Chapter 6

Valuing Bonds

Chapter Outline
6.1 Bond Cash Flows, Prices, and Yields
6.2 Dynamic Behavior of Bond Prices
6.3 The Yield Curve and Bond Arbitrage
6.4 Corporate Bonds
6.5 Sovereign Bonds

6.1 Bond Cash Flows, Prices, and Yields

Bond Terminology
Bond Certificate
States the terms of the bond

Maturity Date
Final repayment date

Term
The time remaining until the repayment date

Coupon
Promised interest payments

6.1 Bond Cash Flows, Prices, and Yields (cont'd)

Bond Terminology
Face Value
Notional amount used to compute the interest payments

Coupon Rate
Determines the amount of each coupon payment, expressed as an
APR

Coupon Payment
Coupon Rate Face Value
CPN =
Number of Coupon Payments per Year

Zero-Coupon Bonds
Zero-Coupon Bond
Does not make coupon payments
Always sells at a discount (a price lower than face
value), so they are also called pure discount
bonds
Treasury Bills are U.S. government zero-coupon
bonds with a maturity of up to one year.

Zero-Coupon Bonds (cont'd)

Suppose that a one-year, risk-free, zero-coupon
bond with a $100,000 face value has an initial
price of $96,618.36. The cash flows would be:

Although the bond pays no interest, your

compensation is the difference between the initial
price and the face value.

Zero-Coupon Bonds (cont'd)

Yield to Maturity
The discount rate that sets the present value of
the promised bond payments equal to the current
market price of the bond.
Price of a Zero-Coupon bond

FV
P =
(1 + YTM n ) n

Zero-Coupon Bonds (cont'd)

Yield to Maturity
For the one-year zero coupon bond:
100,000
96,618.36 =
(1 + YTM 1 )
1 + YTM 1 =

100,000
96,618.36

= 1.035

Thus, the YTM is 3.5%.

Zero-Coupon Bonds (cont'd)

Yield to Maturity
Yield to Maturity of an n-Year Zero-Coupon Bond
YTM n

FV
=

Alternative Example 6.1

Problem
Suppose that the following zero-coupon bonds are
selling at the prices shown below per $100 face
value. Determine the corresponding yield to
maturity for each bond.
Maturity
Price

1 year
$98.04

2 years
$95.18

3 years
$91.51

4 years
$87.14

Alternative Example 6.1 (cont'd)

Solution:
YTM = (100 / 98.04) 1 = 0.02 = 2%
YTM = (100 / 95.18)1/2 1 = 0.025 = 2.5%
YTM = (100 / 91.51)1/3 1 = 0.03 = 3%
YTM = (100 / 87.14)1/4 1 = 0.035 = 3.5%

Zero-Coupon Bonds (cont'd)

Risk-Free Interest Rates
A default-free zero-coupon bond that matures on date n
provides a risk-free return over the same period. Thus, the
Law of One Price guarantees that the
risk-free interest rate equals the yield to maturity on such
a bond.
Risk-Free Interest Rate with Maturity n

rn = YTM n

Zero-Coupon Bonds (cont'd)

Risk-Free Interest Rates
Spot Interest Rate
Another term for a default-free, zero-coupon yield

Zero-Coupon Yield Curve

A plot of the yield of risk-free zero-coupon bonds as a
function of the bonds maturity date

Coupon Bonds
Coupon Bonds
Pay face value at maturity
Pay regular coupon interest payments

Treasury Notes
U.S. Treasury coupon security with original
maturities of 110 years

Treasury Bonds
U.S. Treasury coupon security with original
maturities over 10 years

Alternative Example 6.2

The U.S. Treasury has just issued a ten-year, $1000
bond with a 4% coupon and semi-annual coupon
payments. What cash flows will you receive if you
hold the bond until maturity?

Alternative Example 6.2 (cont'd)

The face value of this bond is $1000. Because this
bond pays coupons semiannually, from Eq. 8.1 you will
receive a coupon payment every six months of CPN =
$1000 X 4%/2 = $20. Here is the timeline, based on a
six-month period:

Note that the last payment occurs ten years (twenty sixmonth periods) from now and is composed of both a coupon
payment of $20 and the face value payment of $1000.

Coupon Bonds (cont'd)

Yield to Maturity
The YTM is the single discount rate that equates the present value of
the bonds remaining cash flows to its current price.

