Capital Budgeting

FINC 361 Fall 201

Professor Mahdi Mohseni

Roadmap of the lecture

NPV rule and the with-without principle
Advanced FCF computation methods
oExample 1: FCF for Linksyss HomeNet
project

Minimizing costs approach

oExample 2: Beryl Iced Teas choice of the

bottling machines

Real-world complications
Robustness checks

Capital Budgeting
Evaluation of projects
NPV rule = Gold standard of capital budgeting

We need to compute:
FCF1 FCF2
+
+
NPV = FCF0 +
2
1 + r (1 + r )

Where:
r: Appropriate discount rate for the project
FCFt: Free cash flow generated by the project at year t

How do we compute the free cash flows?

Free Cash Flows (FCF)

Definition:

FCF = EBIT (1 - c )
+ Depreciation
Increases in Net Working Capital
Capital expenditures

Projects and firms: Same formula!

At the project-level:
We compute the projects incremental contribution to
firm-wide free cash flow
Remark: EBIT*(1-) is called incremental earnings

Effect of project financing?

Recall:
FCFs exclude all financing costs and
benefits
E.g. tax shield benefits of debt

Why?
Because they are reflected in the discount rate

NPV is what matters!

Earnings Forecasts
Sales Revenue
COGS
Gross profit
SG&A
Depreciation
EBIT
Income tax
Incremental earnings

1
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

2
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

3
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

4
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

5
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

6
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

7
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

8
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

9
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

Your boss is thinking: $5M a year, we should take it!

Is that the appropriate approach?
Outline what should be the proper approach to evaluating
this project
Be polite and tactful!

10
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06

How do we get the NPV of the project?

For NPV computations, we need the FCFs of the project
and the appropriate discount rate
Assume:
Cost of capital for project: 13%
See below for other assumptions necessary for Free Cash Flows
Assumptions:
Equipement depreciated using straight-line method
Tax rate
0.35
Further assumptions
Increase in Working Capital:
$10M at time zero, fully recovered at year 10
Initial CAPEX:
$19M
SG&A overhead allocation:
Out of $1.52M, $0.76M (50% of $1.52) would have been incurred anyways

Costs already incurred should not be included in this projects FCFs!

Typical pattern: Increase at time zero (building up inventories, etc.)
which are then released when the project is terminated.

Solution
Earnings Forecasts
Sales Revenue
COGS
Gross profit
SG&A
Depreciation
EBIT
Income tax
Incremental earnings
Add: Depreciation
Minus: CAPEX
Minus: Increases in NWC
Free Cash Flows

1
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

2
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

3
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

4
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

5
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

6
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

7
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

8
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

9
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451

10
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
10.00
17.451

(19.00)
(10.00)
(29.000)

Cost of capital for project

PV
NPV

13%
-29 6.593805 5.835226 5.163917 4.569838 4.044104 3.578853 3.167127 2.802767 2.480325 5.140861
14.37682

The with-without principle

Imagine two worlds
1. One in which the investment is made
2. The other in which the investment is not made
Cash flows that are different in these two worlds
are relevant
Cash flows that are the same in these two worlds
are irrelevant

Consequences of with-without principle

1. Sunk cost fallacy
A sunk cost is one that has already been incurred
They are the same whether you continue the project or not
They should not be taken into account to measure the
profitability of your project!

2. Indirect effects of project

Need to take into account all the ramifications of a project
Two big categories:
A. Opportunity costs
B. Externalities

Positive or negative

Consequences of with-without principle

1. Sunk cost fallacy
A sunk cost is one that has already been incurred
It should not intervene in the decision to take the
project or not
Project should only be continued if the future
anticipated benefits exceed the remaining costs

However, psychologically hard!

It goes against our human nature!
Behavioral bias: Regret avoidance due to loss aversion

Typical example: Large projects with big cost overrun

Concorde, Eurotunnel, etc.

