Fundamentals of Capital Budgeting: From Forecasting Earnings to

Project Cash FlowsDr. Himanshu Joshi

FORE School of Management

Tata Nano

• In July 2006, Ratan Tata, Chairman of Tata Motors, announced to the shareholders at the annual general body meeting that the company would be launching a Tata Nano- A car that would be sold for Rs. 1 Lakh only. He said that the launch of the car would create a new paradigm in low cost personal transport, carve-out a new market segment, and reach a broader base of pyramid.

Tata Nano• The decision of Tata Motors to launch Nano

represents the typical capital budgeting decision.• How would the managers of the Tata Motors make a

decision about this investment?• What will be the impact of this decision on the value

of the company and wealth of its shareholders?• The managers of Tata Motors have to evaluates the

benefits and the costs of the Nano car project.• We will discuss tools for evaluating projects such as

Tata Nano…

FORE -casting Earnings

• A Capital Budget lists the project and investments that a company plans to undertake during the coming year. To determine this list, firm analyze alternate projects and decide which one to accept through a process called capital budgeting.

• This process begins with the forecasts of the project’s future consequences for the firm.

• Some of the consequences will affect its revenues and others will affect its costs.

• Our ultimate goal is to determine the effect of the decision on the firm’s cash flows.

Cash Flows Vs. Earnings..

• For the purpose of Project evaluation cash flows are important not the earnings. However, as a practical matter, to derive the forecasted cash flows of the project, financial managers often begin by determining the incremental earnings of a project…

Linksys..

• Linksys is a division of CISCO systems, a maker of consumer networking hardware. Linksys is considering the development of a wireless home networking appliance, called HomeNet, that will provide both the hardware and the software necessary to run an entire home from any internet connection. In addition to the connecting PCs and Printers, Home Net will control new internet capable stereos, digital video recorder, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on.

• Linksys has already conducted an intensive, $3,00,000 feasibility study to assess the attractiveness of the new product.

Linksys• HomeNet’s target market is upscale residential “smart” homes

and home offices. Based on extensive marketing surveys, the sales forecast for HomeNet is 1,00,000 units per year. Given the pace of technological change, Linksys expects the product will have a four year life. It will be sold through high end stereo and electronics stores for a retail price of $375, with an expected wholesale price of $260.

• Developing the new hardware will be relatively inexpensive, as existing technologies can be repackaged in a newly designed, home friendly box. Industrial design team will make the box and packaging aesthetically pleasing to the residential market. Linksys expect total engineering and design costs to amount to $5 million. Once the design is finalized, actual production will be outsourced at a total cost (including packaging) of $110 per unit

Linksys• In addition to the hardware requirements, Linksys must build a new

software application to allow virtual control of home through web. This software development project requires coordination with each of the web appliance manufacturers and is expected to take a dedicated team of 50 software engineers a full year to complete. The cost of a software engineer (including benefits and related costs) is $2,00,000 per year.

• To verify the compatibility of new consumer-internet-ready appliances with the HomeNet system as they become available, Linksys must also build a new lab for testing purposes. The lab will occupy existing facilities but will require $7.5 million of new equipment.

• The software and hardware design will be completed, and the lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2.8 million per year on marketing and support for this project.

Incremental Earnings Forecast

Capital Expenditure and Depreciation

• While investments in plant, equipment and property are cash expenses, they are not directly listed as expenses when calculating earnings. Instead the firm deducts a fraction of the cost of these items each year as depreciation.

• If we assume straight-line depreciation over a life of five years for the lab equipment, HomeNet’s depreciation expense is $1.5 million per year.

Interest Expenses

• To compute the firm’s net income, we must first deduct interest expenses from EBIT. When evaluating a capital budgeting decision like the HomeNet project, however, generally we do not include interest expense.

• 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 financing decision.

• So we calculate unlevered income.

Taxes

• 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.

• Incremental income tax = EBIT * Tc• Where Tc is the firm’s marginal tax rate.

Taxes• In year 1, HomeNet will contribute an

additional $10.7 million to Cisco’s EBIT, which will result in $10.7 million* 40% = $4.28 million in corporate tax that Cisco will owe.

• We deduct this amount to determine HomeNet’s net income.

• In year 0, however, HomeNet’s EBIT is negative. Are taxes relevant in this case?

Taxes

• Yes HomeNet’s will reduce the Cisco’s taxable income in year 0 by $15 million.

• As long as Cisco earns taxable income elsewhere in year 0 against which it can offset HomeNet’s losses, Cisco will owe $15 million* 40% = $6 million less in taxes in year 0.

• The firm should credit this tax savings to the HomeNet Project.

• A similar credit applies in year 5, when a firm claims its final depreciation expense.

Unlevered income calculation

• Unlevered Net Income = EBIT * (1-Tc) • = (Revenues – Costs –Depreciation) * (1-Tc)

Indirect Effects on Incremental Earnings

• All changes between the firm’s earnings with project Versus firm’s earnings without the project.

