Example of capital budgeting Forecasting earnings Determining Free Cash Flow and NPV Analyzing the project

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

Forecasting Earnings Revenue and cost estimates Sales forecast: 100,000 units per year Sales forecast: 100,000 units per year Product will have a 4-year life Product will have a 4-year life Wholesale price: $260 per unit Wholesale price: $260 per unit Cost of outsourcing production: $110 per unit Cost of outsourcing production: $110 per unit Engineering and design costs: $5 mln Engineering and design costs: $5 mln Software engineering: Software engineering: 50 engineers needed Cost of software engineer $200,000 per year Will take one year to complete Testing lab: $7.5 mln Testing lab: $7.5 mln Marketing and support: $2.8 mln per year Marketing and support: $2.8 mln per year

HomeNets Incremental Earnings Forecast (Spreadsheet)

Capital expenditures and depreciation $7.5 mln was invested in a lab $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. 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 You should use marginal tax rate Dont forget to add taxes when the project reduces the taxable income of your firm Dont forget to add taxes when the project reduces the taxable income of your firm Notes on the forecast spreadsheet

Indirect effects on Incremental Earnings Have we missed anything in our calculations? Yes: Opportunity costs Opportunity costs Project externalities (side effects) Project externalities (side effects)

Accounting for Opportunity Costs

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)

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

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

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 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

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) 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 – ΔCash + interest. Remember we had CF to investors = CF from operations – CF from investment – ΔCash + interest. When the firm is unlevered: CF from operations = Unlevered Net Income + Depreciation – ΔNWC + ΔCash When the firm is unlevered: CF from operations = Unlevered Net Income + Depreciation – ΔNWC + ΔCash CF from investment = CapEx CF from investment = CapEx Hence, we obtain precisely the formula above

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

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 = mln. Hence, the net Receivables = mln. For Payables, cash and inventory – the same.

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

Computing HomeNets NPV (Spreadsheet)

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

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). 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 Now we have inventory requirement = $9.5 mln / 12 = $0.792 mln Hence, ignoring Receivables that do not change: 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

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

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 c (Sale Price – Book Value) = 40% * $2 mln = $0.8 mln Hence the cash from the sale = 2 – 0.8 = 1.2 mln Hence the cash from the sale = 2 – 0.8 = 1.2 mln We would have to account for this cash in year 5. We would have to account for this cash in year 5.

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 T+1 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

Example of accounting for continuation value

Accounting for inflation Simply discount cash flows correctly: If real values are used, use real R. If real values are used, use real R. If nominal values – use nominal R. If nominal values – use nominal R. 1 + Rn = (1 + Rr)(1 + i) Rr Rn – i CFr t = CFn t /(1 + i) t

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) 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