Consequences of with-without principle

2. Indirect effects
A. Opportunity cost

Using firm resources that could be put to other use

Example: Suppose you use an existing warehouse to store new

products for your project
Warehouse cannot be used to store products from existing lines
Even if warehouse already exists, it does not come for free!

B. Externalities

Indirect effects of your new project on firms overall profitability

Can be positive or negative

Typical example: Cannibalization

New product eats into market share of your existing product

Classic example: New generation of Ipads, Iphones, Windows, etc.

Roadmap of the lecture

NPV rule and the with-without principle
Advanced FCF computation methods
oExample 1: FCF for Linksyss HomeNet
project

Minimizing costs approach

oExample 2: Beryl Iced Teas choice of the

bottling machines

Real-world complications
Robustness checks

Example 1: Advanced FCF Computation

FCF for Linksys's HomeNet Project

Linksys
HomeNet : New product
$300,000 feasibility study to assess its potential
Should this cost be factored into the NPV computation?

Step 1:
For each year in the life of the project:
Compute incremental earnings defined as EBIT(1-),
Also called unlevered net income in textbook

Step 2:
For each year in the life of the project:
Make necessary adjustments to go from earnings to cash flows

Assumptions for project

The project generates sales for only four years
Short-lived due to obsolescence

1. Revenue Estimates
Annual Sales = 100,000 units/year
Per Unit Price = $260

2. Cost Estimates
Up-Front R&D = $15,000,000
Operating expense

Up-Front New Equipment = $7,500,000

Expected life of the new equipment is five years

Straight-line depreciation
No salvage value (end of year five)
Capitalized expense

Annual General Overhead Cost (Year 1-4) = $2,800,000

Per Unit Production Cost = $110

3. Marginal tax rate: 40%

Assume that a loss on the project will yield a tax saving for Cisco

Step 1: Compute incremental earnings

of project
At time zero:

Incremental earnings forecast

1. No revenues
Sales
Cost of Goods Sold
2. Up-front costs
Which ones are reflected Gross profit
Selling, General and Administrative
in the accounting
earnings?
Research and Development
Depreciation
Loss
Tax benefit as Cisco will EBIT
Income tax (40%)
save on its total tax bill
Incremental earnings
By how much?

T ime 0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)

Step 1: Compute incremental earnings

of project
From years 1 to 4:

Annual sales?
COGS?
SG&A?
Depreciation?
Tax impact?

Incremental earnings forecast

Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings

T ime 0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)

1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000

2
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000

3
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000

4
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000

Step 1: Compute incremental earnings

of project
What about the last year (year 5)?
Revenues?
Costs?
Taxes?

Time
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings

Time 0

1
2
3
4
5
- 26,000,000 26,000,000 26,000,000 26,000,000
- (11,000,000) (11,000,000) (11,000,000) (11,000,000)
- 15,000,000 15,000,000 15,000,000 15,000,000
(2,800,000) (2,800,000) (2,800,000) (2,800,000)
(15,000,000)
(1,500,000) (1,500,000) (1,500,000) (1,500,000) (1,500,000)
(15,000,000) 10,700,000 10,700,000 10,700,000 10,700,000 (1,500,000)
6,000,000
(4,280,000) (4,280,000) (4,280,000) (4,280,000)
600,000
(9,000,000)
6,420,000
6,420,000
6,420,000
6,420,000
(900,000)

From incremental earnings to FCFs

Remember: Earnings cash!
Make following adjustments:
1. Depreciation
Non-cash expense

Accounting technique that reflects use of an asset over time

Need to add back $1.5M for years 1 to 5

Need to reflect cash outflows when they actually occur

Through capital expenditures!

2. Capital expenditures

Actual purchase of lab at time zero:

Cash outflow not reflected in income statement

Recall: Capitalized expense are reflected through depreciation

Need to subtract $7.5M at time zero

From incremental earnings to FCFs II

3. Changes in Net Working Capital
NWC Cash + Inventory + Receivables - Payables
Examples of increases in NWC (use of cash):
1.

