Financial Management

Lecture 3: Capital Budgeting

Professor Andrea Vedolin

ETH Zürich
 Today

Objectives and Principles of Capital Budgeting

From Accounting to Finance

How do we get...?
I Gross Profit
I EBIT
I Unlevered Net Income
I Free Cash Flow

Robustness Analysis

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 Notation

IRR: internal rate of return

EBIT : earning before interest and taxes
τc : marginal corporate tax rate
NWCt : net working capital
CAPEX : capital expenditures
FCFt : free cash flow
PV : present value
r : projected cost of capital

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 How to calculate the IRR?
The(Internal(Rate(of(Return:(Example(
Consider&the&following&project:&
For example, use the IRR functions of an Excel spreadsheet
-$200 $50 $100 $150

0 1 2 3
$50 $100 $150
NPV = 0 = −$200 + + +
(1 + IRR) (1 + IRR) 2 (1 + IRR) 3

Calculator(
CFj( CFj( CFj( CFj( IRR/YR(
\200& 50& 100& 150& 19.44(

Excel:(“=IRR(A1:A4)”&"&.1944& 12

However, Excel’s NPV formula requires “=NPV(0.1944,A2:A4)+A1” to

reconcile the zero NPV, which means it’s really a “present value” formula.

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 How to solve for a power N?

Consider the following equation:

xN = y

How do we solve for N?

ln x N = ln(y )

ln(y )
N ln(x) = ln(y ) ⇒ N=
ln(x)

Useful to solve for N in problems that involve the annuity formula:

 
C 1
NPV0 = C0 + 1−
r (1 + r )N

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 Capital Budgeting: Objectives

Capital Budgeting: Process used to analyze investment opportunities and

decide which ones to accept.

From previous class: We should use the NPV rule!

N 
X Cn >0 ⇒ invest
NPV0 = C0 +
(1 + r )n 60 ⇒ do not invest
n=1

But, how do we get the relevant cash flows C0 and Cn ? And r ?

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 Capital Budgeting: Principles

Assume project is fully equity financed

(we want to evaluate the project on its own, separate from the financing decision)

Forecast the incremental earnings of a project

(amount by which the firm’s earnings are expected to change as a result of the investment decision)

Calculate the project’s free cash flow from earnings in any period
(the first ingredient of our NPV formula)

Determine the appropriate discount rate reflecting the risk of the project
(the second ingredient of our NPV formula)

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 What do we really need?

For any relevant period, we need to determine:

1. Gross Profit

2. EBIT (Earnings Before Interest and Taxes)

3. Unlevered Net Income

4. Free Cash Flow

Then, we can apply the NPV formula.

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 From Accounting... to Finance
From+Accoun3ng+…+to+Finance+
From+Accoun3ng+…+to+Finance+
Accounting
Accounting

Sales
Sales 100.0m
100.0m
Costs
Costs of goods
of goods sold
sold -60.0m
-60.0m
General
General expenses
expenses -10.0m
-10.0m Finance
Finance
Depreciation
Depreciation -7.0m
-7.0m
EBIT
EBIT (OP)
(OP) 23.0m
23.0m EBIT
EBIT (OP)
(OP) 23.00m
23.00m
Interest
Interest expenses
expenses -10.0m
-10.0m Taxes
Taxes on on EBIT
EBIT -7.82m
-7.82m
Earnings
Earnings 13.0m
13.0m Unlevered
Unlevered NetNet Income
Income 15.18m
15.18m
Taxes
Taxes (34%)
(34%) -4.4m
-4.4m (NOPAT)
(NOPAT)
NetNet income
income 8.6m
8.6m Depreciation
Depreciation +7.00m
+7.00m
Changes
Changes in NWC
in NWC -4.00m
-4.00m
CAPEX
CAPEX -15.00m
-15.00m
Free
Free Cash
Cash Flow
Flow 3.18m
3.18m
4 4

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 How do we get the Gross Profit?

