Description
Organize notes based on the contents of the two PDFsFind the key points in the content to help you reviewThe final result is in word format
Unformatted Attachment Preview
CH AP T E R
Fundamentals of Capital
Budgeting
IN EARLY 2017, NINTENDO RELEASED ITS SEVENTH MAJOR VIDEO
game console, the Nintendo Switch. The Switch was developed after Nintendo’s
previous game console, the Wii U, had disappointing sales that led to several
quarters of financial losses in 2014. The Switch took four years to develop and
consumed a significant portion of the company’s $2.4 billion R&D budget during
that time. It distinguished itself with a unique controller and portability features
designed to appeal to more casual gamers. While investors were initially skeptical, sales immediately exceeded expectations with nearly 18 million units in the
first year, causing Nintendo’s stock price to almost double.
Nintendo’s decision to invest hundreds of millions of dollars in the Switch is
a classic capital budgeting decision. To make such a decision, firms like Nintendo
use the NPV rule to assess the potential impact on the firm’s value. How do managers quantify the cost and benefits of a project like this one to compute the NPV?
An important responsibility of corporate financial managers is determining
which projects or investments a firm should undertake. Capital budgeting, the
focus of this chapter, is the process of analyzing investment opportunities and
deciding which ones to accept. As we learned in Chapter 7, the NPV rule is the most
accurate and reliable method for allocating the firm’s resources so as to maximize
8
NOTATION
IRR internal rate of return
EBIT earnings before interest
and taxes
τ c marginal corporate
tax rate
NPV net present value
NWC t net working capital in
year t
∆NWC t increase in net working
capital between year t
and year t − 1
CapEx capital expenditures
FCFt free cash flow in year t
PV present value
r projected cost of
capital
its value. To implement the NPV rule, financial managers must compute the NPV
of the firm’s projects and only accept those for which the NPV is positive. The first
step in this process is to forecast the project’s revenues and costs, and from these
forecasts, estimate the project’s expected future cash flows. In this chapter, we
will consider in detail the process of estimating a project’s expected cash flows,
which are crucial inputs in the investment decision process. Using these cash
flows, we can then compute the project’s NPV—its contribution to shareholder
value. Finally, because the cash flow forecasts almost always contain uncertainty,
we demonstrate how to compute the sensitivity of the NPV to the uncertainty in
the forecasts.
275
M08_BERK6318_06_GE_C08.indd 275
26/04/23 6:16 PM
276
Chapter 8 Fundamentals of Capital Budgeting
8.1 Forecasting Earnings
A capital budget lists the projects and investments that a company plans to undertake
during the coming year. To determine this list, firms analyze alternative projects and decide
which ones to accept through a process called capital budgeting. This process begins
with forecasts of the project’s future consequences for the firm. Some of these consequences will affect the firm’s revenues; others will affect its costs. Our ultimate goal is to
determine the effect of the decision on the firm’s cash flows, and evaluate the NPV of
these cash flows to assess the consequences of the decision for the firm’s value.
As we emphasized in Chapter 2, earnings are not actual cash flows. However, as a practical
matter, to derive the forecasted cash flows of a project, financial managers often begin
by forecasting earnings. Thus, we begin by determining the incremental earnings of a
project—that is, the amount by which the firm’s earnings are expected to change as a result
of the investment decision. Then, in Section 8.2, we demonstrate how to use the incremental earnings to forecast the cash flows of the project.
Let’s consider a hypothetical capital budgeting decision faced by managers of the router
division of Cisco Systems, a maker of networking hardware. Cisco 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. In addition to connecting computers and smartphones, HomeNet will control Internet-based telepresence and phone systems, home entertainment systems, heating
and air-conditioning units, major appliances, security systems, office equipment, and so on.
Cisco has already conducted an intensive, $300,000 feasibility study to assess the attractiveness of the new product.
Revenue and Cost Estimates
We begin by reviewing the revenue and cost estimates for HomeNet. HomeNet’s target
market is upscale residential “smart” homes and home offices. Based on extensive marketing surveys, the sales forecast for HomeNet is 100,000 units per year. Given the pace of
technological change, Cisco expects the product will have a four-year life. It will be sold
through high-end electronics stores for a retail price of $375, with an expected wholesale
price of $260.
