Chapter8a+notes - Chapter 8 Fundamentals of Capital...

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Unformatted text preview: Chapter 8 Fundamentals of Capital Budgeting Focusing Question China Unicom spends 18.7 billion yuan on its wireless network in 2008 and plans to increase its capital expenditure to 100 billion yuan for 2009 and 2010. How does China Unicom determine this capital budget, and why its stock price fell at the announcement? Spring 2009 2 Course Plan Financial Management Valuation Short-term Financial Management Risk and Return Long-term Financing Decisions Valuation Principle Capital Budgeting Working Capital Management Cost of Capital Capital Structure Investment Decision Rules Bonds and Stocks Foundation and Tools Financial Statement Analysis Time Value of Money Spring 2009 Payout Policy 3 Outline Capital Budgeting Forecasting Incremental Earnings Determining Free Cash Flows Tax Shield Approach Spring 2009 Replacement Decisions Analyzing the Project Indirect Effects 4 Learning Objectives 1. Given a set of facts, identify relevant cash flows for a capital budgeting problem. 2. Prepare a pro forma income statement for a given project and compute the forecasted incremental earnings (unlevered net income). 3. Show the accounting treatment for capital expenditures versus operating expenses. 4. Illustrate the impact of depreciation expense on incremental cash flows. 5. Demonstrate how to incorporate changes in net working capital in estimating incremental cash flows. 6. Convert forecasted incremental earnings to incremental cash flows for a given project. Capital Budgeting Capital Budget: a list of the investments that a company plans to undertake Capital Budgeting : the process of analyzing alternate investments and deciding which ones to accept Steps in Capital Budgeting 1. Estimate the project’s expected future cash flows 2. Estimate the required return for projects of this risk level 3. Apply capital budgeting decision rules and compute NPV or IRR 4. Compute the sensitivity of the NPV to the uncertainty of the forecast Spring 2009 6 Cash Flows in a Typical Project Spring 2009 7 Estimating Free Cash Flow Free Cash Flow The incremental effect of a project on a firm’s available cash Start by estimating the incremental earnings of a project How the investment decision will affect the firm’s reported profits from an accounting perspective. Information from pro forma income statement Key issues in estimating the project’s free cash flow: When is a cash flow incremental? Earnings are not actual cash flows. How to calculate free cash flow from accounting earnings? What are the common pitfalls? Spring 2009 8 Earnings Reported on Income Statement Spring 2009 9 Calculating Free Cash Flows Year Revenues Cost of Goods Sold Gross Profit Selling, General and Admin Depreciation EBIT Income Tax at 40% Incremental Earnings + : Add Back Depreciation - : Minus Cost of Equipment - : Minus Changes in NWC Incremental Earnings (unlevered net income) = EBIT (1 – tc) = (Revenues – Costs – Depreciation) (1 – tc) Incremental Free Cash Flows = Incremental Earnings + Depreciation – Net Capital Expenditures – Change in NWC Incremental Free Cash Flows Spring 2009 10 Forecasting Incremental Earnings Operating Expenses vs. Capital Expenditures Upfront cash outflows to purchase and set-up equipment is not recognized as an expense when calculating earnings in year 0. Instead, it is recorded as depreciation expenses on the income statement during its useful life. Depreciation expenses do not correspond to actual cash outflows. Spring 2009 8-1111 Forecasting Incremental Earnings Interest Expenses Interest expense is typically not included. The rationale is that the project should be judged on its own operating costs and benefits, not on its financing cost. Separation of investment and financing decisions Financing costs NOT included as these are not cash flows from assets Debt-equity mix of the financing arrangement should be considered separately Spring 2009 12 Forecasting Incremental Earnings Taxes Incremental income tax expense = EBIT x firm’s marginal corporate tax rate Tax expense on the marginal or incremental dollar of pre-tax income. Tax is a cash outflow. Operating expenses and Depreciation reduce taxable earnings resulting in tax credit. Note: A negative tax is equal to a tax credit. Spring 2009 13 Quick Quiz 1. Which of the following is not included in the forecast of incremental earnings for a capital budgeting project? A. Capital expenditures B. Interest expenses C. Operating expenses D. Taxes Spring 2009 14 Outline Capital Budgeting Forecasting Incremental Earnings Determining Free Cash Flows Tax Shield Approach Spring 2009 Replacement Decisions Analyzing the Project Indirect Effects 15 Incremental Earnings Forecast Example 8.1 Problem: Linksys of Cisco System is considering the development of a wireless home networking compliance, HomeNet. Linksys has completed a $300,000 feasibility study to assess its attractiveness. 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 with an expected retail price of $375 per unit. The wholesale price of $260. Actual production will be outsourced at a cost (including packaging) of $110 per unit. Spring 2009 8-1616 Incremental Earnings Forecast Problem (cont'd): To verify the compatibility of new consumer Internet-ready appliances, 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. 