2.
3.
4.

Higher cash holdings necessary to run operations

Potential need to maintain a higher cash balance due to project

Recall: Notion of excess cash:
Many firms hold much more cash than is necessary to run operations. So most
analysts actually ignore the cash position in computing changes in NWC in
firm-wide FCFs as it does not reflect a use of cash
For small firms, it is easy to think that every new project will require it to hold more
cash as a buffer to run operations smoothly!

Higher inventories

Potential need to hold more inventories of raw material and unfinished products
due to project

Higher receivables

Potential need to offer generous terms to customers (to make them switch to new
product)

Lower payables

New suppliers might not offer same terms of trade (worse trade credit)

From incremental earnings to FCFs II

3. Changes in Net Working Capital (NWC)
Assume in our specific problem :
1.
2.
3.
4.

No incremental cash needed

No extra inventory requirements
Annual receivables equal 15% of annual project revenues
Annual payables equal 15% of annual project COGS

T ime
Net Working Capital Forecast
Cash Requirements
Inventory
Receivables (15% of sales)
Payables (15%) of COGS
Net Working Capital
Increases in NWC

Step 1: Compute NWC each year

1
-

3,900,000
(1,650,000)
2,250,000
2,250,000

2
3,900,000
(1,650,000)
2,250,000
-

3
3,900,000
(1,650,000)
2,250,000
-

4
3,900,000
(1,650,000)
2,250,000
-

5
(2,250,000)

Step 2: Compute (NWC)

Remark: Increases in NWC are typically fully
reversed at the end of a project

Free cash flow for project

T ime
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings
Plus: Depreciation
Less: Capital Expenditures
Less: Increases in NWC
Free Cash Flow

0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
(7,500,000)
(16,500,000)

1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000

2
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000

3
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000

4
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000

5
(1,500,000)
(1,500,000)
600,000
(900,000)
1,500,000

(2,250,000)
5,670,000

7,920,000

7,920,000

7,920,000

2,250,000
2,850,000

NPV computation
Need a discount rate!
Suppose appropriate discount rate for project is 12%
What is the NPV of the project?
Should Linksys undertake it?
FCF3
FCF5
FCF1 FCF2
FCF4
+
+
+
+
1 + r (1 + r ) 2 (1 + r ) 3 (1 + r ) 4 (1 + r ) 5
= 16.5M + 5.06 M + 6.31M + 5.64 M + 5.03M + 1.62 M
= 7.16 M > 0
NPV = FCF0 +

NPV rule: Linksys should undertake it!

Same project but new assumptions

1. Cannibalization of existing routers
Suppose 25% of projected new units (25,000 units) come from
clients who would have purchased an existing Linksys router
Two effects need to be taken into account:

1.
2.

Assumptions on the existing Linksys router:

1.
2.

Lower sales for the existing product (negative impact)

Lower COGS for the existing product (positive impact)

Existing router generates revenues of $100 per unit

Existing router costs $60 per unit in COGS

As a consequence:
1.

Lost annual revenues on existing router

2.

$100 * (25% of projected units sold) = $100 * (25%*100,000) = $2.5M

Annual revenues will be lower by $2.5M due to introduction of new router

Saved annual COGS on existing router

$60 * (25% of projected units sold) = $60 * (25%*100,000) = $1.5M

Annual COGS will be lower by $1.5M due to introduction of new router

Same project but new assumptions

2. Opportunity cost of office space
Suppose the space could have been rented out for $200,000
per year for years 1-4

$200K foregone rent revenues

Be careful: Rent revenues would have been taxed at 40% (=80K per year)
Foregone after-tax incremental earnings of $120K per year ($200K-$80K)
Where can we reflect this extra cost in our pro-forma forecasting?

In higher SG&A expenses

Lets see how that would work:

Suppose annual SG&A expenses are $200K higher

EBIT will be lower by $200K every year
Tax bill will be lower by $80K every year
Incremental earnings will be $120K lower per year
Exactly what we wanted to reflect the opportunity cost of the project!