Yield to Maturity of a Coupon Bond

1
1
FV
P = CPN
+
1
N
y
(1 + y )
(1 + y ) N

Textbook Example 6.3

Textbook Example 6.3 (cont'd)

Textbook Example 6.4

Textbook Example 6.4 (cont'd)

6.4 Corporate Bonds

Corporate Bonds
Issued by corporations

Credit Risk
Risk of default

Corporate Bond Yields

Investors pay less for bonds with credit risk
than they would for an otherwise identical
default-free bond.
The yield of bonds with credit risk will be
higher than that of otherwise identical
default-free bonds.

Corporate Bond Yields (cont'd)

No Default
Consider a 1-year, zero coupon Treasury Bill with a YTM of 4%.

What is the price?

P =

1000
1000
=
= $961.54
1 + YTM 1
1.04

Corporate Bond Yields (cont'd)

Certain Default
Suppose now bond issuer will pay 90% of
the obligation.

What is the price?

900
900
P =
=
= $865.38
1 + YTM 1
1.04

Corporate Bond Yields (cont'd)

Certain Default
When computing the yield to maturity for a bond
with certain default, the promised rather than the
actual cash flows are used.
FV
1000
YTM =
1 =
1 = 15.56%
P
865.38
900
= 1.04
865.38

Corporate Bond Yields (cont'd)

Certain Default
The yield to maturity of a certain default bond is
not equal to the expected return of investing in
the bond. The yield to maturity will always be
higher than the expected return of investing in the
bond.

Corporate Bond Yields (cont'd)

Risk of Default
Consider a one-year, $1000, zero-coupon bond
issued. Assume that the bond payoffs are
uncertain.
There is a 50% chance that the bond will repay its face
value in full and a 50% chance that the bond will
default and you will receive $900. Thus, you would
expect to receive $950.
Because of the uncertainty, the discount rate is 5.1%.

Corporate Bond Yields (cont'd)

Risk of Default
The price of the bond will be
P =

950
= $903.90
1.051

The yield to maturity will be

FV
1000
YTM =
1 =
1 = .1063
P
903.90

Corporate Bond Yields (cont'd)

Risk of Default
A bonds expected return will be less than the
yield to maturity if there is a risk of default.
A higher yield to maturity does not necessarily
imply that a bonds expected return is higher.

Corporate Bond Yields (cont'd)

Table 6.3 Price, Expected Return, and Yield to Maturity of
a One-Year, Zero-Coupon Avant Bond with Different
Likelihoods of Default

Bond Ratings
Investment Grade Bonds
Speculative Bonds
Also known as Junk Bonds or High-Yield Bonds

Table 6.4 Bond Ratings

Table 6.4 Bond Ratings (contd)

Corporate Yield Curves

Default Spread
Also known as Credit Spread
The difference between the yield on corporate
bonds and Treasury yields

Figure 6.3 Corporate Yield Curves for Various Ratings, June 2012

Source: Bloomberg

Figure 6.4 Yield Spreads and the Financial Crisis

Source:
Bloomberg.com

6.5 Sovereign Bonds

Bonds issued by national governments
U.S. Treasury securities are generally considered
to be default free
All sovereign bonds are not default free
e.g. Greece defaulted on its outstanding debt in 2012

Importance of inflation expectations

Potential to inflate away the debt

European sovereign debt, the EMU, and the ECB

Figure 6.5 Percent of Countries in Default or Restructuring Debt, 18002006

Source: Data from This Time Is Different, Carmen Reinhart and Kenneth Rogoff, Princeton University Press, 2009.

Figure 6.6 European Government Bond Yields, 19632011

Source: Nowakwoski, David, Government Bonds/Rates: High, Low and Normal, Roubini Global Economics, June 8, 2012.

Chapter 7
Investment
Decision Rules

Chapter Outline
7.1 NPV and Stand-Alone Projects
7.2 The Internal Rate of Return Rule
7.3 The Payback Rule
7.4 Choosing Between Projects
7.5 Project Selection with Resource Constraints

7.1 NPV and Stand-Alone Projects

Consider a take-it-or-leave-it investment
decision involving a single, stand-alone project
for Fredricks Feed and Farm (FFF).
The project costs $250 million and is expected to
generate cash flows of $35 million per year,
starting at the end of the first year and lasting
forever.

NPV Rule
The NPV of the project is calculated as:
35
NPV = 250 +
r
The NPV is dependent on the discount rate.

Figure 7.1 NPV of Fredricks Fertilizer Project

If FFFs cost of capital is 10%, the NPV is $100 million and they should undertake the
investment.

