Incremental Earnings, Depreciation, Working Capital, Free Cash Flow, NPV Calculation
Case
iphoneMind or iphone5?
Apple is facing stiff competition with Samsung and therefore is considering to
introduce yet another version of hitech phone iPhoneMind. Based on
marketing surveys the forecast is 100,000 units sales per year. The
technology is changing rapidly; Apple therefore expects the new phone to
have a life of just four-year. iPhoneMind will be sold through mobile phone
stores with an expected wholesale price of £260.
Apple has conducted a thorough feasibility study to assess the attractiveness
of iPhoneMind including all necessary technical study. As per the study it will
require a new hardware and software.
Hardware: Developing the new hardware will be relatively inexpensive, as
existing technologies can be used to simply repackage the phones in a newly
designed water proof cover. The design team will make the water proof cover
and its packaging aesthetically pleasing to the phone users. Apple expects
total engineering and design cost to amount to £5 million. Once the design is
finalised, actual production including packaging will be outsourced at a cost of
£110 per unit.
Software: New software is required to further improve the touch pad screen
and graphics. This software development project requires coordination with
appliances manufacturer and is expected to take a dedicated team of 50
software engineers a full year to complete. The cost per software engineer is
£200,000 per year. Apple must also build a new lab for testing purposes. This
lab will occupy existing facilities but will require £7.5 million for new
equipment which has a life of 5 years.
The software and hardware design will be completed and the lab will be
operational at the end of one year. At that time, iphoneMind will be ready to
sale. Apple expects to spend £ 2.8 million per year on marketing and support
for this product.
Discuss
Apple has accumulated substantial fund in its reserve over the years so
iphoneMind project will not use any debt to finance. The marginal corporate
tax rate is 40%
You are asked to make the incremental earnings forecast for the iphoneMind
phone. You are also requested to discuss any assumptions you made
particularly in relation to the feasibility study, depreciation, interest expenses
and treatment of tax.
Capital
Expenditur
es and
Depreciati
on
Interest
Expenses
Taxes
Sunk Costs
and
Increment
al Earnings
Fixed OH
expenses
Past R&D
Expenditur
es
Sunk Cost
Fallacy
Discussions(Incremental Earnings Forecast)
iphoneMindrequires £7.5 million in equipment for a new lab. In earning
calculations the cost of equipment is not directly listed as expenses. Instead, the
firm deducts a fraction of the cost of these items each year as depreciation.
Using SLM (asset cost divided equally over its life) we get £1.5 million per year if
we assume life of a 5 year for the lab equipment. The EBIT is given after
deduction for depreciation. This treatment of capital expenditures is one of the
key reasons why earnings are not an accurate representation of cash flows.
We generally do not include interest expenses. Any incremental interest
expenses will be related to the firm’s decision regarding how to finance the
project. Here we wish to evaluate the project on its own, separate from the
financing decision. Thus we evaluate the iphoneMind project as if Apple will not
use any debt to finance it and we postpone the consideration of alternative
financing choices. For this reason, we refer to the net income as the unlevered
net income of the project, to indicate that it does not include any interest
expenses associated with leverage.
The final expense we must account for is corporate taxes. The correct tax rate
to use is the firm’s marginal corporate tax rate, which is the tax rate it will pay
on an incremental dollar of pre-tax income. In year 0, iphoneMind will reduce
Apple’s taxable income by £15 million dollars. Income Tax = EBIT x Tr where Tr
is the firm’s marginal tax rate
A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk
costs have been or will be paid regardless of the decision whether or not to
proceed with the project. Therefore they are not incremental with respect to the
current decision and should not be included in its analysis. For this reason, we
did not include in our analysis the £300,000 already expended on the marketing
and feasibility studies for IphoneMind. A good rule to remember is that “if our
decision does not affect a cash flow, then the cash flow should not affect our
decision”. Common examples of sunk costs are Fixed Overhead Expenses, Past
Research and Development Expenditures.
OH expenses are associated with activities that are not directly attributable to a
single business activity but instead affect many different areas of the
corporation. These expenses are often allocated to the different business
activities for accounting purposes. To the extent that these OH costs are fixed
and will be incurred in any case, they are not incremental to the project and
should not be included. Only include as incremental expenses the additional OH
expenses that arise because of the decision to take on the project.
