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Capital Budgeting Process: Forecasting Incremental Earnings and Free Cash Flows

This chapter discusses the process of capital budgeting, including forecasting incremental earnings and determining incremental free cash flows. It covers topics such as operating expenses, capital expenditures, depreciation, revenue and cost estimates, taxes, and incremental earnings forecast.

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Capital Budgeting Process: Forecasting Incremental Earnings and Free Cash Flows

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  1. Chapter 9 Fundamentals of Capital Budgeting

  2. Chapter Outline 9.1 The Capital Budgeting Process 9.2 Forecasting Incremental Earnings 9.3 Determining Incremental Free Cash Flow 9.4 Other Effects on Incremental Free Cash Flows 9.5 Analyzing the Project 9.6 Real Options in Capital Budgeting

  3. Learning Objectives • Identify the types of cash flows needed in the capital budgeting process • Forecast incremental earnings in a pro forma earnings statement for a project • Convert forecasted earnings to free cash flows and compute a project’s NPV • Recognize common pitfalls that arise in identifying a project’s incremental free cash flows • Assess the sensitivity of a project’s NPV to changes in your assumptions • Identify the most common options available to managers in projects and understand why these options can be valuable

  4. 9.1 The Capital Budgeting Process • Capital Budget • Capital Budgeting • Incremental Earnings

  5. Figure 9.1 Cash Flows in a Typical Project

  6. 9.2 Forecasting Incremental Earnings • Operating Expenses Versus Capital Expenditures • Operating Expenses • Capital Expenditures

  7. 9.2 Forecasting Incremental Earnings • Operating Expenses Versus Capital Expenditures • Depreciation • Depreciation expenses do not correspond to actual cash outflows • Straight-Line Depreciation

  8. 9.2 Forecasting Incremental Earnings • Incremental Revenue and Cost Estimates • Factors to consider when estimating a project’s revenues and costs: • A new product typically has lower sales initially • The average selling price of a product and its cost of production will generally change over time • For most industries, competition tends to reduce profit margins over time

  9. 9.2 Forecasting Incremental Earnings • Incremental Revenue and Cost Estimates • The evaluation is on how the project will change the cash flows of the firm • Thus, focus is on incremental revenues and costs

  10. 9.2 Forecasting Incremental Earnings • Incremental Revenue and Cost Estimates Incremental Earnings Before Interest and Taxes (EBIT) = Incremental Revenue – Incremental Costs – Depreciation (Eq. 9.1)

  11. 9.2 Forecasting Incremental Earnings • Taxes • Marginal Corporate Tax Rate • The tax rate a firm will pay on an incremental dollar of pre-tax income (Eq. 9.2) Income Tax = EBIT  The Firm’s Marginal Corporate Tax Rate

  12. 9.2 Forecasting Incremental Earnings • Incremental Earnings Forecast Incremental Earnings = (Incremental Revenues – Incremental Costs – Depreciation)  (1 – Tax Rate) (Eq. 9.3)

  13. Example 9.1 Incremental Earnings Problem: • Suppose that 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. HomeNet will also control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on. The major competitor for HomeNet is a product being developed by Brandt-Quigley Corporation.

  14. Example 9.1 Incremental Earnings Problem: • Based on extensive marketing surveys, the sales forecast for HomeNet is 50,000 units per year. Given the pace of technological change, Linksys expects the product will have a four-year life and an expected wholesale price of $260 (the price Linksys will receive from stores). Actual production will be outsourced at a cost (including packaging) of $110 per unit.

  15. Example 9.1 Incremental Earnings Problem (cont'd): • To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Linksys must also establish a new lab for testing purposes. They will rent the lab space, but will need to purchase $7.5 million of new equipment. The equipment will be depreciated using the straight-line method over a 5-year life. Linksys' marginal tax rate is 40%.

  16. Example 9.1 Incremental Earnings Problem (cont'd): • 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 rental costs for the lab space, as well as rent marketing and support for this product. Forecast the incremental earnings from the HomeNet project.

  17. Example 9.1 Incremental Earnings Solution: Plan: • We need 4 items to calculate incremental earnings: (1) incremental revenues, (2) incremental costs, (3) depreciation, and (4) the marginal tax rate: • Incremental Revenues are: additional units sold  price = 50,000  $260 = $13,000,000 • Incremental Costs are: additional units sold  production costs = 50,000  $110 = $5,500,000

  18. Example 9.1 Incremental Earnings Plan: • Selling, General and Administrative = $2,800,000 for marketing and support • Depreciation is: Depreciable basis / Depreciable Life = $7,500,000 / 5 = $1,500,000 • Marginal Tax Rate: 40% • Note that even though the project lasts for 4 years, the equipment has a 5-year life, so we must account for the final depreciation charge in the 5th year.