Gross Profit = (Sales − Cost of Goods Sold)

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 How do we get the EBIT?

EBIT = (Gross Profit − R&D Expenses − Other Expenses − Depreciation)

| {z }
marketing expenses
selling expenses
design expenses
engineering expenses
admin. expenses
EBIT = (Revenues − Costs − Depreciation)

Note:

Depreciation reflects the capital expenditures spread out over time

Revenues and costs must include indirect effects on incremental earnings
Sunk costs should NOT be considered for the incremental earnings
EBIT is often called Operating Profit

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 Capital Depreciation

Capital Expenditures (for instance the purchase of a new equipment) are a

cash expense when they take place;
However, in the financial reports the firm deducts a fraction of these
expenditures each year as (Capital) Depreciation. Why?

Two methods to compute depreciation:

Straight Line Depreciation. The asset’s cost is divided equally over its life.
Divide the difference between an asset’s cost and its expected liquidation
value by the number of years it is expected to be used.
Accelerated Depreciation. For instance, according to the Modified
Accelerated Cost Recovery System (MACRS), the amount of
depreciation taken each year is higher during the earlier years of an asset’s life.
Which depreciation methods is preferred?

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 Indirect Effects and Sunk Costs

Revenues and costs must include indirect effects on incremental earnings:

I Opportunity costs: the value a certain resource could have generated (in its
best alternative use) if not used for the new project
I Project Externalities: profits of other business activities of the firm created or
destroyed by the new project (cannabalization)

Sunk costs (such as fixed overhead expenses, past R&D expenditures)

should NOT be considered for the incremental earnings since they represent
costs that have been or will be paid regardless of the decision whether or not
to process with the new project

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 How do we get the Unlevered Net Income?

Income Tax = EBIT × τc

Unlevered Net Income = EBIT − Income Tax

= EBIT × (1 − τc )
= (Revenues − Costs − Depreciation) × (1 − τc )

Note:

τc is the marginal corporate tax rate

tax rate to be paid on an incremental dollar of pre-tax income
A negative tax (due to a negative EBIT) is equal to a tax credit
Interest expenses should NOT be included (why?)
Unlevered Net Income is often called Net Operating Profit After Tax
(NOPAT)

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 Example: HomeNet
Linksys has completed a $300,000 feasibility study to assess the
attractiveness of a new product, HomeNet.
The project has an estimated life of 4 years.
Revenue Estimates:
I Sales = 100,000 units/year
I Price per unit = $260
Cost Estimates:
I Cost per unit = $110
I Up-Front R&D expenses = $15,000,000
I Up-Front CapEx on New Equipment = $7,500,000
Expected life is 5 years
Housed in one of the company’s lab with rental value = $200,000 per year
I Marketing expenses = $2,800,000
Externalities:
I 25% of sales come from customers who would have purchased an existing
Linksys wireless router (price per unit = $100, cost per unit = $60) if
HomeNet were not available
Marginal tax rate = 40%
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 Example: HomeNet

25% × 100,000 units × $100/unit = $2.5 M reduction in sales forecast from

$26 M to $23.5 M

25% × 100,000 units × $60/unit = $1.5 M reduction in cost forecast from

$11 M to $9.5 M

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 How do we get the Free Cash Flow?

Unlevered Net Income

z }| {
Free Cash Flow = (Revenues − Costs − Depreciation) × (1 − τc )
+ Depreciation − CapEx − ∆Net Working Capital

= (Revenues − Costs) × (1 − τc ) + τc × Depreciation

− CapEx − ∆Net Working Capital

Note:

Free Cash Flow (FCF) represents the cash that a company is able to generate
after laying out the money required to maintain or expand its asset base.
τc × Depreciation is called depreciation tax shield: tax savings from
deducting depreciation

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 CapEx and Depreciation

Capital Expenditures include the actual cash outflows when an asset is

purchased, and inflows when it is sold.