Developing the new hardware will be relatively inexpensive, as existing technologies can
be simply repackaged in a newly designed, home-friendly box. Industrial design teams will
make the box and its packaging aesthetically pleasing to the residential market. Cisco expects total engineering and design costs to amount to $5 million. Once the design is finalized, actual production will be outsourced at a cost (including packaging) of $110 per unit.
In addition to the hardware requirements, Cisco must build a new software application
to allow virtual control of the home from the Web. This software development project
requires coordination with each of the Web appliance manufacturers and is expected to
take a dedicated team of 50 software engineers a full year to complete. The cost of a
software engineer (including benefits and related costs) is $200,000 per year. To verify the
compatibility of new consumer Internet-ready appliances with the HomeNet system as
they become available, Cisco must also install new equipment that will require an up-front
investment of $7.5 million.
The software and hardware design will be completed, and the new equipment will be
operational, at the end of one year. At that time, HomeNet will be ready to ship. Cisco
expects to spend $2.8 million per year on marketing and support for this product.
M08_BERK6318_06_GE_C08.indd 276
26/04/23 6:16 PM
8.1 Forecasting Earnings
277
Incremental Earnings Forecast
Given the revenue and cost estimates, we can forecast HomeNet’s incremental earnings, as shown
in the spreadsheet in Table 8.1. After the product is developed in year 0, it will generate sales of
100,000 units × $260 unit = $26 million each year for the next four years. The cost of producing these units is 100,000 units × $110/unit = $11 million per year. Thus, HomeNet will produce a gross profit of $26 million − $11 million = $15 million per year, as shown in line 3 of
Table 8.1. Note that while revenues and costs occur throughout the year, we adopt the standard
accounting convention of listing revenues and costs at the end of the year in which they occur.1
The project’s operating expenses include $2.8 million per year in marketing and support
costs, which are listed as selling, general, and administrative expenses. In year 0, Cisco will
spend $5 million on design and engineering, together with 50 × $200,000 = $10 million on
software, for a total of $15 million in research and development expenditures.
Capital Expenditures and Depreciation. HomeNet also requires $7.5 million in equipment
that will be required to allow third-party manufacturers to upload the specifications and verify
the compatibility of any new Internet-ready appliances that they might produce. To encourage
the development of compatible products and provide service for existing customers, Cisco expects to continue to operate this equipment even after they phase out the current version of the
product. Recall from Chapter 2 that while investments in plant, property, and equipment are a
cash expense, they are not directly listed as expenses when calculating earnings. Instead, the firm
deducts a fraction of the cost of these items each year as depreciation. Several different methods are used to compute depreciation. The simplest method is straight-line depreciation,
in which the asset’s cost ( less any expected salvage value) is divided equally over its estimated
useful life (we discuss other methods in Section 8.4). If we assume the equipment is purchased
just before the end of year 0, and then use straight-line depreciation over a five-year life for the
new equipment, HomeNet’s depreciation expense is $1.5 million per year in years 1 through 5.2
TABLE 8.1
SPREADSHEET
HomeNet’s Incremental Earnings Forecast
Year
0
1
2
3
4
5
Incremental Earnings Forecast ($000s)
—
1 Sales
—
26,000 26,000 26,000 26,000
—
2 Cost of Goods Sold
—
(11,000) (11,000) (11,000) (11,000)
—
3 Gross Profit
—
15,000 15,000 15,000 15,000
—
4 Selling, General, and Administrative —
(2,800) (2,800) (2,800) (2,800)
5 Research and Development
(15,000)
—
—
—
—
6 Depreciation
—
(1,500) (1,500) (1,500) (1,500) (1,500)
7 EBIT
(15,000) 10,700 10,700 10,700 10,700 (1,500)
8 Income Tax at 20%
3,000
(2,140) (2,140) (2,140) (2,140)
300
9 Unlevered Net Income
(12,000)
8,560
8,560
8,560
8,560 (1,200)
1
Note that for our cash flow timeline, we will associate each year as a “point” in the timeline (i.e., Year 0 =
date 0, etc.). Doing so mixes cash flows that may occur at the beginning or the end of the year. When
additional precision is required, cash flows are often estimated on a quarterly or monthly basis. (See also
the appendix to Chapter 5 for a method of converting continuously arriving cash flows to annual ones.)
