– Taxes and Negative EBIT
• In the example of HomeNet, in the last year EBIT is negative,
due to the final depreciation expense; taxes are still relevant
because if the company earns taxable income elsewhere the tax
savings associated with the HomeNet depreciation expense can
be recouped.

Illustration: NRG
• NRG, Inc. plans to launch a new line of energy drinks.
– The marketing expenses associated with launching the new
product will generate operating losses of $500 million next
year for the product.
– NRG expects to earn pre-tax income of $7 billion from
operations other than the new energy drinks next year.
– NRG pays a 39% tax rate on its pre-tax income.
– What will NRG owe in taxes next year without the new
energy drinks?
– What will it owe with the new energy drinks?

Solution
• Without the new energy drinks, NRG will owe corporate
taxes next year in the amount of:
– $7 billion × 39% = $2.730 billion
• With the new energy drinks, NRG will owe corporate
taxes next year in the amount of:
– $6.5 billion × 39% = $2.535 billion
• Pre-Tax Income = $7 billion - $500 million = $6.5 billion
• Launching the new product reduces NRG’s taxes next

year by:
– $2.730 billion − $2.535 billion = $195 million.

Indirect Effects on Incremental Earnings
• Opportunity Cost
– The value a resource could have provided in its best
alternative use
– Because this value is lost when the resource is used by
another project, we should include the opportunity cost as an
incremental cost of the project
• 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 displace
sales of an existing product. The project externalities should
be included as an incremental cost of the project
FINA 5120 – Opportunity Cost and Forecasting Incremental Earnings

Illustration
• Suppose NRG’s new energy drink line will be housed
in a factory that the company could have otherwise
rented out for $900 million per year.
– How would this opportunity cost affect NRG’s incremental
earnings next year?
• The opportunity cost of the factory is the forgone rent.

• The opportunity cost would reduce NRG’s incremental
earnings next year by:
– $900 million × (1 − .39) = $549 million.
FINA 5120 – Opportunity Cost and Forecasting Incremental Earnings

Sunk Costs and Incremental Earnings
• Sunk costs are costs that have been or will be paid
regardless of whether or not the investment is
undertaken.
– Sunk costs should not be included in the incremental
earnings analysis.
• Sunk costs include:
• Fixed Overhead Expenses
• Past Research and Development Expenditures
• Unavoidable Competitive Effects
FINA 5120 – Sunk Costs & Forecasting Incremental Earnings

Determining Incremental Free Cash Flow: From
Earnings to Free Cash Flow
• Earnings are an accounting measure of the firm’s
performance.
• The firm needs cash to buy things and pay for
expenses.
– Therefore when evaluating a capital budgeting decision we
must determine its consequences on the firm’s available cash.
• Incremental Free Cash Flow
– The incremental effect of a project on a firm’s available
cash
• The most important differences between earnings and
cash flow come from Capex and Depreciation.
FINA 5120 – Determining Incremental Free Cash Flow Copyright ©2015 Pearson Education, Inc. All rights reserved.
Application: Depreciation Impact
• A project has incremental gross profit of $1 million and $200,000 depreciation
expense; the firm’s tax rate is 40%
• Incremental earnings are:
• (1,000,000-200,000)(1-0.40)=$480,000
• But in cash the firm still has $680,000 because the 200,000 depreciation
expense is not a cash expense

FINA 5120 – Determining Incremental Free Cash Flow
Illustration: Capex & Depreciation - HomeNet Part 2
• In the previous example, we computed the incremental earnings for

HomeNet, but we need the incremental free cash flows to decide
whether Linksys should proceed with the project.
• What is the incremental free cash flow at year 3?

SPREADSHEET Spreadsheet HomeNet Example

1 Year 1 2 3 4 5 Assumptions
2 Revenues 8,000 8,000 8,000 8,000 Units Sold (thousands) 40
3 Cost of Goods Sold -3,600 -3,600 -3,600 -3,600 Sale price ($/unit) 200
4 Gross Profit 4,400 4,400 4,400 4,400 Cost of goods ($/unit) 90

5 Admin -2,000 -2,000 -2,000 -2,000 NWC ($ thousands) 660
Selling, General and Admin
6 Depreciation -1,300 -1,300 -1,300 -1,300 -1,300 ($ thousands) 2,000
7 EBIT 1,100 1,100 1,100 1,100 -1,300 Depreciation ($ thousands) 1,300
8 Income Tax at 40% -440 -440 -440 -440 520 Income Tax Rate 40%
Incremental Earnings
9 (Unlevered Net Income) 660 660 660 660 -780 Cost of purchase in year 0 6,500

Solution
• The difference between the incremental earnings and incremental free
cash flows in the HomeNet example will be driven by the equipment
purchased for the lab.
• We need to recognize the $6.5 million cash outflow associated with
the purchase in year 0 and add back the $1.3 million depreciation
expenses from year 1 to 5 as they are not actually cash outflows.