Alternative Rules Versus the NPV Rule

Sometimes alternative investment rules may
give the same answer as the NPV rule, but at
other times they may disagree.
When the rules conflict, the NPV decision rule
should be followed.

7.2 The Internal Rate of Return Rule

Internal Rate of Return (IRR) Investment Rule
Take any investment where the IRR exceeds the
cost of capital. Turn down any investment whose
IRR is less than the cost of capital.

The Internal Rate of Return Rule (cont'd)

The IRR Investment Rule will give the same answer as
the NPV rule in many, but not all, situations.
In general, the IRR rule works for a stand-alone
project if all of the projects negative cash flows
precede its positive cash flows.
In Figure 7.1, whenever the cost of capital is below the IRR
of 14%, the project has a positive NPV and you should
undertake the investment.

Applying The IRR Rule

In other cases, the IRR rule may disagree with
the NPV rule and thus be incorrect.
Situations where the IRR rule and NPV rule may be
in conflict:
Delayed Investments
Nonexistent IRR
Multiple IRRs

Applying The IRR Rule (cont'd)

Delayed Investments
Assume you have just retired as the CEO of a successful
company. A major publisher has offered you a book deal.
The publisher will pay you $1 million upfront if you agree
to write a book about your experiences. You estimate that
it will take three years to write the book. The time you
spend writing will cause you to give up speaking
engagements amounting to $500,000 per year. You
estimate your opportunity cost to be 10%.

Applying The IRR Rule (cont'd)

Delayed Investments
Should you accept the deal?
Calculate the IRR.

The IRR is greater than the cost of capital. Thus,

the IRR rule indicates you should accept the deal.

Applying The IRR Rule (cont'd)

Delayed Investments
Should you accept the deal?
NPV = 1,000,000

500, 000
500, 000
500, 000

= $243,426
2
3
1.1
1.1
1.1

Since the NPV is negative, the NPV rule indicates

you should reject the deal.

Figure 7.2 NPV of Stars $1 Million Book Deal

When the benefits of an investment occur before the costs, the NPV is an increasing
function of the discount rate.

Applying The IRR Rule (cont'd)

Multiple IRRs
Suppose Star informs the publisher that it needs
to sweeten the deal before he will accept it. The
publisher offers $550,000 advance and
$1,000,000 in four years when the book is
published.
Should he accept or reject the new offer?

Applying The IRR Rule (cont'd)

Multiple IRRs
The cash flows would now look like:

The NPV is calculated as:

500, 000
500, 000
500, 000 1, 000, 000
NPV = 550,000
2
3
1 + r
(1 + r )
(1 + r )
(1 + r ) 4

Applying The IRR Rule (cont'd)

Multiple IRRs
By setting the NPV equal to zero and solving for r,
we find the IRR. In this case, there are two IRRs:
7.164% and 33.673%. Because there is more than
one IRR, the IRR rule cannot be applied.

Figure 7.3 NPV of Stars Book Deal with Royalties

Applying The IRR Rule (cont'd)

Multiple IRRs
Between 7.164% and 33.673%, the book deal has
a negative NPV. Since your opportunity cost of
capital is 10%, you should reject the deal.

Applying The IRR Rule (cont'd)

Nonexistent IRR
Finally, Star is able to get the publisher to increase
his advance to $750,000, in addition to the $1
million when the book is published in four years.
With these cash flows, no IRR exists; there is no
discount rate that makes NPV equal to zero.

Figure 7.4 NPV of Stars Final Offer

No IRR exists because the NPV is positive for all values of the discount rate. Thus the
IRR rule cannot be used.

Applying The IRR Rule (cont'd)

IRR Versus the IRR Rule
While the IRR rule has shortcomings for making
investment decisions, the IRR itself remains
useful. IRR measures the average return of the
investment and the sensitivity of the NPV to any
estimation error in the cost of capital.

Textbook Example 7.1

Textbook Example 7.1 (contd)

Figure 7.5 NPV Profiles for Example 7.1

While the IRR Rule works for project A, it fails for each of the
other projects.

7.3 The Payback Rule

The payback period is amount of time it takes
to recover or pay back the initial investment. If
the payback period is less than a pre-specified
length of time, you accept the project.
Otherwise, you reject the project.
The payback rule is used by many companies
because of its simplicity.

Alternative Example 7.2

Problem
Projects A, B, and C each have an expected life
of 5 years.
Given the initial cost and annual cash flow information
below, what is the payback period for each project?
A

Cost

$80

$120

$150

Cash Flow

$25

$30

$35

Alternative Example 7.2

Solution
Payback A
$80 $25 = 3.2 years

Project B
$120 $30 = 4.0 years

Project C
$150 $35 = 4.29 years

The Payback Rule (contd)

Pitfalls:
Ignores the projects cost of capital and time value
of money.
Ignores cash flows after the payback period.
Relies on an ad hoc decision criterion.