New projection for incremental

earnings of project

Effect of cannibalization:
Sales = $23.5M instead of $26M
COGS = $9.5M instead of $11M
Time

Incremental earnings forecast

Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings

Time 0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)

1
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000

2
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000

3
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000

4
5
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000) (1,500,000)
9,500,000 (1,500,000)
(3,800,000)
600,000
5,700,000
(900,000)

Opportunity cost on office space:

SG&A = $3M instead of $2.8M
From these incremental earnings (=EBIT(1-)), we still need to go to free cash flows!

From incremental earnings to FCFs

1. Depreciation

Same assumption as before ($1.5M for year 1-5)

2. Capital expenditures

Same assumption as before ($7.5M at time zero)

3. Changes in Net Working Capital

Same assumptions as before

1.
2.
3.
4.

No extra cash requirement

No extra inventories
Receivables
= 15% sales
= 15% of COGS
Payables
Be careful: Need to apply to the new sales (23.5M) and COGS (9.5M) numbers
It is the only difference from earlier computations
T ime

Net Working Capital Forecast

Cash Requirements
Inventory
Receivables (15% of sales)
Payables (15%) of COGS
Net Working Capital
Increases in NWC

T ime 0

1
-

3,525,000
(1,425,000)
2,100,000
2,100,000

2
3,525,000
(1,425,000)
2,100,000
-

3
3,525,000
(1,425,000)
2,100,000
-

3,525,000
(1,425,000)
2,100,000
- (2,100,000)

Free cash flow for project

Time
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings
Plus: Depreciation
Less: Capital Expenditures
Les: Increases in NWC
Free Cash Flow

0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
(7,500,000)
(16,500,000)

1
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
(2,100,000)
5,100,000

2
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000

7,200,000

3
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000

7,200,000

4
5
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000) (1,500,000)
9,500,000 (1,500,000)
(3,800,000)
600,000
5,700,000
(900,000)
1,500,000
1,500,000

7,200,000

2,100,000
2,700,000

NPV computation
Suppose as before that appropriate discount
rate for project is 12%
What is the NPV of the project?
Should Linksys undertake it?
FCF3
FCF5
FCF1 FCF2
FCF4
+
+
+
+
NPV = FCF0 +
2
3
4
1 + r (1 + r )
(1 + r ) (1 + r )
(1 + r ) 5
= 16.5MM + 4.55MM + 5.74 MM + 5.12 MM + 4.58MM + 1.53MM
= 5.03MM > 0

Lower than before but NPV rule says we should

still undertake it!

Roadmap of the lecture

NPV rule and the with-without principle
Advanced FCF computation methods
oExample 1: FCF for Linksyss HomeNet
project

Minimizing costs approach

oExample 2: Beryl Iced Teas choice of the

bottling machines

Real-world complications
Robustness checks

Example 2 Minimizing Costs Approach

Beryl Iced Tea's Choice of the Bottling Machines

Beryl Iced Tea and its current bottling operations:

1. Renting (leasing) machine

[Rent + maintenance] = $54K a year

Two new purchasing options:

2. Purchasing rented machine

Upfront purchase price: $160K

No rent & reduced annual maintenance costs: Only $24K a year

3. Purchasing more advanced machine

Upfront purchase price: $260K

No rent & reduced annual maintenance: Only $19K a year
Furthermore, relative to options 1 and 2:

Upfront training costs for new operators: $39K

Reduction in general bottling costs by $14K a year

Minimizing costs approach

Structure is always the same: Its a trade-off!
A. Higher initial capital spending
B. Lower annual production costs in the future

Approach to solve these problems

Use the NPV rule!
Its the only way to balance appropriately the higher current
costs with the future benefits

Capital budgeting decision:

Minimizing costs approach
Key assumption: Revenues are the same across all projects

All machines generate the same amount of bottles

We do not look at revenues linked to selling the Iced Tea
Assuming revenues are constant:
Maximizing NPV of project Minimizing NPV of projects costs

Further assumptions:
1.
2.
3.
4.
5.

