Example of capital budgeting
Forecasting earnings
Determining Free Cash Flow and NPV
Analyzing the project
Setup
Linksys, a division of Cisco Systems, is
considering development of a wireless
home networking appliance, HomeNet
Linksys has already conducted an
intensive, $300,000 feasibility study to
assess the attractiveness of the new
product
Forecasting Earnings
Revenue and cost estimates
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Sales forecast: 100,000 units per year
Product will have a 4-year life
Wholesale price: $260 per unit
Cost of outsourcing production: $110 per unit
Engineering and design costs: $5 mln
Software engineering:
50 engineers needed
Cost of software engineer $200,000 per year
Will take one year to complete
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Testing lab: $7.5 mln
Marketing and support: $2.8 mln per year
HomeNet’s Incremental Earnings
Forecast (Spreadsheet)
Notes on the forecast spreadsheet
Capital expenditures and depreciation
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$7.5 mln was invested in a lab
Assuming 5-year life for the lab and straight line depreciation we
get $1.5 mln annual depreciation expense.
Interest is not included into calculation. Usually in capital
budgeting we evaluate a project as if it is financed only
through equity. Any adjustment for debt financing – in the
discount rate (we discuss this in a few lectures).
Hence we get Unlevered Net Income
Taxes = EBIT*(1-c)
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You should use marginal tax rate
Don’t forget to add taxes when the project reduces the taxable
income of your firm
Indirect effects on Incremental
Earnings
Have we missed anything in our
calculations?
Yes:
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Opportunity costs
Project externalities (side effects)
Accounting for Opportunity Costs
Project Externalities
Suppose that 25% of HomeNet’s sales come
from customers who would have purchased an
existing Linksys appliance if HomeNet were not
available.
Such reduction in sales of an existing product is
called cannibalization.
We should account for it. It affects Sales and
Costs of Goods Sold
Remark: project externalities can also be
positive (synergies)
Accounting for Cannibalization
Assuming the existing appliance is sold for
$100. So, the expected loss in sales:
25%  100,000 units  $100/unit = $2.5
mln
Assuming the cost of existing appliance is
$60 per unit. So, the expected reduction in
costs of goods sold:
25%  100,000 units  $60/unit = $1.5 mln
HomeNet’s Incremental Earnings Forecast
Including Cannibalization and Lost Rent
(Spreadsheet)
Sunk Costs
Why did not we include $300,000 spent on
the feasibility study?
It’s sunk and should have no effect on our
decision about the project
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In reality managers sometimes tend to justify
going on with a project on the ground that “we
can’t give up after so much money has
already been spent”
Determining Free Cash Flow
What is the relation between the Cash Flow to investors
we computed in lecture 3 and Free Cash Flow?
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Here it is in fact Cash Flow to investors, but as if the project is
unlevered (hence, no interest, no differences in net borrowing)
Remember we had CF to investors = CF from operations – CF
from investment – ΔCash + interest.
When the firm is unlevered: CF from operations = Unlevered Net
Income + Depreciation – ΔNWC + ΔCash
CF from investment = CapEx
Hence, we obtain precisely the formula above
Calculation of HomeNet’s Free Cash Flow
(Including Cannibalization and Lost Rent)
(Spreadsheet)
Notes on FCF calculation
Depreciation – not a cash expense. Hence, must be added back
CapEx – money spent on the testing lab, $7.5 mln
NWC = Current Assets – Current Liabilities = Cash + Inventory +
Receivables – Payables.
Assume Cash = Inventory = 0, Receivables = 15% of annual sales,
Payables = 15% of annual cost of goods sold.
Note: we implicitly assume that NWC requirements for the
cannibalized business of Cisco are the same. In reality, recevables
for HomeNet = 15%  26 mln = 3.9 mln, but receivables of the
cannibalized business fall by 15%  2.5 mln = 0.375 mln. Hence, the
net Receivables = 3.525 mln. For Payables, cash and inventory –
the same.
Note
FCF can be rewritten as
The last term is called depreciation tax
shield – tax savings resulting from the
ability to deduct depreciation
Computing HomeNet’s NPV
(Spreadsheet)
5
5
FCFt
 5.027 mln
t
t 0 (1  r )
NPV   PV ( FCFt )  
t 0
1
– t - year discount factor
t
(1  r )
Choosing among alternatives
Assume instead of outsourcing production for $110 per
unit Cisco could assemble the product in-house at a cost
of $95 per unit. But this would require $5 mln of upfront
operating expenses to reorganize the assembly facility.
In addition, Cisco will need to maintain inventory equal to
one month’s production.
We can exclude from calculations things that do not
differ between the projects, and include only what differs
Cannibalization and lost rent effects do not change –
exclude
Sales revenues do not change – exclude
Cost of sales (ignoring cannibalization) changes: $11
mln for outsourcing, $9.5 mln for in-house. In addition, in
year 0, $5 mln in operating expenses appear for inhouse. EBIT, Tax and Net Income change
correspondingly.
CapEx do not change - exclude
NWC changes:
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Change in the amount of Payables. Payables were 15%  $11
mln = $1.65 mln (ignoring cannibalization). Now they are 15% 
$9.5 mln = $1.425 mln (ignoring cannibalization).
Now we have inventory requirement = $9.5 mln / 12 = $0.792
mln
Hence, ignoring Receivables that do not change:
For outsourcing, NWC = -$1.65 mln
For in-house production, NWC = Inventory – Payables = $0.792 mln
- $1.425 mln = -$0.633 mln
NPV Cost of Outsourced Versus In-House
Assembly of HomeNet (Spreadsheet), using only
cash flows that differ
Outsourced Assembly is better!
Accounting for liquidation (salvage)
value
If you sell some assets at the end of the project
this generates cash.
Imagine the salvage value of the lab’s
equipment in the end of year 5 is $2 mln. It’s
book value in the end of year 5 is $0 mln. We
could sell the equipment for $2 mln, but we
would have to pay taxes on capital gain:
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c(Sale Price – Book Value) = 40% * $2 mln = $0.8
mln
Hence the cash from the sale = 2 – 0.8 = 1.2 mln
We would have to account for this cash in year 5.
Accounting for terminal
(continuation) values
For long-lived projects sometimes cash
flows are forecasted until year T and then
certain assumption about the cash flow
growth starting from T+1 is made.
That allows to compute a terminal value at
T as if the project is finished is T and the
cash equal to the terminal value is
realized. Then this terminal value is used
in NPV calculation
Example of accounting for
continuation value
Accounting for inflation
Simply discount cash flows correctly:
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If real values are used, use real R.
If nominal values – use nominal R.
1 + Rn = (1 + Rr)(1 + i)
Rr  Rn – i
CFrt = CFnt/(1 + i)t
Some things to remember
Use only incremental cash flows (i.e. the
changes in the firm’s cash flows that occur as a
consequence of the project)
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Note: pay attention to side effects (like cannibalization
and synergies)
Ignore sunk costs
Don’t ignore opportunity costs
Don’t forget working capital requirements
Don’t forget liquidation values (or costs) and
terminal values
Be careful with inflation