7.4 Choosing Between Projects

Mutually Exclusive Projects
When you must choose only one project among
several possible projects, the choice is mutually
exclusive.
NPV Rule
Select the project with the highest NPV.

IRR Rule
Selecting the project with the highest IRR may lead
to mistakes.

Textbook Example 7.3

Textbook Example 7.3 (contd)

Alternative Example 7.3

Problem
A small commercial property is for sale near your university. Given its
location, you believe a student-oriented business would be very successful
there. You have researched several possibilities and come up with the
following cash flow estimates (including the cost of purchasing the
property). Which investment should you choose?

Project

Initial
Investment

First-Year
Cash Flow

Growth
Rate

Cost of
Capital

Used Book Store

$250,000

$55,000

4%

7%

Sandwich Shop

$350,000

$75,000

4%

8%

Hair Salon

$400,000

$120,000

5%

8%

Clothing Store

$500,000

$125,000

8%

12%

Alternative Example 7.3 (contd)

Solution
Assuming each business lasts indefinitely, we can compute the present value of
the cash flows from each as a constant growth perpetuity. The NPV of each
project is
$55,000
= $1,583,333
7% 4%
$75,000
NPV (Sandwich Shop) = -$350,000 +
= $1,525, 000
8% 4%
$120,000
= $2, 600, 000
NPV (Hair Salon) = -$400,000 +
8% 5%
$125,000
NPV (Clothing Store) = -$500,000 +
= $2, 625, 000
12% 8%

NPV (Used Book Store) = -$250,000 +

Thus, all of the alternatives have a positive NPV. But because we can only choose
one, the clothing store is the best alternative.

IRR Rule and Mutually Exclusive Investments: Differences in Scale

If a projects size is doubled, its NPV will

double. This is not the case with IRR. Thus, the
IRR rule cannot be used to compare projects
of different scales.

IRR Rule and Mutually Exclusive Investments: Differences in Scale (contd)

Consider two of the projects from Example 7.3

Bookstore
Initial Investment
Cash FlowYear 1
Annual Growth Rate
Cost of Capital
IRR
NPV

$300,000
$63,000
3%
8%
24%
$960,000

Coffee Shop
$400,000
$80,000
3%
8%
23%
$1,200,000

IRR Rule and Mutually Exclusive Investments: Timing of Cash Flows

Another problem with the IRR is that it can be affected by

changing the timing of the cash flows, even when the scale is
the same.
IRR is a return, but the dollar value of earning a given return depends
on how long the return is earned.

Consider again the coffee shop and the music store

investment in Example 7.3. Both have the same initial scale
and the same horizon. The coffee shop has a lower IRR, but a
higher NPV because of its higher growth rate.

IRR Rule and Mutually Exclusive Investments: Differences in Risk

An IRR that is attractive for a safe project need not be
attractive for a riskier project.
Consider the investment in the electronics store from Example
7.3. The IRR is higher than those of the other investment
opportunities, yet the NPV is the lowest.
The higher cost of capital means a higher IRR is necessary to
make the project attractive.

The Incremental IRR Rule

Incremental IRR Investment Rule
Apply the IRR rule to the difference between the
cash flows of the two mutually exclusive
alternatives (the increment to the cash flows of
one investment over the other).

Alternative Example 7.4

Problem
Suppose your firm is considering two different projects, one that lasts one
year and another that lasts five years. The cash flows for the two projects
look like this:

What is the IRR of each proposal? What is the incremental IRR? If your
firms cost of capital is 10%, what should you do?

Alternative Example 7.4 (contd)

Solution
We can compute the IRR of Project L using the
annuity calculator:
NPER
Given
Solve
for rate

RATE

PV
-100

14.87%

PMT
0

FV

Excel formula

200
=RATE(4,0,-100,200)

Alternative Example 7.4 (contd)

Solution
We can compute the IRR of Project S using the
annuity calculator:
NPER
Given
Solve
for rate

RATE

PV
-100

25%

PMT
0

FV

Excel formula

125
=RATE(1,0,-100,125)

Alternative Example 7.4 (contd)

Solution
We can calculate the incremental IRR this way:
Project

-100

-100

125

Difference

-125

NPER
Given
Solve
for rate

5
200

RATE

200
PV
-125

12.47%

PMT
0

FV

Excel formula

200
=RATE(4,0,-125,200)

Alternative Example 7.4 (contd)

Solution
Because the 12.47% incremental IRR is bigger
than the cost of capital of 10%, the long-term
project is better than the short-term project, even
though the short-term project has a higher IRR.