2
Recall that although new product sales have ceased, the equipment will remain in use in year 5. Note also
that as in Chapter 2, we list depreciation expenses separately rather than include them with other expenses
(i.e., COGS, SG&A, and R&D are “clean” and do not include non-cash expenses. Using clean expenses is
preferred in financial models.)
M08_BERK6318_06_GE_C08.indd 277
26/04/23 6:16 PM
278
Chapter 8 Fundamentals of Capital Budgeting
Deducting these depreciation expenses leads to the forecast for HomeNet’s earnings before
interest and taxes (EBIT) shown in line 7 of Table 8.1. This treatment of capital expenditures is
one of the key reasons why earnings are not an accurate representation of cash flows.3
Interest Expenses. In Chapter 2, we saw that to compute a firm’s net income, we
must first deduct interest expenses from EBIT. When evaluating a capital budgeting
decision like the HomeNet project, however, we generally do not include interest expenses.
Any incremental interest expenses will be related to the firm’s decision regarding how
to finance the project. Here we wish to evaluate the project on its own, separate from
the financing decision, as we will incorporate the appropriate cost of capital in our NPV
calculation.4 Thus, we evaluate the HomeNet project as if Cisco will not use any debt to
finance it (whether or not that is actually the case), and we postpone the consideration
of alternative financing choices until Part 5 of the book. For this reason, we refer to the
net income we compute in Table 8.1 as the unlevered net income of the project, to
indicate that it does not include any interest expenses associated with debt.
Taxes. The final expense we must account for is corporate taxes. The correct tax rate to use
is the firm’s marginal corporate tax rate, which is the tax rate it will pay on an incremental dollar
of pretax income. In Table 8.1, we assume the marginal corporate tax rate for the HomeNet
project is 20% each year. The incremental income tax expense is calculated in line 8 as
Income Tax = EBIT × τ c
(8.1)
where τ c is the firm’s marginal corporate tax rate.
In year 1, HomeNet will contribute an additional $10.7 million to Cisco’s EBIT, which
will result in an additional $10.7 million × 20% = $2.14 million in corporate tax that Cisco
will owe. We deduct this amount to determine HomeNet’s after-tax contribution to net
income.
In year 0, however, HomeNet’s EBIT is negative. Are taxes relevant in this case? Yes.
HomeNet will reduce Cisco’s taxable income in year 0 by $15 million. As long as Cisco
earns taxable income elsewhere in year 0 against which it can offset HomeNet’s losses,
Cisco will owe $15 million × 20% = $3 million less in taxes in year 0. The firm should credit
this tax savings to the HomeNet project. A similar credit applies in year 5, when the firm
claims its final depreciation expense for the equipment.
EXAMPLE 8.1
Taxing Losses for Projects in Profitable Companies
Problem
Kellogg plans to launch a new line of high-fiber, gluten-free breakfast pastries. The heavy advertising expenses associated with the product launch will generate operating losses of $20 million
next year. Kellogg expects to earn pretax income of $460 million from operations other than the
new pastries next year. If Kellogg pays a 25% tax rate on its pretax income, what will it owe in
taxes next year without the new product? What will it owe with it?
3
Starting in 2022, the 2017 TCJA requires that firms also capitalize and depreciate R&D expenses over
five years, though it is expected that Congress will act to delay this tax change.
4
This approach is motivated by the Separation Principle (see Chapter 3): When securities are fairly priced,
the NPV of financing is zero, and so the NPV of an investment is independent of how it is financed.
Later in the text, we consider cases in which financing may influence the project’s value, and extend our
capital budgeting techniques accordingly in Chapter 18.
M08_BERK6318_06_GE_C08.indd 278
26/04/23 6:16 PM
8.1 Forecasting Earnings
279
Solution
Without the new pastries, Kellogg will owe $460 million × 25% = $115 million in corporate
taxes next year. With the new pastries, Kellogg’s pretax income next year will be only
$460 million − $20 million = $440 million, and it will owe $440 million × 25% = $110 million
in tax. Thus, launching the new product reduces Kellogg’s taxes next year by $115 million
− $110 million = $5 million, which equals the tax rate (25%) times the loss ($20 million).