Incremental Free Cash Flows
Spreadsheet -- HomeNet Example Continued
SPREADSHEET

1 Year 1 2 3 4 5
2 Revenues 8,000 8,000 8,000 8,000
3 Cost of Goods Sold -3,600 -3,600 -3,600 -3,600
4 Gross Profit 4,400 4,400 4,400 4,400
5 Selling, General and Admin -2,000 -2,000 -2,000 -2,000
6 Depreciation -1,300 -1,300 -1,300 -1,300 -1,300
7 EBIT 1,100 1,100 1,100 1,100 -1,300
8 Income Tax at 40% -440 -440 -440 -440 520
9 Incremental Earnings 660 660 660 660 -780
10 Add Back Depreciation 1,300 1,300 1,300 1,300 1,300
11 Purchase Equipment -6,500
12 Incremental Free Cash Flows -6,500 1,960 1,960 1,960 1,960 520

Determining Incremental Free Cash Flow
• Net Working Capital
Net Working Capital = Current Assets  Current Liabilities
= Cash + Inventory + Receivables  Payables
– Note we don’t include short term financing such as notes

payable or short term debt (which are current liabilities)
because these result from financing decisions rather than
capital budgeting decisions
• Trade Credit
– The difference between receivables and payables is the net
amount of the firm’s capital that is consumed as a result of
these credit transactions

• Net Working Capital reflects a short term investment
that ties up cash flow that could be used elsewhere.
• Only changes in Net Working Capital impact cash
flows.
• When Net Working Capital increases, it represents a
reduction in cash flow that year. The cash flow effect
from a change in NWC is always equal and opposite to
the change in NWC
• The change in NWC in year t is defined as:
Change in NWC in Year t = NWCt  NWCt 1

Application: Calculating the Change in NWC
• A 3 year project causes the firm to build up initial
inventory by $20,000- and maintain that level of
inventory in years 1 and 2, before drawing it down as
the project ends and the product is sold.
• The level of incremental NWC in each year, the
corresponding change in NWC and cash flow
implications are:

Illustration: HomeNet Part 3
• 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 annual sales, and payables are expected to be 15% of the
annual cost of goods sold (COGS). 15% of $8 million in sales is $1.2
million and 15% of $3.6 million in COGS is $540,000.
• How does this requirement affect the project’s free cash flow?
Illustration – HomeNet Part 3 (ct’d)
HomeNet’s net working capital requirements are shown in the following table.
1 Year 0 1 2 3 4 5
Net Working Capital
2 Forecast($000s)
3 Cash Requirements
4 Inventory
Receivables (15% of
5 Sales) 1,200 1,200 1,200 1,200
6 Payables (15% of COGS) -540 -540 -540 -540
7 Net Working Capital 660 660 660 660
1 Year 0 1 2 3 4 5
2 Net Working Capital 0 660 660 660 660
3 Change in NWC 660 -660
4 Cash Flow Effect -660 660

Incorporating Changes in Net Working Capital
The incremental free cash flows would then be:
1 Year 1 2 3 4 5
2 Revenues 8,000 8,000 8,000 8,000
3 Cost of Goods Sold -3,600 -3,600 -3,600 -3,600
4 Gross Profit 4,400 4,400 4,400 4,400
5 Admin -2,000 -2,000 -2,000 -2,000
6 Depreciation -1,300 -1,300 -1,300 -1,300 -1,300
7 EBIT 1,100 1,100 1,100 1,100 -1,300
8 Income Tax at 40% -440 -440 -440 -440 520
9 Incremental Earnings 660 660 660 660 -780
10 Add Back Depreciation 1,300 1,300 1,300 1,300 1,300

11 Purchase Equipment -6,500
Subtract Changes in
12 NWC -660 660
13 Incremental Free Cash Flows -6,500 1,300 1,960 1,960 1960 1,180

• Calculating Free Cash Flow Directly
• Depreciation Tax Shield = Tax Rate x Depreciation