The Incremental IRR Rule (cont'd)

Shortcomings of the Incremental IRR Rule
The incremental IRR may not exist.
Multiple incremental IRRs could exist.
The fact that the IRR exceeds the cost of capital
for both projects does not imply that either
project has a positive NPV.
When individual projects have different costs of
capital, it is not obvious which cost of capital the
incremental IRR should be compared to.

7.5 Project Selection with Resource Constraints

Evaluation of Projects with Different Resource
Constraints
Consider three possible projects with a $100 million
budget constraint
Table 7.1 Possible Projects for a $100 Million Budget

Profitability Index
The profitability index can be used to identify
the optimal combination of projects to
undertake.
Value Created
NPV
Profitability Index =
=
Resource Consumed
Resource Consumed

From Table 7.1, we can see it is better to take

projects II & III together and forego project I.

Alternative Example 7.5

Problem
Suppose your firm has the following five positive NPV projects to choose
from. However, there is not enough manufacturing space in your plant to
select all of the projects. Use profitability index to choose among the
projects, given that you only have 100,000 square feet of unused space.

Project

NPV

Square feet needed

Project 1

100,000

40,000

Project 2

88,000

30,000

Project 3

80,000

38,000

Project 4

50,000

24,000

Project 5

12,000

1,000

330,000

133,000

Total

Alternative Example 7.5 (contd)

Solution
Compute the PI for each project.
Project

NPV

Square feet
needed

Profitability Index
(NPV/Sq. Ft)

Project 1

100,000

40,000

2.5

Project 2

88,000

30,000

2.93

Project 3

80,000

38,000

2.10

Project 4

50,000

24,000

2.08

Project 5

12,000

1,000
12.0

Total

330,000

133,000

Alternative Example 7.5 (contd)

Solution
Rank order them by PI and see how many projects
you can have before you run out of space.
Project

NPV

Square
feet
needed

Profitability
Index
(NPV/Sq. Ft)

Cumulative total
space used

Project 5

12,000

1,000

12

1,000

Project 2

88,000

30,000

2.93

31,000

Project 1

100,000

40,000

2.5

71,000

Project 3

80,000

38,000

2.11

Project 4

50,000

24,000

2.08

Shortcomings of the Profitability Index

In some situations the profitability Index does not
give an accurate answer.
Suppose in Example 7.4 that NetIt has an additional small
project with a NPV of only $120,000 that requires 3
engineers. The profitability index in this case is
0.1 2/ 3 = 0.04, so this project would appear at the bottom
of the ranking. However, 3 of the 190 employees are not
being used after the first four projects are selected. As a
result, it would make sense to take on this project even
though it would be ranked last.

Shortcomings of the Profitability Index (cont'd)

With multiple resource constraints, the
profitability index can break down completely.

Chapter 8
Fundamentals of
Capital Budgeting

Chapter Outline
8.1 Forecasting Earnings
8.2 Determining Free Cash Flow and NPV
8.3 Choosing Among Alternatives
8.4 Further Adjustments to Free Cash Flow
8.5 Analyzing the Project

8.1 Forecasting Earnings

Capital Budget
Lists the investments that a company plans
to undertake

Capital Budgeting
Process used to analyze alternate investments and
decide which ones to accept

Incremental Earnings
The amount by which the firms earnings are expected
to change as a result of the investment decision

Revenue and Cost Estimates

Example
Linksys has completed a $300,000 feasibility study
to assess the attractiveness of a new product,
HomeNet. The project has an estimated life of
four years.
Revenue Estimates
Sales = 100,000 units/year
Per Unit Price = $260

Revenue and Cost Estimates (cont'd)

Example
Cost Estimates
Up-Front R&D = $15,000,000
Up-Front New Equipment = $7,500,000
Expected life of the new equipment is 5 years
Housed in existing lab

Annual Overhead = $2,800,000

Per Unit Cost = $110

Incremental Earnings Forecast

Table 8.1 Spreadsheet HomeNets Incremental Earnings
Forecast

Capital Expenditures and Depreciation

The $7.5 million in new equipment is a cash expense,
but it is not directly listed as an expense when
calculating earnings. Instead, the firm deducts a
fraction of the cost of these items each year as
depreciation.
Straight Line Depreciation
The assets cost is divided equally over its life.
Annual Depreciation = $7.5 million 5 years = $1.5 million/year

Interest Expense
In capital budgeting decisions, interest
expense is typically not included. The rationale
is that the project should be judged on its
own, not on how it will be financed.