The decision to continue or abandon should be based only on the incremental
costs and benefits of the product going forward.
Sunk cost fallacy is a term used to describe the tendency of people to be
influenced by sunk costs and to “throw good money after bad.” That is, people
sometimes continue to invest in a project that has a negative NPV because they
have already invested a large amount in the project and feel that by not
continuing it, the prior investment will be wasted. The sunk cost fallacy is also
sometimes called the “Concorde effect,” a term that refers to the British and
French government’s decision to continue funding the joint development of the
Concorde aircraft even after it was clear that sales of the plane would fall far
short of what was necessary to justify its continued development. Although the
project was viewed by the British government as a commercial and financial
disaster, the political implications of halting the project – and thereby publicly
admitting that all past expenses on the project would result in nothing –
ultimately prevented either government from abandoning the project
New
Information
1
Discuss 1
New Information: Project Externalities
Suppose that approximately 25% of iphoneMind sales come from customers
who would have purchased an existing Iphone5 if iphoneMind were not
available. iphone5 is selling for £100. In addition, the cost of iphone5 is £60
per unit. Suppose also that the space that the new lab (for testing purposes)
will occupy can be rented out for £200,000 per year.
You are now asked to incorporate the new information and make the
incremental earnings forecast for the iphoneMind phone again.
Project
Externalities
Discussions 1 (Project Externalities, Indirect Effects on Incremental
Earnings)
Project externalities are indirect effects of the project that may increase or
decrease the profits of other business activities of the firm. For instance,
When sales of a new product displace sales of an existing product, the
situation is often referred to as cannibalisation.
For the cannibalisation, suppose that the existing router wholesales for £100 so
the expected loss in sales is
25% x 100,000 units x £100/ unit = 2500,000 this when deducted from
26000000 = 23500,000
The sales forecast falls from £26 million to £23.5 milion. In addition suppose
the cost of existing router is £60 per unit. Then the cost of goods sold is
reduced by 25% x 100,000 units x £60/ unit = 1,500,000
Thus because Cisco will no longer need to produce as many of its existing
wireless routers, the incremental cost of goods sold of the HomeNet project
drops from £11 million to £9.5 million. HomeNet's incremental gross profit
therefore declines by £2.5 million - £1.5 milion = £1 milion once we account
for this externality.
Opportunity
Costs
Many projects use a resource that the company already owns. Because the
firm does not need to pay cash to acquire this resource for a new project, it is
tempting to assume that the resource is available for free. However, in many
cases the resource could provide value for the firm in another opportunity or
project. The opportunity cost of using a resource is the value it 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. In the case of the HomeNet project, space
will be required for the new lab. Even though the lab will be hosueed in an
existing facility, we must include the opportunity cost of not using the space in
an alternative way.
New
Information
2
Discuss 2
Sales and Cost figures changed
Suppose sales of iphoneMind were expected to be 100,000 units in year 1,
125,000 units in years 2 and 3, and 50,000 units in year 4. Suppose also that
iphoneMind’s sale price and manufacturing cost are expected to decline by
10% per year, as with other phones.
By contrast, selling, general, and administrative expenses are expected to rise
with inflation by 4% per year.
Discuss why might the sales and cost figures have been changed. Update the
incremental earnings forecast (based on your calculation after new
information 1) to account for these effects.
Real World
is complex
Discussion 2
The assumption that the same number of iphoneMind will be sold each year is
highly unlikely. Every product will have a product life cycle. 1 lower sales 2
accelerate 3 plateau and 4 decline. Similarly, average selling price and the
cost of production will also change over time. Prices and costs tend to rise
with the general level of inflation in the country. The prices of technological
products often fall over time as newer, superior technologies emerge and
production costs decline. For most industries, competition tends to reduce
profit margins over time. These factors should be considered when estimating
a project’s revenue and costs.
New
Information
3
Discuss 3
New
Information
4
Discuss 4
Working capital
Suppose that iphoneMind will have no incremental cash or inventory
requirements. However receivables related to iphoneMind will be 15% of
annual sales, and payables are expected to be 15% of the annual cost of
goods sold.