Calculating the Project’s NPV
• To compute a project’s NPV, one must discount its free
cash flow at the appropriate cost of capital r

Illustration: HomeNet Part 4
• Assume that Linksys’s managers believe that the HomeNet project has
risks similar to its existing projects, for which it has a cost of capital of
12%.
• Compute the NPV of the HomeNet project.
• The incremental free cash flows for the HomeNet project are (in $000s):
1 Year 0 1 2 3 4 5
2 Incremental Free Cash Flows -6,500 1,300 1,960 1,960 1,960 1,180
• NPV = -6,500+ + + + = -466.52

Adjusting Free Cash Flow (FCF)
• Timing of Cash Flows
– We can forecast FCF on a semiannually, quarterly, monthly or
continuous basis when greater accuracy is required
• Accelerated Depreciation/MACRS
– Because depreciation contributes positively to the firm’s cash
flow through the depreciation tax shield, it is in the firm’s best
interest to use the most accelerated method of depreciation
allowable for tax purposes
– In the US, the most accelerated depreciation method allowed
by the IRS is MACRS (Modified Accelerated Cost Recovery
System). Based on the recovery period, MACRS depreciation
tables assign a fraction of the purchase price that the firm can
depreciate each year. Copyright ©2015 Pearson Education, Inc. All rights reserved.
FINA 5120 – Other Effects on Incremental Free Cash Flow

Other Effects on Incremental Free Cash Flows
• Adjusting Free Cash Flow
– Tax Loss Carryforwards/Tax Loss Carrybacks
• Allow corporations to take losses during a current year and offset
them against gains in nearby years
• Replacement Decisions
– Often the financial manager must decide whether to replace
an existing piece of equipment
• The new equipment may allow increased production, resulting in
incremental revenue, or it may simply be more efficient, lowering
costs

Adjusting Free Cash Flow
• Liquidation or Salvage Value
– When an asset is liquidated, any capital gain is
taxed as income
Capital Gain = Sale Price  Book Value
Book Value = Purchase Price  Accumulated Depreciation
After-Tax Cash Flow from Asset Sale

= Sale Price  (Tax Rate  Capital Gain)

Illustration: Replacing a Machine
• You are trying to decide whether to replace a machine on your
production line.
• The new machine will cost $5 million, but will be more efficient than the
old machine, reducing costs by $1,500,000 per year.
• Your old machine is fully depreciated, but you could sell it for
$100,000.
• You would depreciate the new machine over a 5-year life using MACRS
- assume the
0 following 1rates: 2 3 4 5
20% 32% 19.20% 11.52% 11.52% 5.76%
• The new machine will not change your working capital needs. Your tax
rate is 40% and your cost of capital is 9%.
• Should you replace the machine?

Solution
• Incremental revenues: 0
• Incremental costs: -1,500,000
• Depreciation schedule :
0 1 2 3 4 5
20% 32% 19.20% 11.52% 11.52% 5.76%
1,000,000 1,600,000 960,000 576,000 576,000 288,000
Capital Gain on salvage = $100,000 - $0= $100,000

Cash flow from salvage value: 100,000 – (100,000)(.4) = 60,000

Solution
0 1 2 3 4 5
inc. revenues 0 0 0 0 0 0
inc. costs -1,500,000 -1,500,000 -1,500,000 -1,500,000 -1,500,000
inc gross profit 0 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000
inc SGA 0 0 0 0 0 0
inc
depreciation 1,000,000 1,600,000 960,000 576,000 576,000 288,000
inc EBIT -1,000,000 -100,000 540,000 924,000 924,000 1,212,000
tax @ 40% -400,000 -40,000 216,000 369,600 369,600 484,800
Inc. earnings -600,000 -60,000 324,000 554,400 554,400 727,200
add back dep 1,000,000 1,600,000 960,000 576,000 576,000 288,000
capex -5,000,000
salvage cash
flow 60,000
Inc. FCF -4,540,000 1,540,000 1,284,000 1,130,400 1,130,400 1,015,200

Solution
• Calculate the NPV of all the cash flows using the 9% discount rate:
• NPV= -4,540,000+ 1,540,000+ 1,284,000+ 1,130,400 +1,130,400
(1+.09)^1 (1+.09)^2 (1+.09)^3 (1+.09)^4
• +1,015,200 = $287,051.56
• (1+.09)^5
• NPV = $287,051.56
• Even though the decision has no impact on revenues, it still matters for
cash flows because it reduces costs. Further, both selling the old
machine and buying the new machine involve cash flows with tax
implications.