Taxes
Marginal Corporate Tax Rate
The tax rate on the marginal or incremental dollar
of pre-tax income. Note: A negative tax is equal to
a tax credit.
Income Tax = EBIT c

Taxes (cont'd)
Unlevered Net Income Calculation
Unlevered Net Income = EBIT (1 c )
= (Revenues Costs Depreciation) (1 c )

Alternative Example 8.1

Problem
NRG, Inc. plans to launch a new line of energy drinks.
The marketing expenses associated with launching the new product
will generate operating losses of $500 million next year for the
product.
NRG expects to earn pre-tax income of $7 billion from operations other
than the new energy drinks next year.
NRG pays a 39% tax rate on its pre-tax income.

Alternative Example 8.1

Problem (continued)
What will NRG owe in taxes next year without the
new energy drinks?
What will it owe with the new energy drinks?

Alternative Example 8.1

Solution
Without the new energy drinks, NRG will owe corporate taxes next
year in the amount of:
$7 billion 39% = $2.730 billion

With the new energy drinks, NRG will owe corporate taxes next year in
the amount of:
$6.5 billion 39% = $2.535 billion
Pre-Tax Income = $7 billion - $500 million = $6.5 billion

Launching the new product reduces NRGs taxes next year by:
$2.730 billion $2.535 billion = $195 million.

Indirect Effects on Incremental Earnings

Opportunity Cost
The value a resource could have provided in its best
alternative use
In the HomeNet project example, space will be required
for the investment. Even though the equipment will be
housed in an existing lab, the opportunity cost of not using
the space in an alternative way (e.g., renting it out) must
be considered.

Alternative Example 8.2

Problem
Suppose NRGs new energy drink line will be
housed in a factory that the company could have
otherwise rented out for $900 million per year.
How would this opportunity cost affect NRGs
incremental earnings next year?

Alternative Example 8.2

Solution
The opportunity cost of the factory is the
forgone rent.
The opportunity cost would reduce NRGs
incremental earnings next year by:
$900 million (1 .39) = $549 million.

Indirect Effects on Incremental Earnings (cont'd)

Project Externalities
Indirect effects of the project that may affect the
profits of other business activities of the firm.
Cannibalization is when sales of a new product
displaces sales of an existing product.

Indirect Effects on Incremental Earnings (cont'd)

Project Externalities
In the HomeNet project example, 25% of sales come from
customers who would have purchased an existing Linksys
wireless router if HomeNet were not available. Because
this reduction in sales of the existing wireless router is a
consequence of the decision to develop HomeNet, we
must include it when calculating HomeNets incremental
earnings.

Indirect Effects on Incremental Earnings (cont'd)

Table 8.2 Spreadsheet HomeNets Incremental Earnings
Forecast Including Cannibalization and Lost Rent

Sunk Costs and Incremental Earnings

Sunk costs are costs that have been or will be
paid regardless of the decision whether or not
the investment is undertaken.
Sunk costs should not be included in the
incremental earnings analysis.

Sunk Costs and Incremental Earnings (cont'd)

Fixed Overhead Expenses
Typically overhead costs are fixed and not
incremental to the project and should not be
included in the calculation of incremental
earnings.

Sunk Costs and Incremental Earnings (cont'd)

Past Research and Development Expenditures
Money that has already been spent on R&D is a
sunk cost and therefore irrelevant. The decision to
continue or abandon a project should be based
only on the incremental costs and benefits of the
product going forward.

Sunk Costs and Incremental Earnings (cont'd)

Unavoidable Competitive Effects
When developing a new product, firms may be concerned
about the cannibalization of existing products.
However, if sales are likely to decline in any case as a result
of new products introduced by competitors, then these
lost sales should be considered a sunk cost.

Real-World Complexities
Typically,
sales will change from year to year.
the average selling price will vary over time.
the average cost per unit will change over time.

Textbook Example 8.3

Textbook Example 8.3 (cont'd)

8.2 Determining Free Cash Flow and NPV

The incremental effect of a project on a firms
available cash is its free cash flow.

Calculating the Free Cash Flow from Earnings

Capital Expenditures and Depreciation
Capital Expenditures are the actual cash outflows
when an asset is purchased. These cash outflows
are included in calculating free cash flow.
Depreciation is a non-cash expense. The free cash
flow estimate is adjusted for this non-cash
expense.