Discount rate for project

9% (for all three options)

Assume annual costs are paid at the end of the year

Depreciation scheme for both machines:

Straight-line method over 7 years

Fully depreciated

Life of machine for both machines

10 years
No salvage value

Marginal tax rate

38%

Option 1: Renting
Timing
Rent
Effect on EBIT
Effect on taxes
Effect on incremental earnings
Effect on FCF*
Cost of capital
PV
NPV

0
-

1
(54,000)
(54,000)
20,520
(33,480)
(33,480)

2
(54,000)
(54,000)
20,520
(33,480)
(33,480)

3
(54,000)
(54,000)
20,520
(33,480)
(33,480)

4
(54,000)
(54,000)
20,520
(33,480)
(33,480)

5
(54,000)
(54,000)
20,520
(33,480)
(33,480)

6
(54,000)
(54,000)
20,520
(33,480)
(33,480)

7
(54,000)
(54,000)
20,520
(33,480)
(33,480)

8
(54,000)
(54,000)
20,520
(33,480)
(33,480)

9
(54,000)
(54,000)
20,520
(33,480)
(33,480)

10
(54,000)
(54,000)
20,520
(33,480)
(33,480)

9%
(214,863)

(30,716)

(28,179)

(25,853)

(23,718)

(21,760)

(19,963)

(18,315)

(16,802)

(15,415)

(14,142)

* No Depreciation, no CAPEX, no Increases in NWC

Option 2: Purchasing current machine

Timing
0
-

Maintenance
Depreciation
Effect on EBIT
Effect on taxes
Effect on incremental earnings
Add: Depreciation
Minus: CAPEX
Effect on FCF*

(160,000)
(160,000)

Cost of capital
PV
NPV

9%
(160,000)
(211,780)

Annual depreciation:
Over 7 years, straight line
fully depreciated

22,857

1
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

2
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

3
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

4
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

5
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

6
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

7
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857

8
(24,000)
(24,000)
9,120
(14,880)
-

9
(24,000)
(24,000)
9,120
(14,880)
-

10
(24,000)
(24,000)
9,120
(14,880)
-

(6,194)

(6,194)

(6,194)

(6,194)

(6,194)

(6,194)

(6,194)

(14,880)

(14,880)

(14,880)

(5,683)

(5,214)

(4,783)

(4,388)

(4,026)

(3,693)

(3,388)

(7,468)

(6,851)

(6,285)

Option 3: Purchasing advanced

machine
T iming
0
(39,000)

Maintenance
Other costs/benefits
Depreciation
Effect on EBIT
Effect on taxes
Effect on incremental earnings
Add: Depreciation
Minus: CAPEX
Effect on FCF*

(260,000)
(284,180)

Cost of capital
PV
NPV

9%
(284,180)
(233,038)

Annual depreciation:
Over 7 years, straight line
fully depreciated

(39,000)
14,820
(24,180)

37,143

1
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

2
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

3
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

4
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

5
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

6
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

7
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143

8
(19,000)
14,000
(5,000)
1,900
(3,100)
-

9
(19,000)
14,000
(5,000)
1,900
(3,100)
-

10
(19,000)
14,000
(5,000)
1,900
(3,100)
-

11,014

11,014

11,014

11,014

11,014

11,014

11,014

(3,100)

(3,100)

(3,100)

10,105

9,271

8,505

7,803

7,159

6,567

6,025

(1,556)

(1,427)

(1,309)

NPV rule
Given same revenues across each project
Maximizing NPV of project = Minimizing NPV of costs
1. Option 1:

Renting has a NPV cost of $214.9K

2. Option 2:

Purchasing current machine has a NPV cost of $211.8K

3. Option 3:

Purchasing current machine has a NPV cost of $233K

Choose option 2!

