Example of capital budgeting

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Example of capital budgeting

• Forecasting earnings
• Determining Free Cash Flow and NPV
• Analyzing the project

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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

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Forecasting Earnings

• Revenue and cost estimates
• 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
• Testing lab 7.5 mln
• Marketing and support 2.8 mln per year

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HomeNets Incremental Earnings Forecast
(Spreadsheet)
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Notes on the forecast spreadsheet

• Capital expenditures and depreciation
• 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)
• You should use marginal tax rate
• Dont forget to add taxes when the project
  reduces the taxable income of your firm

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Indirect effects on Incremental Earnings

• Have we missed anything in our calculations?
• Yes
• Opportunity costs
• Project externalities (side effects)

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Accounting for Opportunity Costs
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Project Externalities

• Suppose that 25 of HomeNets 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)

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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

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HomeNets Incremental Earnings Forecast Including
Cannibalization and Lost Rent (Spreadsheet)
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Sunk Costs

• Why did not we include 300,000 spent on the
  feasibility study?
• Its sunk and should have no effect on our
  decision about the project
• In reality managers sometimes tend to justify
  going on with a project on the ground that we
  cant give up after so much money has already
  been spent

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Determining Free Cash Flow

• What is the relation between the Cash Flow to
  investors we computed in lecture 3 and Free Cash
  Flow?
• 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 ?Cash
  interest.
• When the firm is unlevered CF from operations
  Unlevered Net Income Depreciation ?NWC
  ?Cash
• CF from investment CapEx
• Hence, we obtain precisely the formula above

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Calculation of HomeNets Free Cash Flow
(Including Cannibalization and Lost Rent)
(Spreadsheet)
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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.

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Note

• FCF can be rewritten as
• The last term is called depreciation tax shield
  tax savings resulting from the ability to deduct
  depreciation

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Computing HomeNets NPV (Spreadsheet)
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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 months production.
• We can exclude from calculations things that do
  not differ between the projects, and include only
  what differs

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• 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 in-house. EBIT, Tax and Net
  Income change correspondingly.
• CapEx do not change - exclude
• NWC changes
• 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

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NPV Cost of Outsourced Versus In-House Assembly
of HomeNet (Spreadsheet), using only cash flows
that differ

• Outsourced Assembly is better!

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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 labs equipment
  in the end of year 5 is 2 mln. Its 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
• ?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.

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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 T1 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

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Example of accounting for continuation value
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Accounting for inflation

• Simply discount cash flows correctly
• 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

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Some things to remember

• Use only incremental cash flows (i.e. the changes
  in the firms cash flows that occur as a
  consequence of the project)
• Note pay attention to side effects (like
  cannibalization and synergies)
• Ignore sunk costs
• Dont ignore opportunity costs
• Dont forget working capital requirements
• Dont forget liquidation values (or costs) and
  terminal values
• Be careful with inflation