Discuss working capital and calculate iphoneMind’s net working capital
requirement
Free Cash Flows
Earnings include non-cash charges such as depreciation but do not include the
cost of capital investment. To determine IphoneMind’s free cash flow from its
incremental earnings, we must adjust for these differences. Because earnings
is an accounting measure. It is not profit in real terms. The firm cannot use its
earnings to buy goods, pay employees, fund new investments, or pay
dividends shareholders.
To do those things, a firm needs cash. Thus, to evaluate a capital budgeting
decision, we must determine its consequences for the firm’s available cash.
The incremental effect of a project on the firm’s available cash is the project’s
free cash flow.
What is a free cash flow? Following new information 2 and 3 above, forecast
the free cash flow.
Working
Capital
Discussion 3 (Working Capital)
We know NWC = CA-CL or Cash + Inventory + Receivables – Payables
We define the increase in NWC in year t as
Change in NWCt = NWCt – NWCt-1
In year 1, NWC increased by £2.1 million. This increase represents a cost to
the firm. This reduction of free cash flow correspond to the fact that £3.525
million of the firms sale in year 1 and £1.425 million of its cost have not yet
been paid.
In years 2-4, NWC does not change, so no further contribution are needed.
In year 5 the project ends, NWC falls by £2.1 million as a payment of the last
customers are received and the final bills are paid. We add this £2.1 million to
free cash flow in year 5.
Capital
Expenditure
and
Depreciation
Discussion 4 (Free Cash Flows)
Depreciation is not a cash expense that is paid by the firm. Rather, it is a
method used for accounting and tax purposes to allocate the original purchase
cost of the asset over its life. Because depreciation is not a cash flow we do
not include it in the cash flow forecast. Instead we include the actual cash
cost of the asset when it is purchased.
Hence, we must add back to earnings the depreciation expense for the lab
equipment (a non-cash charge) and subtract the actual capital expenditureof
£7.5 million that will be paid for the equipment in year 0. We
Note that the FCF in the first 2 years is lower than unlevered net income. It is
so because there are upfront investment in equipment and NWC required by
the project. In later years, FCF exceeds unlevered net income because
depreciation is not a cash expense. In the last year, the firm ultimately
recovers the investment in net working capital further boosting the free cash
flow.
New
Information
5
Discuss 5
Net Working capital with changing sales
Above in New information 2 we saw the complexity of real world and we
assumed that the sales will change.
Forecast the required investment in net working capital for iphoneMind under
the scenario of real world complexity (information 2) where sales are
changing.
NPV Calculation (without changes in Sales and including working capital)
Continue from Project externalities (information 1) on cannibalisation
New
Information
6
Discuss 6
Calculate NPV
NPV Calculation (withchanges in Sales and including working capital)
Continue from Project externalities (information 1) on cannibalisation
New
Information
7
Discuss 7
New
Information
8
Calculate NPV
Choosing among alternatives
Suppose Apple is considering an alternative manufacturing plants for the
iPhoneMind.
Option 1
Fully outsource the production at a cost of £110 per unit. In this option
payables will be 15% of the cost of goods sold. This amount is a credit Apple
will receive from its supplier in year 1 and will maintain until year 5.
Option 2
Alternatively Apple can assemble product inhouse at a cost of £95 per unit.
However, in this option £5 million will be required upfront operating expenses
to reorganise the assembly facility and apple will need to maintain inventory
equal to 1 month production.
If assembly is done in house payables are 15% of the cost of assembling
(15% x £9.5 million = £1.425). In addition, Apple will need to maintain
inventory equal to one month production which has a cost of £9.5 million/12
= £0.792 million. Thus NWC will decrease by £(1.425 – 0.792) million =
£0.633 million in year 1 and will increase by the same amount in year 5.
You are aware from the case above that Apple will be selling 100,000 units of
iphoneMind per annum
Discuss 8
Compute the NPV for both the options
Discussions for information 5-8
Working
Capital
Discussion 5 (Working Capital with changing sales)
Similar to discussion 3
In this case WC changes each year. A large initial investment in WC is
required in year 1, followed by small investment in year 2 as sales continue to
grow.
Working capital is recovered in years 3-5 as sales decline.