Projects with unequal useful lives

Consider the two purchasing options
What if the two machines had unequal lives?

Suppose:
1. Current machine would now last 15 years
Assume same maintenance costs beyond year 10 (see Excel)
Now: NPV (costs) = $236K

2. Advanced machine would still last only 10 years

Recall: NPV(costs) = $233K

Which one should you choose?

Can you still simply take the one with the lowest NPV(costs)?
Whats wrong with that?

Solution to unequal lives

Need to make them comparable!
One solution: Equivalent Annual Costs (EAC)

How?
1. Take total NPV(costs) of a project
2. Compute equivalent annual cost over the life of project
Spread out total cost evenly over projects life
Annuity formula!
1
1
NPV(costs) PV(annuity) = EAC 1
r (1 + r ) N
NPV(costs)
EAC =
1
1
1
r (1 + r ) N

Solution to unequal lives

In our example:
EAC1 =

NPV1 (costs)
= 29,306

1
1

1
15
.09 (1 + .09)

Be careful to take the

right number of years!

NPV2 (costs)
= 36,312
EAC2 =

1
1

1
10
.09 (1 + .09)

Purchase the machine you are currently renting as it has

a lower equivalent annual cost!
What are you implicitly assuming when you are
computing the EAC for the project with the shorter life?

Comparison of EACs
EAC1=29,306

EAC2>EAC1

EAC2>EAC1

10 11

EAC2>EAC1

1
EAC2>EAC1

15

Time 0

Time 0
1

10 11

EAC2=36,312

15

Roadmap of the lecture

NPV rule and the with-without principle
Advanced FCF computation methods
oExample 1: FCF for Linksyss HomeNet
project

Minimizing costs approach

oExample 2: Beryl Iced Teas choice of the

bottling machines

Real-world complications
Robustness checks

Making it more realistic

There are several real-world complications that can
still be added to the forecasting exercise
1. Accelerated depreciation

Up to now, we considered only straight-line depreciation

For tax purposes, firms can accelerate their depreciation
scheme

MACRS (Modified Accelerated Cost Recovery System)

Approach will increase NPV relative to straight-line as we have
higher depreciation expenses at the beginning of the useful life of
the asset (hence higher tax savings early in the projects life)
It is simply another depreciation schedule

Nothing hard, just compute depreciation numbers with the

rules given by the problem

Making it more realistic

2. Tax Carryforwards and carrybacks
Up to now, we assumed there were tax benefits of a
loss if and only if the firm as a whole was profitable
Tax loss carryforwards and carrybacks allow (as their
name suggest) corporations to take losses during its
current year and offset them against taxable income in
nearby years
Upshot: Even if the firm is losing money in the current
year, a loss on a project can still have tax advantages

Tax loss carryforward: Example

Case 1: You get the tax benefit
immediately
(40% of $15M = $6M)
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings

0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)

1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000

Case 2: Suppose you cannot use

$15M cost at time zero. But you
can carry forward the loss of
$15M to reduce your tax bill at
time 1 (by $6M)
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Loss carried forward
New taxable income
Income tax (40%)
Incremental earnings (after-tax EBIT )

0
(15,000,000)
(15,000,000)

(15,000,000)

1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(15,000,000)
(4,300,000)
(1,720,000)
12,420,000

Although the tax savings are of the same amount, the fact that they are
deferred in case 2 makes it slightly less interesting in present value (PV)
terms

GM Could Be Free of Taxes for Years

Advantages of Chapter 11 for GM

The usual: Erased billions in debt, laid

off thousands of employees, and
jettisoned money losing brands
The unusual: Tax-Loss Carryforward
Tax Break worth $18 Billion
Why unusual? Because usually granted
only under certain restrictions
Including no significant change in
ownership, i.e. no Chapter 11!