Terminal or Continuation Value
• This amount represents the market value as of the last
forecast period of the free cash flow from the project at
all future dates.
FINA 5120 – Terminal or Continuation Value

Illustration: Plentix
• Plentix is considering a new project that costs $200
million and will generate free cash flows in its first
three years of $10 million, $15 million, and $20
million, respectively.
• After the third year, free cash flows are expected to
grow at an annual rate of 7%.
• Plentix’s has determined that the appropriate cost of
capital for this project is 16%.
• What is the year 3 continuation value?
What is the NPV of the project?

Solution
• The year 3 continuation value is calculated as:
FCFYear3  (1+g )
Year 3 Continuation Value 
rg
 $20  1.07 
Year 3 Continuation Value    = $237.78 million
 .16  .07 
• The NPV of the project is
$10 $15 $20  $237.78

NPV = -$200 + 1
 2
 3
 $15.08 million
1.16 1.16 1.16

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.
• Sensitivity Analysis shows how the NPV varies with a
change in one of the assumptions, holding the other
assumptions constant.
• Scenario Analysis considers the effect on the NPV of
simultaneously changing multiple assumptions.
FINA 5120 – Analyzing the Project

Illustration: NRG – sensitivity analysis
• Assume NRG originally forecasted its marketing and
support costs at $500,000 per year during years 1–3.
• Suppose the marketing 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%.

Solution
• We can answer the question by computing the NPV of
the resulting free cash flow, given the change in
marketing and support costs.
– 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.

Your Turn!
• Which of the following best defines
incremental earnings?
A) cash flows arising from a particular
investment decision
B) the amount by which a firm's earnings
are expected to change as a result of
an investment decision
C) the earnings arising from all projects
that a company plans to undertake in a
fixed time span
D) the net present value (NPV) of
earnings that a firm is expected to
receive as the result of an investment Answer B
decision
FINA 5120 –Questions

Your Turn!
• CathFoods will release a new range of candies
which contain anti-oxidants. New equipment to
manufacture the candy will cost $4 million,
which will be depreciated by straight-line
depreciation over 6 years. In addition, there will
be $5 million spent on promoting the new
candy line. It is expected that the new range of
candies will bring in revenues of $6 million per
year for five years with production and support
costs of $1.5 million per year. If CathFood's
marginal tax rate is 35%, what are the
incremental earnings in the second year of this
project?
A) $2.492 million
B) $2.100 million
C) $3.833 million Answer A
D) $1.342 million

Solution:
Year 1 - 5
Revenue 6
Production and support costs (1.5)
Depreciation ($4m / 6 ) (0.66667)
Earning before tax 3.83333
Tax ($3.83333 x 35% ) (1.341)
Earning after tax 2.492
• The incremental earnings in the second year of this
project is $2.492 million.

Your Turn!
• CathFoods will release a new range of
candies which contain antioxidants. New
equipment to manufacture the candy will cost
$2 million, which will be depreciated by
straight-line depreciation over four years. In
addition, there will be $5 million spent on
promoting the new candy line. It is expected
that the range of candies will bring in
revenues of $4 million per year for four years
with production and support costs of $1.5
million per year. If CathFood's marginal tax
rate is 35%, what are the incremental free
cash flows in the second year of this project?
A) $1.8 million
B) $1.4 million
C) $2 million
D) $0.7 million Answer A

Solution:
Year 1 - 4
Revenue 4
Production and support costs (1.5)
Depreciation ($2m / 4) (0.5)
Earning before tax 2
Tax ($2 x 35%) (0.7)
Earning after tax 1.3
Depreciation 0.5
Free cash flow 1.8
• The free cash flow in the second year of this project is $1.8 million.