  19. Example 9.1 Incremental Earnings Execute:

  20. Example 9.1 Incremental Earnings Evaluate: • These incremental earnings are an intermediate step on the way to calculating the incremental cash flows that would form the basis of any analysis of the HomeNet project. The cost of the equipment does not affect earnings in the year it is purchased, but does so through the depreciation expense in the following five years.

  21. Example 9.1 Incremental Earnings Evaluate (cont'd): • Note that the depreciable life, which is based on accounting rules, does not have to be the same as the economic life of the asset—the period over which it will have value. Here the firm will use the equipment for four years, but depreciates it over five years.

  22. Example 9.1a Incremental Earnings Problem: • Suppose that 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. HomeNet will also control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on. The major competitor for HomeNet is a product being developed by Brandt-Quigley Corporation.

  23. Example 9.1aIncremental Earnings Problem: • Based on extensive marketing surveys, the sales forecast for HomeNet is 40,000 units per year. Given the pace of technological change, Linksys expects the product will have a four-year life and an expected wholesale price of $200 (the price Linksys will receive from stores). Actual production will be outsourced at a cost (including packaging) of $90 per unit.

  24. Example 9.1aIncremental Earnings Problem (cont'd): • To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Linksys must also establish a new lab for testing purposes. They will rent the lab space, but will need to purchase $6.5 million of new equipment. The equipment will be depreciated using the straight-line method over a 5-year life.

  25. Example 9.1aIncremental Earnings Problem (cont'd): • The lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2.0 million per year on rental costs for the lab space, as well as marketing and support for this product. Forecast the incremental earnings from the HomeNet project.

  26. Example 9.1aIncremental Earnings Solution: Plan: • We need 4 items to calculate incremental earnings: (1) incremental revenues, (2) incremental costs, (3) depreciation, and (4) the marginal tax rate: • Incremental Revenues are: additional units sold  price = 40,000  $200 = $8,000,000 • Incremental Costs are: additional units sold  production costs = 40,000  $90 = $3,600,000

  27. Example 9.1aIncremental Earnings Plan: • Selling, General and Administrative = $2,000,000 for marketing and support • Depreciation is: Depreciable basis / Depreciable Life = $6,500,000 / 5 = $1,300,000 • Marginal Tax Rate: 40% • Note that even though the project lasts for 4 years, the equipment has a 5-year life, so we must account for the final depreciation charge in the 5th year.

  28. Example 9.1aIncremental Earnings Execute:

  29. Example 9.1aIncremental Earnings Evaluate: • These incremental earnings are an intermediate step on the way to calculating the incremental cash flows that would form the basis of any analysis of the HomeNet project. The cost of the equipment does not affect earnings in the year it is purchased, but does so through the depreciation expense in the following five years.

  30. Example 9.1aIncremental Earnings Evaluate (cont'd): • Note that the depreciable life, which is based on accounting rules, does not have to be the same as the economic life of the asset—the period over which it will have value. Here the firm will use the equipment for four years, but depreciates it over five years.

  31. 9.2 Forecasting Incremental Earnings • Incremental Earnings Forecast • Pro Forma Statement • Taxes and Negative EBIT • Interest Expense • Unlevered Net Income

  32. Example 9.2 Taxing Losses for Projects in Profitable Companies Problem: • Kellogg Company plans to launch a new line of high-fiber, zero-trans-fat breakfast pastries. The heavy advertising expenses associated with the new product launch will generate operating losses of $15 million next year for the product. Kellogg expects to earn pre-tax income of $460 million from operations other than the new pastries next year. If Kellogg pays a 40% tax rate on its pre-tax income, what will it owe in taxes next year without the new pastry product? What will it owe with the new pastries?

  33. Example 9.2 Taxing Losses for Projects in Profitable Companies Solution: Plan: • We need Kellogg’s pre-tax income with and without the new product losses and its tax rate of 40%. We can then compute the tax without the losses and compare it to the tax with the losses.

  34. Example 9.2 Taxing Losses for Projects in Profitable Companies Execute: • Without the new pastries, Kellogg will owe $460 million  40% = $184 million in corporate taxes next year. With the new pastries, Kellogg’s pre-tax income next year will be only $460 million - $15 million = $445 million, and it will owe $445 million  40% = $178 million in tax.