Unlevered Net Income Calculation. We can express the calculation in the Table 8.1
spreadsheet as the following shorthand formula for unlevered net income:
Unlevered Net Income = EBIT × ( 1 − τ c )
= ( Revenues − Costs − Depreciation ) × ( 1 − τ c )
(8.2)
That is, a project’s unlevered net income is equal to its incremental revenues less costs and
depreciation, evaluated on an after-tax basis.5
Indirect Effects on Incremental Earnings
When computing the incremental earnings of an investment decision, we should include all
changes between the firm’s earnings with the project versus without the project. Thus far,
we have analyzed only the direct effects of the HomeNet project. But HomeNet may have
indirect consequences for other operations within Cisco. Because these indirect effects will
also affect Cisco’s earnings, we must include them in our analysis.
Opportunity Costs. Many projects use a resource that the company already owns. Because
the firm does not need to pay cash to acquire this resource for a new project, it is tempting
to assume that the resource is available for free. However, in many cases the resource could
provide value for the firm in another opportunity or project. The opportunity cost of
using a resource is the value it could have provided in its best alternative use.6 Because this
value is lost when the resource is used by another project, we should include the opportunity
cost as an incremental cost of the project. In the case of the HomeNet project, suppose the
project will require space for a new lab. Even though the lab will be housed in an existing
facility, we must include the opportunity cost of not using the space in an alternative way.
EXAMPLE 8.2
The Opportunity Cost of HomeNet’s Lab Space
Problem
Suppose HomeNet’s new lab will be housed in office space that the company would have otherwise rented out for $200,000 per year during years 1–4. How does this opportunity cost affect
HomeNet’s incremental earnings?
Solution
In this case, the opportunity cost of the office space is the foregone rent. This cost would reduce
HomeNet’s incremental earnings during years 1– 4 by $200,000 × ( 1 − 20% ) = $160,000, the
after-tax benefit of renting out the office space.
5
Unlevered net income is sometimes also referred to as net operating profit after tax (NOPAT).
In Chapter 5, we defined the opportunity cost of capital as the rate you could earn on an alternative
investment with equivalent risk. We similarly define the opportunity cost of using an existing asset in a
project as the cash flow generated by the next-best alternative use for the asset.
6
M08_BERK6318_06_GE_C08.indd 279
26/04/23 6:16 PM
280
Chapter 8 Fundamentals of Capital Budgeting
COMMON MISTAKE
The Opportunity Cost of an Idle Asset
A common mistake is to conclude that if an asset is currently
idle, its opportunity cost is zero. For example, the firm might
have a warehouse that is currently empty or a machine that
is not being used. Often, the asset may have been idled in
anticipation of taking on the new project, and would have
otherwise been put to use by the firm. Even if the firm has
no alternative use for the asset, the firm could choose to sell
or rent the asset. The value obtained from the asset’s alternative use, sale, or rental represents an opportunity cost that
must be included as part of the incremental cash flows.
Project Externalities. Project externalities are indirect effects of the project that may
increase or decrease the profits of other business activities of the firm. For instance, in the
Nintendo example in the chapter introduction, purchasers of the Switch are also likely to
buy additional games and accessories from Nintendo. On the other hand, when sales of a
new product displace sales of an existing product, the situation is often referred to as cannibalization. Suppose that approximately 25% of HomeNet’s sales come from customers
who would have purchased an existing Cisco device if HomeNet were not available. If
this reduction in sales of the existing product is a consequence of the decision to develop
HomeNet, then we must include it when calculating HomeNet’s incremental earnings.
The spreadsheet in Table 8.2 recalculates HomeNet’s incremental earnings forecast including the opportunity cost of the office space and the expected cannibalization of the
existing product. The opportunity cost of the office space in Example 8.2 increases selling,
general, and administrative expenses from $2.8 million to $3.0 million. For the cannibalization, suppose that the existing device wholesales for $100 so the expected loss in sales is
25% × 100,000 units × $100 unit = $2.5 million
Compared to Table 8.1, the sales forecast falls from $26 million to $23.5 million. In addition, suppose the cost of the existing device is $60 per unit. Then, because Cisco will no
longer need to produce as many of its existing product, the incremental cost of goods sold
attributable to the HomeNet project is reduced by
25% × 100,000 units × ( $60 cost per unit ) = $1.5 million
from $11 million to $9.5 million. HomeNet’s incremental gross profit therefore declines by
$2.5 million − $1.5 million = $1 million once we account for this externality.