Your Turn!
• Which of the following is an
example of cannibalization?
A) A toothpaste manufacturer adds a
new line of toothpaste (that
contains baking soda) to its product
line.
B) A grocery store begins selling T-
shirts featuring the local university's
mascot.
C) A basketball manufacturer adds
basketball hoops to its product line.
D) A convenience store begins selling Answer A
pre-paid cell phones.
SUMMARY
• The evaluation is on how the project will change the
cash flows of the firm
• Our revenue and cost estimates should be
incremental, meaning that we only account for the
additional sales and costs generated by the project
– Thus, focus is on incremental revenues and costs
Incremental Earnings Before Interest and Taxes (EBIT) = Incremental Revenue –

Incremental Costs – Depreciation

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

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

Deducting and then Adding Back Depreciation

• Converting from Earnings to Free Cash Flow
– Net Working Capital
Net Working Capital = Current Assets  Current Liabilities

= Cash + Inventory + Receivables  Payables
– Note we don’t include short term financing such as notes payable or

short term debt (which are current liabilities) because these result
from financing decisions rather than capital budgeting decisions
• Trade Credit
– The difference between receivables and payables is the net amount
of the firm’s capital that is consumed as a result of these credit
transactions

• Net Working Capital reflects a short term investment
that ties up cash flow that could be used elsewhere.
• Only changes in Net Working Capital impact cash
flows.
• When Net Working Capital increases, it represents a
reduction in cash flow that year. The cash flow effect
from a change in NWC is always equal and opposite to
the change in NWC
• The change in NWC in year t is defined as:
Change in NWC in Year t = NWCt  NWCt 1

• Calculating Free Cash Flow Directly
• Depreciation Tax Shield = Tax Rate x Depreciation

• Calculating the NPV
– To compute a project’s NPV, one must discount its free cash
flow at the appropriate cost of capital r

Adjusting Free Cash Flow
• Liquidation or Salvage Value
– When an asset is liquidated, any capital gain is
taxed as income
Capital Gain = Sale Price  Book Value
Book Value = Purchase Price  Accumulated Depreciation
After-Tax Cash Flow from Asset Sale

= Sale Price  (Tax Rate  Capital Gain)

FINA 5120 - Fall (1) 2022 - Session 4 (With Answers) - Capital Budgeting - 26aug22

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FINA 5120 – Capital Budgeting

FINA 5120 – Capital Budgeting Process

• Operating Expenses (opex) = surveys, prototypes, ad

FINA 5120 – Forecasting Incremental Earnings

– Depreciation expenses do not correspond to actual cash outflows

– There are different methods of depreciation, in particular straight

– The justification of this accounting method is to match the cost of

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FINA 5120 – Forecasting Incremental Earnings

FINA 5120 – Forecasting Incremental Earnings

Incremental Earnings Before Interest and Taxes (EBIT) = Incremental Revenue –

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FINA 5120 – Forecasting Incremental Earnings

Copyright ©2017 Pearson Education, Inc. All rights reserved.

FINA 5120 – Forecasting Incremental Earnings

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

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FINA 5120 – Forecasting Incremental Earnings

FINA 5120 – Forecasting Incremental Earnings

• The cost of $1 Million of the new equipment and the

• The additional costs to operate the new machine are

FINA 5120 – Forecasting Incremental Earnings

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FINA 5120 – Forecasting Incremental Earnings

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Forecasting Incremental Earnings

Incremental Earnings = (Incremental Revenues – Incremental Costs – Depreciation)  (1

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FINA 5120 – Forecasting Incremental Earnings

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Forecasting Incremental Earnings

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FINA 5120 – Forecasting Incremental Earnings

2 Revenues 8,000 8,000 8,000 8,000 Units Sold (thousands) 40

4 Gross Profit 4,400 4,400 4,400 4,400 Cost of goods ($/unit) 90

7 EBIT 1,100 1,100 1,100 1,100 -1,300 Depreciation ($ thousands) 1,300

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FINA 5120 – Forecasting Incremental Earnings

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Forecasting Incremental Earnings

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FINA 5120 – Forecasting Incremental Earnings

• Launching the new product reduces NRG’s taxes next

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FINA 5120 – Forecasting Incremental Earnings

FINA 5120 – Opportunity Cost and Forecasting Incremental Earnings

• The opportunity cost of the factory is the forgone rent.

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FINA 5120 – Opportunity Cost and Forecasting Incremental Earnings

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FINA 5120 – Sunk Costs & Forecasting Incremental Earnings

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• In the previous example, we computed the incremental earnings for

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FINA 5120 – Determining Incremental Free Cash Flow

2 Revenues 8,000 8,000 8,000 8,000 Units Sold (thousands) 40

4 Gross Profit 4,400 4,400 4,400 4,400 Cost of goods ($/unit) 90

7 EBIT 1,100 1,100 1,100 1,100 -1,300 Depreciation ($ thousands) 1,300

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Determining Incremental Free Cash Flow

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Determining Incremental Free Cash Flow