Government ruled that restrictions do not

apply to companies that received TARP
AIG insurance company is another
example

Investors view tax-loss carry

forwards as important assets in
bolstering a companys balance
sheet

Making it more realistic

3. Salvage (Liquidation) value

At the end of a project ,we might sell the PP&E (equipment, etc.) related
to the project

Additional cash flow to take into account!

Need to make some assumptions

Often book value of assets related to project are fully depreciated

Depends on the depreciation scheme we use

More generally, we have:

=
Book Value

Profits from sale over the book value are called capital gains

Purchase Price Accumulated Depreciation

Capital gains = Sale Price Book value

Capital gains are taxable!

Ultimate cash flow impact:

1.
2.

Cash received when selling the PP&E

Tax impact of sale

After-Tax Cash Flow from Asset

=
Sale

Sale Price (c Capital Gain)

Example of salvage value impact

HomeNet example
Equipment was fully depreciated at the end of year 5
Book value = 0

Suppose Linksys was able to sell the equipment for $800K in

cash (salvage value at the end of year 5)
Capital gains = $800K - $0
Taxes linked to capital gains = 40% * $800K = $320K

What would be the impact on cash flows?

Sales price Taxes linked to capital gains = $800 - $320 = $480K

Free cash flows would be the following:

Free Cash Flows
After-tax Salvage value
New Free Cash Flows

(16,500,000) 5,100,000
(16,500,000) 5,100,000

7,200,000
7,200,000

7,200,000
7,200,000

7,200,000
7,200,000

2,700,000
480,000
3,180,000

Roadmap of the lecture

NPV rule and the with-without principle
Advanced FCF computation methods
oExample 1: FCF for Linksyss HomeNet
project

Minimizing costs approach

oExample 2: Beryl Iced Teas choice of the

bottling machines

Real-world complications
Robustness checks

Advanced analysis
Up to now, we have looked at a static case
Relied on many assumptions to get one NPV number

To help your boss understand how critical some

of your assumptions are, you should perform
three robustness checks:
1. Break-even analysis
2. Sensitivity analysis
3. Scenario analysis

1. Break-even analysis
As it name suggests, the break-even level of an input is
the level that causes the NPV of the investment to
equal zero
Potential inputs:
#Units sold
Wholesale price per unit
COGS
Cost of capital
In that case you get the Internal Rate of Return (IRR)!
Etc.

Break-even analysis: Cost of capital

T ime
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings
Plus: Depreciation
Less: Capital Expenditures
Les: Increases in NWC
Free Cash Flow

(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
(7,500,000)
(16,500,000)

Discount rate
PV

24%
(16,500,000)

NPV

(0)

Use Solver (add-on in Data)

Step 1:
Choose target cell (NPV)
Step 2:
Choose value for target cell (zero)
Step 3:
Choose the key cell that can be changed (discount rate)

1
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000

2
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000

3
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000

4
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000

5
(1,500,000)
(1,500,000)
600,000
(900,000)
1,500,000

(2,100,000)
5,100,000

7,200,000

7,200,000

7,200,000

2,100,000
2,700,000

4,109,119

4,674,009

3,765,894

3,034,217

916,762

2. Sensitivity analysis
Sensitivity Analysis:
1. NPV changes given a change in one of the
assumptions
2. Holding the other assumptions constant

Example:
Cost of capital
We just saw two cases:
1. Cost of capital: 12%
NPV = $5M

2. Cost of capital: 24%

NPV = 0

What about the NPV for other levels of cost of capital?

Sensitivity analysis: See Excel

IRR

This picture is very useful as it gives a range of discount

rates that yields a positive NPV for the project!

Best and worst case approach

Requires good business acumen

Best and worst case approach

Units Sold is clearly the most sensitive parameter in terms of NPV

3. Scenario analysis
Is changing one parameter at a time realistic?
Usually the variables are interconnected
One of the best examples:
Price per unit and units sold move together!

Scenario Analysis considers the effect on NPV of

simultaneously changing multiple assumptions
Requires good business judgment