Calculating the Free Cash Flow from Earnings (cont'd)

Capital Expenditures and Depreciation

Table 8.3 Spreadsheet Calculation of HomeNets Free Cash Flow
(Including Cannibalization and Lost Rent)

Calculating the Free Cash Flow from Earnings (cont'd)

Net Working Capital (NWC)
Net Working Capital = Current Assets Current Liabilities
= Cash + Inventory + Receivables Payables

Most projects will require an investment in net

working capital.
Trade credit is the difference between receivables
and payables.

The increase in net working capital is defined as:

NWCt = NWCt NWCt 1

Calculating the Free Cash Flow from Earnings (cont'd)

Table 8.4 Spreadsheet HomeNets Net Working
Capital Requirements

Alternative Example 8.4

Problem
Rising Star Inc is forecasting that their sales will
increase by $250,000 next year, $275,000 the
following year, and $300,000 in the third year. The
company estimates that additional cash requirements
will be 5% of the change in sales, inventory will
increase by 7% of the change in sales, receivables will
increase by 10% of the change in sales, and payables
will increase by 8% of the increase in sales. Forecast
the increase in net working capital for Rising Star over
the next three years.

Alternative Example 8.4 (contd)

Solution
The required increase in net working capital is
shown below:
Year
0
Sales Forecast (increase)
Net Working Capital Forecast
Cash Requirements (5% of sales)
Inventory (7% of sales)
Receivables (10% of sales)
Payables (8% of sales)
Net Working Capital

1
2
3
$250,000 $275,000 $300,000
$12,500
$17,500
$25,000
$20,000
$35,000

$13,750
$19,250
$27,500
$22,000
$38,500

$15,000
$21,000
$30,000
$24,000
$42,000

Calculating Free Cash Flow Directly

Free Cash Flow
Unlevered Net Income
6444444444
74444444448
Free Cash Flow = (Revenues Costs Depreciation) (1 c )

+ Depreciation CapEx NWC

Free Cash Flow = (Revenues Costs) (1 c ) CapEx NWC
+ c Depreciation

The term c Depreciation is called the depreciation

tax shield.

Calculating the NPV

PV ( FCFt ) =

FCFt
= FCFt
t
(1 + r )

1
(1 + r )t
1
424
3

t = year discount factor

HomeNet NPV (WACC = 12%)

NPV = 16,500 + 4554 + 5740 + 5125 + 4576 + 1532
= 5027

Table 8.5 Spreadsheet Computing HomeNets NPV

8.3 Choosing Among Alternatives

Launching the HomeNet project produces a
positive NPV, while not launching the project
produces a 0 NPV.
Evaluating Manufacturing Alternatives

8.3 Choosing Among Alternatives (cont'd)

Evaluating Manufacturing Alternatives
In the HomeNet example, assume the company
could produce each unit in-house for $95 if it
spends $5 million upfront to change the assembly
facility (versus $110 per unit if outsourced). The
in-house manufacturing method would also
require an additional investment in inventory
equal to one months worth of production.

8.3 Choosing Among Alternatives (cont'd)

Evaluating Manufacturing Alternatives
Outsource
Cost per unit = $110
Investment in A/P = 15% of COGS
COGS = 100,000 units $110 = $11 million
Investment in A/P = 15% $11 million = $1.65 million
NWC = $1.65 million in Year 1 and will increase by $1.65 million in
Year 5
NWC falls since this A/P is financed by suppliers

8.3 Choosing Among Alternatives (cont'd)

Evaluating Manufacturing Alternatives
In-House
Cost per unit = $95
Up-front cost of $5,000,000
Investment in A/P = 15% of COGS
COGS = 100,000 units $95 = $9.5 million
Investment in A/P = 15% $9.5 million = $1.425 million
Investment in Inventory = $9.5 million / 12 = $0.792 million
NWC in Year 1 = $0.792 million $1.425 million =
$0.633 million
NWC will fall by $0.633 million in Year 1 and increase by $0.633 million in Year 5

8.3 Choosing Among Alternatives (cont'd)

Evaluating Manufacturing Alternatives
Table 8.6 Spreadsheet NPV Cost of Outsourced Versus
In-House Assembly of HomeNet

8.3 Choosing Among Alternatives (cont'd)

Comparing Free Cash Flows Ciscos
Alternatives
Outsourcing is the less expensive alternative.