NPV
Discussion 6 (NPV no changes sales and WC)
Knowledge of PV
NPV
Discussion 7 (NPV with changes in sales and WC)
Knowledge of PV
Choosing
among
alternatives
Discussion 8 (Choosing among Alternatives)
Because Apple will borrow this amount from its supplier NWC falls by £1.65
million in year 1 adding to Apple’s free cash flow. In year 5, Apple’s NWC will
increase as it pays its suppliers.
Option 2
Alternatively Apple can assemble product in house at a cost of £95 per unit.
However, in this option £5 million will be required upfront operating expenses
to reorganise the assembly facility and apple will need to maintain inventory
equal to 1 month production.
If assembly is done in house payables are 15% of the cost of assembling
(15% x £9.5 million = £1.425). In addition, Apple will need to maintain
inventory equal to one month production which has a cost of £9.5 million/12
= £0.792 million. Thus NWC will decrease by £(1.425 – 0.792) million =
£0.633 million in year 1 and will increase by the same amount in year 5.
New
information
9
New
information
10
New
information 11
New
information 12
Accelerated Depreciation
What depreciation deduction will be allowed for the lab equipment using the
MACRS method, assuming the lab equipment is designated to have five years
recovery period. Then calculate the NPV again.
Salvage Value
Suppose that in addition to the £7.5million in the new equipment required for
the iPhoneMind , equipment will be transferred to the lab from another Apple
facility. This equipment has a resale value of £2million and book value of
£1million. If the equipment is kept rather than sold, its remaining book value
can be depreciated next year. When the lab is shot down in year 5, the
equipment will have a salvage value of £800,000. What adjustments will be
made on iPhoneMind free cash flow in this case?
Break Even Analysis
Calculate the IRR of the iPoneMind project
Sensitivity Analysis
Consider the assumptions underlying the calculation of the NPV of the
iPhoneMind project. Use the data below to calculate the best and worst
case assumptions for each parameter.
PARAMETER
UNITS SOLD (000)
WORST
CASE
BEST
CASE
100
70
130
260
240
280
110
120
100
NWC (£000)
2100
3000
1600
CANNIBALISATION
25%
40%
10%
COST OF CAPITAL
12%
15%
10%
SALE PRICE(£/UNIT
CGS (£/UNIT)
New
information 13
INITIAL
ASS.
Scenario Analysis
Calculate the NPV of the iPhoneMind project base on the best and worst
case scenario data given above?
Discussion 9 to 13
Discussion
DISCUSSI
ON
DISCUSSION
DISCUSSION
DISCUSSION
Accelerated Depreciation
With reference to IRS depreciation table A-1, the allowable depreciation
expense is shown on spread sheet
Compared with straight line depreciation, the MACRS method allows for larger
depreciation deductions earlier in the asset’s life, which increases the present
value of the depreciation tax shield and so, will raise the project’s NPV. In the
case of iPhoneMind, computing the NPV using MACRS depreciation leads to an
NPV of £5.34million
Salvage Value
The existing equipment could have sold for £2million. The after tax proceeds
from this sales are the opportunity cost of the using the equipment in the
iPhoneMind. Thus we must reduce iPhoneMind free cash flow in year 0 by
£2million – 40%*(£2million -£1million) = £1.6million
In year 1, the remaining £1million book value of the equipment can be
depreciated creating a depreciation tax shield of 40%*£1million =£400,000.
In year 5, the firm will sale the equipment for a salvage value of £800,000.
Because the equipment will be fully depreciated by that time, the entire
amount will be taxable as capital gain, so the after tax cash flow is
£800,000*(1-40%) = £480,000.
Break Even Analysis
When we are uncertain about the input of a capital budgeting decision, it
is often useful to determine the break even level of that input, which the
level for which the investment has an NPV of zero. There is no reason to
limit our attention to uncertainty in the cost of capital estimate. In a break
even analysis, for each parameter, we calculate the value at which the
NPV of the project is zero.
Sensitivity Analysis
Sensitivity analysis breaks the NPV calculation into its component
assumptions and shows how the NPV varies as the underlying assumptions
change.
Scenario Analysis
Scenario analysis considers the effect of changing multiple project
parameters. For example lowering iPhoneMind price may increase the
number of units sold.