Depreciation is a non-cash expense. The free cash flow is adjusted for this
non-cash expense by adding the depreciation back to the Unlevered Net
Income.

When calculating free cash flow, capital expenditure-related cash outflows are
included in the time they actually occur (and not when they are depreciated).

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 Net Working Capital
Net Working Capital (NWC) is a measurement of the operating liquidity
available for a company to use in developing and growing its business:

Net Working Capital = Current Assets − Current Liabilities

= Cash + Inventory + Receivables − Payables
| {z }
Trade Credit

The change in NWC id defined as:

∆NWCt = NWCt − NWCt−1

An increase in NWC (∆NWCt > 0) represents an investment that reduces

the cash available to the firm: hence it reduces the Free Cash Flow

A decrease in NWC (∆NWCt < 0) increases the the Free Cash Flow

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 Example: HomeNet

...

Receivable are expected to account for 15% of annual sales

Payables are expected to be 15% of the annual cost of goods sold
No incremental cash or inventory requirements

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 Example: HomeNet

where the Net Working Capital in each year is given by

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 Further Adjustments to Free Cash Flow

Terminal or Continuation Value:

Sometimes the firm explicitly forecast FCF over a shorter horizon

In such cases, we estimate the value of the remaining FCF beyond the
forecast horizon by including an additional one-time cash flow called terminal
or continuation value

This additional cash flow is equal to the market value of the FCFs from the
project at all future dates

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 Further Adjustments to Free Cash Flow

Liquidation or Salvage Value

Assets that are no longer needed often have a resale value

If the parts of the assets are sold for scrap we call it salvage value
the liquidation or salvage value can also be negative
The FCF is adjusted as follows to incorporate the asset sale:

∆FCF = Sale Price − (τc × Gain on Sale)

where

Gain on Sale = Sale Price − (Purchase Price − Accumulated Depreciation)

| {z }
Remaining Book Value

It simplifies to ∆FCF = Sale Price × (1 − τc ) if Remaining Book Value = 0.

Financial Management (363-0560) Capital Budgeting 23 / 27

 Example: HomeNet

...

in addition to the investment for the new equipment, some existing

equipment can be used in the lab for HomeNet
the resale value of the this existing equipment is $2M
the book value of the this existing equipment is $1M
if the existing equipment is kept rather than sold, its remaining book value
can be depreciated next year
in year 5 the equipment will have a salvage value of $800,000

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 Example: HomeNet

Year 0: $2 M – 40% × ($2 M – $1 M) = $1.6 equipment’s opportunity cost

Year 1: 40% × $1 M = $400,000 depreciation tax shield from write-off

Year 5: $800,000 × (1 – 40%) = $480,000 after-tax salvage value (see p. 23)

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 Robustness Analysis
Break-even analysis

the break-even level of an input is the level that causes the NPV of the
investment to equal zero
for each parameter we calculate the break-even level
this would tell us how close we are to such level

Sensitivity analysis

calculate the NPV by varying only one parameter at a time

this would give us the sensitivity to each parameter

Scenario analysis

calculate the NPV for different scenarios

each scenario is obtained by varying multiple parameters at the same time

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 Summarizing
To calculate the NPV of a project we need the FCFs
FCF is given by:
Unlevered Net Income
z }| {
Free Cash Flow = (Revenues − Costs − Depreciation) × (1 − τc )
+Depreciation − CapEx − ∆Net Working Capital

Remember:
I include indirect effect (opportunity cots and externalities)
I exclude sunk costs
I exclude interests expenses
I include (− depreciation) before computing the EBIT
I include (+ depreciation) after computing the Unlevered Net Income
I only changes in the NWC affect FCF
I consider a possible termination value
I tax losses can be carried forward (less tax in the future)
or backward (tax refund today)
I the sale of assets increases the FCF
I the tax on gain on sales reduces the FCF

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 Next Class...

We will start covering the (vast) topic of “Options”

Check out Chapter 20 of the book

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