• Thus far we have analyzed only the direct effects of HomeNet project.

• It may also have indirect effects on Cisco’s earnings.

Opportunity Costs.

• Many projects use a resource that 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.

• 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 the another project, we should include the opportunity cost as an incremental cost of the project.

• Is there any opportunity cost in case of HomeNet Project??

Opportunity Costs in HomeNet

• Space will be required for the new lab. Even though the lab will be housed in an existing facility, we must include opportunity cost of not using the space in an alternative way.

• Suppose HomeNet’s lab will be housed in warehouse space that the company would have otherwise rented out for $2,00,000 per year during 1-4 years. How does this opportunity cost affect HomeNet’s incremental earnings.

Project externalities

• Project externalities are indirect effects of the project that may increase or decrease the profits of other business activities of the firm. This is called cannibalization.

• Suppose that 25% of HomeNet’s sales come from customers who would have purchased an existing Linksys wireless router (wholesale price $100 per unit and unit cost $60 ) if HomeNet were not available.

Table 2

Sunk Costs and External Earnings

• A sunk cost is any unrecoverable cost for which firm is already liable. Sunk cost 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 current decision and should not be included in its analysis.

• For this reason we did not include in our analysis the $3,00,000 already expended on marketing and feasibility studies.

Other Sunk costs

• Fixed Overhead Expenses• Past Research and Development Expenses.

Real- World Complexities

• Unit sold.• Price changes.• Manufacturing cost• Competition

Determining Free Cash Flow and NPV

• Calculating Free Cash Flows from Earnings.• Capital Expenditure and Depreciation: Depreciation

is not a cash expense paid by the firm. Rather it is a method used for accounting and tax purposes to allocate the original cost of asset over its life. So it should be added back to determine the free cash flows.

• Capital Expenditure we have to subtract the original cost of the equipment $7.5 million in the year 0.

Net Working Capital

• Net W. Capital = Current Assets – Current Liab.• = cash + inventory + receivables – payables• The difference between receivables and payables is called

trade deficit.• 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 sales, and the payables are expected to be 15% of COGS.

HomeNet’s Net W.C Requirement

HomeNet’s Free Cash Flows

Calculating Free Cash Flows Directly

• Free Cash Flows = (Revenues – Costs – Depreciation) (1-Tc) + Depreciation – Capex – ∆ Net Working Capital

Free Cash Flow = (Revenues – Costs)* (1-Tc) – Capex - ∆ Net Working Capital + Depreciation* (Tc)

Depreciation Tax Shield

• Depreciation Tax Shield = Depreciation * Tc• Often firms report a different depreciation

expense for accounting and for tax purposes.• Because only tax consequences of

depreciation expense are relevant for free cash flows, we should use depreciation charged by the firm for tax purposes only.

Calculating NPV of HomeNet

• “= NPV(r, FCF1:FCF5) + FCF0”

Choosing Among Alternatives

• Because not launching HomeNet produces an additional NPV of zero for the firm, launching HomeNet is the best decision for the firm if its NPV is positive.

• It is a choice between launching HomeNet or Not Launching HomeNet.

Evaluating Manufacturing Alternatives

• Suppose Cisco is considering an alternative manufacturing plan for the HomeNet product. It could assemble the product in house at a cost of $95 per unit. however, it will require $5 million in upfront operating expenses to recognize the assembly facility and Cisco will need to maintain inventory equal to one month’s production.

Evaluating Manufacturing Alternatives

• When comparing between these two alternatives, we compute the free cash flows associated with each choice and Compare their NPV.

• We need to compare only those cash flows that differ between them.

• As we can ignore HomeNet’s revenue as it continue to be same in both the case.

Timing of Cash Flows

• For simplicity, we have treated cash flows for HomeNet as if they occur at annual interval. In reality cash flows will spread through out the year.

• We can forecast cash flows on quarterly, monthly, or even on continues basis.

Liquidation or Salvage Value

• Some assets may have some salvage value when they are no longer needed.

• However, some assets may have negative salvage value.• In the calculation of free cash flows, we include the

liquidation value of any assets that are no longer needed and may be disposed of.

• When an asset is liquidated, any capital gain is taxed as income.

• Capital Gain = Sale Price – Book Value• Book Value = Assets Original Cost – Accumulated

Depreciation.

Liquidation or Salvage Value

• We must adjust the project’s free cash flows to account for the after-tax cash flows that would result from an asset sale:

• After tax cash flow from sale of asset = Sale Price – (Tc*Capital Gain)

HomeNet

• Suppose that in addition to $7.5 million in new equipment required for HomeNet’s lab, another equipment will be transferred to the lab from another Linksys facility.

• This equipment has a resale value of $2 million and a book value of $1 million. If the equipment is kept rather than sold, its remaining value can be depreciated next year. when the lab is shut down in year 5, the equipment will have a salvage value of $8,00,000. what adjustment we must make to HomeNet’s free cash flows in this case?