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 marketing and administrative support for this product. Forecast the incremental earnings from the HomeNet 8-1717 project. Spring 2009 Incremental Earnings Forecast Solution: Plan: Incremental Revenue Estimates Sales = 50,000 units/year; Per Unit Price = $260 50,000 × $260 = $13,000,000 Incremental Cost Estimates Per unit production cost = $110 50,000 × $110 = $5,500,000 Up-front new testing equipment = $7.5 mil Annual depreciation = $1.5 mil Annual operating cost = $2.8 mil Note: project lasts for 4 years, but the equipment has a 5year life. So final depreciation charge in the 5th year. Spring 2009 18 Incremental Earnings Forecast Execute: Incremental earnings during the project’s life (and the lab equipment’s life). 1 Year 1 2 3 4 5 2 Revenues 13,000 13,000 13,000 13,000 - 3 Cost of Goods Sold -5,500 -5,500 -5,500 -5,500 - 7,500 7,500 7,500 7,500 - 5 Selling, General & Admin -2,800 -2,800 -2,800 -2,800 - 6 Depreciation -1,500 -1,500 -1,500 -1,500 -1,500 3,200 3,200 3,200 3,200 -1,500 -1,280 -1,280 -1,280 -1,280 600 1,920 1,920 1,920 1,920 -900 4 Gross Profit 7 EBIT 8 Income Tax at 40% 9 Unlevered Net Income Spring 2009 19 Incremental Earnings Forecast Evaluate: These incremental earnings are an intermediate step to calculating the incremental cash flows. Depreciable life is based on accounting rules ≠ economic life of the asset — the period over which it will have value Spring 2009 8-2020 Outline Capital Budgeting Forecasting Incremental Earnings Determining Free Cash Flows Tax Shield Approach Spring 2009 Replacement Decisions Analyzing the Project Indirect Effects 21 Finding Cash Flows from Earnings Year Incremental Earnings + : Add Back Depreciation - : Minus Cost of Equipment - : Minus Changes in NWC non-cash expense the actual cash outflows when an asset is purchased additional cash tied up in the project Incremental Free Cash Flows Spring 2009 22 Incremental Free Cash Flows Example 8.3 Problem: Let’s return to the HomeNet example. Compute the incremental free cash flows for HomeNet to decide whether Linksys should proceed with the project. Solution: Plan: Recognize the $7.5 million cash outflow associated with the purchase in year 0 Add back the $1.5 million depreciation expenses from year 1 to 5 as they are not actually cash outflows Spring 2009 8-2323 Incremental Free Cash Flows Execute: 1 Year 9 Incremental Earnings 1,920 1,920 1,920 1,920 -900 10 + Depreciation 1,500 1,500 1,500 1,500 1,500 11 - Cost of Equipment 12 - Changes in NWC 13 Incremental Free Cash Flows Spring 2009 0 1 2 3 4 5 -7,500 - -7,500 - 3,420 - 3,420 - 3,420 - 3,420 - 600 8-2424 Incorporating Changes in NWC Most projects will require an investment in NWC Net Working Capital = Current Assets − Current Liabilities = Cash + Inventory + Receivables − Payables accounts receivable will increase if sales related to a project are made on credit accounts payable may increase if inventory and supplies are bought on credit a project may cause inventory to increase or decrease Initial increase in inventory usually occurs prior to first sale, i.e., by end of year 0 Trade credit = receivables – payables net amount of capital consumed as a result of credit transactions Spring 2009 25 Incorporating Changes in NWC When the project ends, accumulated NWC is “recovered,” giving rise to a positive cash flow AR are collected excess inventory is sold off AP are paid off Some NWC may not be recoverable some AR may be written off some inventory may be written off due to loss, damage, or obsolescence Only changes in NWC impact cash flows. Accounting principles require recovery of working capital over the life of the project, i.e., sum of changes in NWC is zero. Spring 2009 26 Incorporating Changes in NWC Example 8.4 Problem: Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS). 15% of $13 million in sales is $1.95 million and 15% of $5.5 million in COGS is $825,000. HomeNet’s net working capital requirements are shown in the following table. Spring 2009 8-2727 Incorporating Changes in NWC Problem (cont'd): 1 Year 0 1 2 3 4 1,950 1,950 1,950 1,950 -825 -825 -825 -825 1,125 1,125 1,125 5 1,125 Net Working Capital 2 Forecast ($000s) 3 Cash Requirements 4 Inventory Receivables (15% of 5 Sales) Payables (15% of 6 COGS) 7 Net Working Capital How does this requirement affect the project’s free cash flow? Spring 2009 8-2828 Incorporating Changes in NWC Solution: Plan: In year 1, NWC increases by $1.125 million. Any increases in NWC represent an investment that reduces the cash available to the firm. In years 2–4, NWC does not change, so no further contributions are needed. In year 5, when the project is shut down, NWC decreases by $1.125 million as the payments of the last customers are received and the final bills are paid. NWCt = NWCt – NWCt-1 sum of changes in NWC = zero Spring 2009 8-2929 Incorporating Changes in NWC Execute: 1 Year 2 Level of Incremental NWC 3 Change in Incremental NWC 4 Cash Flow Effect 0 1 0 1,125 2 1,125 3 1,125 4 5 1,125 1,125 -1,125 -1,125 1,125 Note: Cash Flow Effect from changes in NWC is always opposite in sign to the change of NWC. So in capital budgeting, subtract changes in NWC from earnings to estimate incremental cash flows. Spring 2009 8-3030 Incorporating Changes in NWC Execute (cont’d): The incremental free cash flows would then be: 9 Incremental Earnings 1,920 1,920 1,920 1,920 -900 10 + Depreciation 1,500 1,500 1,500 1,500 1,500 11 - Cost of Equipment 12 - Changes in NWC 13 Incremental Free Cash Flows Spring 2009 -7,500 -1,125 -7,500 2,295 1,125 3,420 3,420 3,420 1,725 8-3131 Quick Quiz 2. To reflect the cash flow effect from changes in NWC in incremental cash flows, the changes in NWC are _________ the incremental earnings of a project. A. B. C. D. Spring 2009 added back to divided by multiplied with subtracted from 32 ...
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