# BD_SM07doc - Chapter 7 Fundamentals of Capital Budgeting...

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Chapter 7 Fundamentals of Capital Budgeting 7-1. a. Sales of new pizza – lost sales of original = 20 – 0.40(20) = \$12 million b. Sales of new pizza – lost sales of original pizza from customers who would not have switched brands = 20 – 0.50(0.40)(20) = \$16 million 7-2. 7-3. a. No, this is a sunk cost and will not be included directly. (But see (f) below.) b. Yes, this is a cost of opening the new store. c. Yes, this loss of sales at the existing store should be deducted from the sales at the new store to determine the incremental increase in sales that opening the new store will generate for HBS. d. No, this is a sunk cost. e. This is a capital expenditure associated with opening the new store. These costs will therefore increase HBS’s depreciation expenses. f. Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS forgoes the after- tax proceeds it could have earned by selling the property. This loss is equal to the sale price less the taxes owed on the capital gain from the sale, which is the difference between the sale price and the book value of the property. The book value equals the initial cost of the property less accumulated depreciation.) g. While these financing costs will affect HBS’s actual earnings, for capital budgeting purposes we calculate the incremental earnings without including financing costs to determine the project’s unlevered net income. Year 1 2 Incremental Earnings Forecast (\$000s) 1 Sales of Mini Mochi Munch 9,000 7,000 2 Other Sales 2,000 2,000 3 Cost of Goods Sold (7,350) (6,050) 4 Gross Profit 3,650 2,950 5 (5,000) - 6 Depreciation - - 7 EBIT (1,350) 2,950 8 Income tax at 35% 473 (1,033) 9 Unlevered Net Income (878) 1,918

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66 Berk/DeMarzo • Corporate Finance 7-4. a. Change in EBIT = Gross profit with price drop – Gross profit without price drop b. = 25,000 × (300 – 200) – 20,000 ×(350 – 200) c. = - \$500,000 d. Change in EBIT from Ink Cartridge sales = 25,000 × \$75 × 0.70 – 20,000 × \$75 × 0.70 = \$262,500 e. Therefore, incremental change in EBIT for the next 3 years is f. Year 1: \$262,500 – 500,000 = -\$237,500 g. Year 2: \$262,500 h. Year 3: \$262,500 7-5. 7-6. Solution: Note – we have assumed any incremental cost of goods sold is included as part of operating expenses. a. Year 1 2 Incremental Earnings Forecast (\$000s) 1 Sales 125.0 160.0 2 Operating Expenses (40.0) (60.0) 3 Depreciation (25.0) (36.0) 4 EBIT 60.0 64.0 5 Income tax at 35% (21.0) (22.4) 6 Unlevered Net Income 39.0 41.6 b. Free Cash Flow (\$000s) 1 2 7 Plus: Depreciation 25.0 36.0 8 Less: Capital Expenditures (30.0) (40.0) 9 Less: Increases in NWC (5.0) (8.0) 10 Free Cash Flow 29.0 29.6 7-7. a.
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BD_SM07doc - Chapter 7 Fundamentals of Capital Budgeting...

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