8.4 Further Adjustments to Free Cash Flow

Other Non-cash Items
Amortization

Timing of Cash Flows

Cash flows are often spread throughout the year.

Accelerated Depreciation
Modified Accelerated Cost Recovery System
(MACRS) depreciation

Alternative Example 8.5

Problem
Canyon Molding is considering purchasing a new
machine to manufacture finished plastic products.
The machine will cost $50,000 and falls into the
MACRS 3-year asset class. What depreciation
deduction would be allowed for the machine
using the MACRS method, assuming the
equipment is put into use in year 0?

Alternative Example 8.5 (contd)

Solution
Based on the percentages in Table 8A.1, the
allowable depreciation expense for the lab
equipment is shown below:
Year
0
MACRS Depreciation
Plastic Molding Machine
MACRS Depreciation Rate
Depreciation Expense

$50,000
33.33% 44.45%
$16,665 $22,225

14.81%
$7,405

7.41%
$3,705

Further Adjustments to Free Cash Flow (cont'd)

Liquidation or Salvage Value
Capital Gain = Sale Price Book Value
Book Value = Purchase Price Accumulated Depreciation
After-Tax Cash Flow from Asset Sale = Sale Price (c Capital Gain)

Textbook Example 8.6

Textbook Example 8.6 (cont'd)

Further Adjustments to Free Cash Flow (cont'd)

Terminal or Continuation Value
This amount represents the market value of the
free cash flow from the project at all future dates.

Textbook Example 8.7

Textbook Example 8.7 (cont'd)

Further Adjustments to Free Cash Flow (cont'd)

Tax Carryforwards
Tax loss carryforwards and carrybacks allow
corporations to take losses during its current year
and offset them against gains in nearby years.

Textbook Example 8.8

Textbook Example 8.8 (cont'd)

8.5 Analyzing the Project

Break-Even Analysis
The break-even level of an input is the level that causes
the NPV of the investment to equal zero.
HomeNet IRR Calculation

Table 8.7 Spreadsheet HomeNet IRR Calculation

8.5 Analyzing the Project (cont'd)

Break-Even Analysis
Break-Even Levels for HomeNet

Table 8.8 Break-Even Levels for HomeNet

EBIT Break-Even of Sales

Level of sales where EBIT equals zero

Sensitivity Analysis
Sensitivity Analysis shows how the NPV varies
with a change in one of the assumptions,
holding the other assumptions constant.

Sensitivity Analysis (cont'd)

Table 8.9 Best- and Worst-Case Parameter Assumptions
for HomeNet

Figure 8.1 HomeNets NPV Under Best- and Worst-Case Parameter

Assumptions

Alternative Example 8.9

Problem
Assume NRG originally forecasted its marketing and
support costs at $500,000 per year during years 1 3.
Suppose the marking and support costs could be as low as
$200,000 or as high as $900,000 per year. How would
these changes impact the NPV of the proposed energy
drink project? Recall, NRG pays a 39% tax rate on its pretax income. Assume their cost of capital is 9%.

Alternative Example 8.9 (contd)

Solution.
We can answer the question by computing the
NPV of the resulting free cash flow, given the
change in marketing and support costs.

Alternative Example 8.9 (contd)

Solution.
A $300,000 decrease in marketing and support costs will
increase NRGs EBIT by $300,000 and will, therefore
increase NRGs free cash flow by an after-tax amount of:
$300,000 x ( 1 0.39) = $183,000
The present value of this increase is:
$183,000 $183,000 $183,000
PV=
+
+
= $463, 227
2
3
1.09
1.09
1.09

thus, the NPV of the project would rise by $463,227.

Alternative Example 8.9 (contd)

Solution.
A $400,000 increase in marketing and support costs will
decrease NRGs EBIT by $400,000 and will, therefore
decrease NRGs free cash flow by an after-tax amount of:
$400,000 x ( 1 0.39) = $244,000
The present value of this decrease is:
PV=

-$244,000 -$244,000 -$244,000

+
+
= $617, 636
2
3
1.09
1.09
1.09

thus, the NPV of the project would fall by $617,636.

Scenario Analysis
Scenario Analysis considers the effect
on the NPV of simultaneously changing
multiple assumptions.
Table 8.10 Scenario Analysis of Alternative Pricing Strategies

Figure 8.2 Price and Volume Combinations for HomeNet with

Equivalent NPV

Table 8A.1 MACRS

Depreciation Table
Showing the
Percentage of the
Assets Cost That May
Be Depreciated Each
Year Based on Its
Recovery Period