Thus, comparing the spreadsheets in Table 8.1 and Table 8.2, our forecast for HomeNet’s
unlevered net income in years 1–4 declines from $8.56 million to $7.6 million due to the
lost rent of the lab space and the lost sales of the existing router.
TABLE 8.2
SPREADSHEET
HomeNet’s Incremental Earnings Forecast (Including
Cannibalization and Lost Rent)
Year
0
1
Incremental Earnings Forecast ($000s)
1 Sales
—
23,500
2 Cost of Goods Sold
—
(9,500)
3 Gross Profit
—
14,000
—
(3,000)
4 Selling, General, and Administrative
(15,000)
—
5 Research and Development
—
(1,500)
6 Depreciation
(15,000)
9,500
7 EBIT
3,000
(1,900)
8 Income Tax at 20%
(12,000)
7,600
9 Unlevered Net Income
M08_BERK6318_06_GE_C08.indd 280
2
23,500
(9,500)
14,000
(3,000)
—
(1,500)
9,500
(1,900)
7,600
3
4
5
23,500 23,500
—
(9,500) (9,500)
—
14,000 14,000
—
(3,000) (3,000)
—
—
—
—
(1,500) (1,500) (1,500)
9,500
9,500 (1,500)
(1,900) (1,900)
300
7,600
7,600 (1,200)
26/04/23 6:16 PM
8.1 Forecasting Earnings
281
Sunk Costs and Incremental Earnings
A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs
have been or will be paid regardless of the decision about whether or not to proceed with
the project. Therefore, they are not incremental with respect to the current decision and
should not be included in its analysis. For this reason, we did not include in our analysis the
$300,000 already expended on the marketing and feasibility studies for HomeNet. Because
this $300,000 has already been spent, it is a sunk cost. A good rule to remember is that if our
decision does not affect the cash flow, then the cash flow should not affect our decision. Below are some
common examples of sunk costs you may encounter.
Fixed Overhead Expenses. Overhead expenses are associated with activities that are
not directly attributable to a single business activity but instead affect many different areas
of the corporation. These expenses are often allocated to the different business activities
for accounting purposes. To the extent that these overhead costs are fixed and will be incurred in any case, they are not incremental to the project and should not be included. Only
include as incremental expenses the additional overhead expenses that arise because of the
decision to take on the project.
Past Research and Development Expenditures. When a firm has already devoted significant resources to develop a new product, there may be a tendency to continue investing
in the product even if market conditions have changed and the product is unlikely to be
viable. The rationale sometimes given is that if the product is abandoned, the money that
has already been invested will be “wasted.” In other cases, a decision is made to abandon a
project because it cannot possibly be successful enough to recoup the investment that has
already been made. In fact, neither argument is correct: Any money that has already been
spent is a sunk cost and therefore irrelevant. The decision to continue or abandon should
be based only on the incremental costs and benefits of the product going forward.
Unavoidable Competitive Effects. When developing a new product, firms often worry
about the cannibalization of their existing products. But if sales are likely to decline in any
case as a result of new products introduced by competitors, then these lost sales are a sunk
cost and we should not include them in our projections.
COMMON MISTAKE
The Sunk Cost Fallacy
Sunk cost fallacy is a term used to describe the tendency of
people to be influenced by sunk costs and to “throw good
money after bad.” That is, people sometimes continue to invest in a project that has a negative NPV because they have
already invested a large amount in the project and feel that
by not continuing it, the prior investment will be wasted.
The sunk cost fallacy is also sometimes called the “Concorde effect,” a term that refers to the British and French
governments’ decision to continue funding the joint development of the Concorde aircraft even after it was clear that
sales of the plane would fall far short of what was necessary
to justify the cost of continuing its development. Although
the project was viewed by the British government as a
M08_BERK6318_06_GE_C08.indd 281
commercial and financial disaster, the political implications
of halting the project—and thereby publicly admitting that
all past expenses on the project would result in nothing—
ultimately prevented either government from abandoning
the project.