  35. Example 9.2 Taxing Losses for Projects in Profitable Companies Evaluate: • Thus, launching the new product reduces Kellogg’s taxes next year by $184 million - $178 million = $6 million. Because the losses on the new product reduce Kellogg’s taxable income dollar for dollar, it is the same as if the new product had a tax bill of negative $6 million.

  36. Example 9.2a Taxing Losses for Projects in Profitable Companies Problem: • Kellogg Company plans to launch a new line of high-fiber, zero-trans-fat breakfast pastries. The heavy advertising expenses associated with the new product launch will generate operating losses of $10 million next year for the product. Kellogg expects to earn pre-tax income of $320 million from operations other than the new pastries next year. If Kellogg pays a 40% tax rate on its pre-tax income, what will it owe in taxes next year without the new pastry product? What will it owe with the new pastries?

  37. Example 9.2a Taxing Losses for Projects in Profitable Companies Solution: Plan: • We need Kellogg’s pre-tax income with and without the new product losses and its tax rate of 40%. We can then compute the tax without the losses and compare it to the tax with the losses.

  38. Example 9.2a Taxing Losses for Projects in Profitable Companies Execute: • Without the new pastries, Kellogg will owe $320 million  40% = $128 million in corporate taxes next year. With the new pastries, Kellogg’s pre-tax income next year will be only $320 million - $10 million = $310 million, and it will owe $310 million  40% = $124 million in tax.

  39. Example 9.2a Taxing Losses for Projects in Profitable Companies Evaluate: • Thus, launching the new product reduces Kellogg’s taxes next year by $128 million - $124 million = $4 million. Because the losses on the new product reduce Kellogg’s taxable income dollar for dollar, it is the same as if the new product had a tax bill of negative $4 million.

  40. 9.3 Determining Incremental Free Cash Flow • Converting from Earnings to Free Cash Flow • Free Cash Flow • The incremental effect of a project on a firm’s available cash • Capital Expenditures and Depreciation

  41. Table 9.1 Deducting and then Adding Back Depreciation

  42. Example 9.3 Incremental Free Cash Flows Problem: • Let’s return to the HomeNet example. In Example 9.1, we computed the incremental earnings for HomeNet, but we need the incremental free cash flows to decide whether Linksys should proceed with the project.

  43. Example 9.3 Incremental Free Cash Flows Solution: Plan: • The difference between the incremental earnings and incremental free cash flows in the HomeNet example will be driven by the equipment purchased for the lab. We need to recognize the $7.5 million cash outflow associated with the purchase in year 0 and add back the $1.5 million depreciation expenses from year 1 to 5 as they are not actually cash outflows.

  44. Example 9.3 Incremental Free Cash Flows Execute:

  45. Example 9.3 Incremental Free Cash Flows Evaluate • By recognizing the outflow from purchasing the equipment in year 0, we account for the fact that $7.5 million left the firm at that time. By adding back the $1.5 million depreciation expenses in years 1 – 5, we adjust the incremental earnings to reflect the fact that the depreciation expense is not a cash outflow.

  46. Example 9.3a Incremental Free Cash Flows Problem: • Let’s return to the HomeNet example. In Example 9.1a, we computed the incremental earnings for HomeNet, but we need the incremental free cash flows to decide whether Linksys should proceed with the project.

  47. Example 9.3a Incremental Free Cash Flows Solution: Plan: • The difference between the incremental earnings and incremental free cash flows in the HomeNet example will be driven by the equipment purchased for the lab. We need to recognize the $6.5 million cash outflow associated with the purchase in year 0 and add back the $1.3 million depreciation expenses from year 1 to 5 as they are not actually cash outflows.

  48. Example 9.3a Incremental Free Cash Flows Execute:

  49. Example 9.3a Incremental Free Cash Flows Evaluate: • By recognizing the outflow from purchasing the equipment in year 0, we account for the fact that $6.5 million left the firm at that time. By adding back the $1.3 million depreciation expenses in years 1 – 5, we adjust the incremental earnings to reflect the fact that the depreciation expense is not a cash outflow.

  50. 9.3 Determining Incremental Free Cash Flow • Converting from Earnings to Free Cash Flow • Net Working Capital • Trade Credit • The difference between receivables and payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions Net Working Capital = Current Assets  Current Liabilities = Cash + Inventory + Receivables  Payables (Eq. 9.4)

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