It is important to note that sunk costs need not always
be in the past. Any cash flows, even future ones, that will
not be affected by the decision at hand are effectively sunk,
and should not be included in our incremental forecast. For
example, if Cisco believes it will lose some sales on its other
products whether or not it launches HomeNet, these lost
sales are a sunk cost that should not be included as part of
the cannibalization adjustments in Table 8.2.
26/04/23 6:16 PM
282
Chapter 8 Fundamentals of Capital Budgeting
Real-World Complexities
We have simplified the HomeNet example in an effort to focus on the types of effects
that financial managers consider when estimating a project’s incremental earnings. For
a real project, however, the estimates of these revenues and costs are likely to be much
more complicated. For instance, our assumption that the same number of HomeNet
units will be sold each year is probably unrealistic. A new product typically has lower sales
initially, as customers gradually become aware of the product. Sales will then accelerate, plateau, and ultimately decline as the product nears obsolescence or faces increased
competition.
Similarly, the average selling price of a product and its cost of production will generally change over time. Prices and costs tend to rise with the general level of inflation in
the economy. The prices of technology products, however, often fall over time as newer,
superior technologies emerge and production costs decline. For most industries, competition tends to reduce profit margins over time. These factors should be considered when
estimating a project’s revenues and costs.
EXAMPLE 8.3
Product Adoption and Price Changes
Problem
Suppose sales of HomeNet were expected to be 100,000 units in year 1, 125,000 units in years 2 and
3, and 50,000 units in year 4. Suppose also that HomeNet’s sale price and manufacturing cost are
expected to decline by 10% per year, as with other networking products. By contrast, selling, general,
and administrative expenses (including lost rent) are expected to rise with inflation by 4% per year.
Update the incremental earnings forecast in the spreadsheet in Table 8.2 to account for these effects.
Solution
HomeNet’s incremental earnings with these new assumptions are shown in the spreadsheet
below:
Year
0
1
2
Incremental Earnings Forecast ($000s)
1 Sales
—
23,500 26,438
2 Cost of Goods Sold
—
(9,500) (10,688)
3 Gross Profit
—
14,000 15,750
4 Selling, General, and Administrative
—
(3,000) (3,120)
5 Research and Development
(15,000)
—
—
6 Depreciation
—
(1,500) (1,500)
7 EBIT
(15,000) 9,500
11,130
8 Income Tax at 20%
3,000 (1,900) (2,226)
9 Unlevered Net Income
(12,000) 7,600
8,904
3
4
5
23,794
(9,619)
14,175
(3,245)
—
(1,500)
9,430
(1,886)
7,544
8,566
(3,463)
5,103
(3,375)
—
(1,500)
228
(46)
183
—
—
—
—
—
(1,500)
(1,500)
300
(1,200)
For example, sale prices in year 2 will be $260 × 0.90 = $234 per unit for HomeNet, and
$100 × 0.90 = $90 per unit for the cannibalized product. Thus, incremental sales in year 2
are equal to 125, 000 units × ( $234 per unit ) − 31, 250 cannibalized units × ( $90 per unit )
= $26.438 million.
CONCEPT CHECK
1. How do we forecast unlevered net income?
2. Should we include sunk costs in the cash flow forecasts of a project? Why or why not?
3. Explain why you must include the opportunity cost of using a resource as an incremental
cost of a project.
M08_BERK6318_06_GE_C08.indd 282
26/04/23 6:16 PM
283
8.2 Determining Free Cash Flow and NPV
8.2 Determining Free Cash Flow and NPV
As discussed in Chapter 2, earnings are an accounting measure of the firm’s performance. They do not represent real profits: The firm cannot use its earnings to buy goods,
pay employees, fund new investments, or pay dividends to shareholders. To do those
things, a firm needs cash. Thus, to evaluate a capital budgeting decision, we must determine its consequences for the firm’s available cash. The incremental effect of a project
on the firm’s available cash, separate from any financing decisions, is the project’s free
cash flow.
In this section, we forecast the free cash flow of the HomeNet project using the earnings forecasts we developed in Section 8.1. We then use this forecast to calculate the NPV
of the project.
Calculating Free Cash Flow from Earnings
As discussed in Chapter 2, there are important differences between earnings and cash flow.
Earnings include non-cash charges, such as depreciation, but do not include the cost of
capital investment. To determine HomeNet’s free cash flow from its incremental earnings,
we must adjust for these differences.
Capital Expenditures and Depreciation. Depreciation is not a cash expense that is paid
by the firm. Rather, it is a method used for accounting and tax purposes to allocate the
original purchase cost of the asset over its life. Because depreciation is not a cash flow, we
do not include it in the cash flow forecast. Instead, we include the actual cash cost of the
asset when it is purchased.
To compute HomeNet’s free cash flow, we must add back to earnings the depreciation
expense for the new equipment (a non-cash charge) and subtract the actual capital expenditure of $7.5 million that will be paid for the equipment in year 0. We show these adjustments in lines 10 and 11 of the spreadsheet in Table 8.3 (which is based on the incremental
earnings forecast of Table 8.2).
TABLE 8.3
SPREADSHEET
Calculation of HomeNet’s Free Cash Flow (Including
Cannibalization and Lost Rent)
Year
0
1
Incremental Earnings Forecast ($000s)
1 Sales
—
23,500
—
(9,500)
2 Cost of Goods Sold
—
14,000
3 Gross Profit
—
(3,000)
4 Selling, General, and Administrative
(15,000)
—
5 Research and Development
—
(1,500)
6 Depreciation
(15,000) 9,500
7 EBIT
3,000 (1,900)
8 Income Tax at 20%
(12,000)
7,600
9 Unlevered Net Income
Free Cash Flow ($000s)
—
1,500
10 Plus: Depreciation
(7,500)
—
11 Less: Capital Expenditures
—
(2,100)
12 Less: Increases in NWC
(19,500)
7,000
13 Free Cash Flow
M08_BERK6318_06_GE_C08.indd 283
2
3
4
5
23,500
(9,500)
14,000
(3,000)
—
(1,500)
9,500
(1,900)
7,600
23,500
(9,500)
14,000
(3,000)
—
(1,500)
9,500
(1,900)
7,600
23,500
—
(9,500) —
14,000
—
(3,000) —
—
—
(1,500) (1,500)
9,500 (1,500)
(1,900) 300
7,600 (1,200)
1,500
—
—
9,100
1,500
—
—
9,100
1,500 1,500
—
—
—
2,100
9,100 2,400
26/04/23 6:16 PM
284
Chapter 8 Fundamentals of Capital Budgeting
Net Working Capital (NWC). In Chapter 2, we defined net working capital as the
difference between current assets and current liabilities. The main components of net
working capital are cash, inventory, receivables, and payables:
Net Working Capital = Current Assets − Current Liabilities
= Cash + Inventory + Receivables − Payables
(8.3)
Most projects will require the firm to invest in net working capital. Firms may need to
maintain a minimum cash balance7 to meet unexpected expenditures, and inventories of raw
materials and finished product to accommodate production uncertainties and demand fluctuations. Also, customers may not pay for the goods they purchase immediately. While sales
are immediately counted as part of earnings, the firm does not receive any cash until the customers actually pay. In the interim, the firm includes the amount that customers owe in its
receivables. Thus, the firm’s receivables measure the total credit that the firm has extended
to its customers. In the same way, payables measure the credit the firm has received from its
suppliers. 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, known as trade credit.
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).8 HomeNet’s net
working capital requirements are shown in the spreadsheet in Table 8.4.
Table 8.4 shows that the HomeNet project will require no net working capital in year 0,
$2.1 million in net working capital in years 1–4, and no net working capital in year 5. How
does this requirement affect the project’s free cash flow? Any increases in net working capital represent an investment that reduces the cash available to the firm and so reduces free
cash flow. We define the increase in net working capital in year t as
∆NWC t = NWC t − NWC t −1
TABLE 8.4
SPREADSHEET
(8.4)
HomeNet’s Net Working Capital Requirements
Year
Net Working Capital Forecast ($000s)
1 Cash Requirements
2 Inventory
3 Receivables (15% of Sales)
4 Payables (15% of COGS)
5 Net Working Capital
0
1
2
3
4
5
—
—
—
—
—
—
—
3,525
(1,425)
2,100
—
—
3,525
(1,425
