Real-world complications
Robustness checks
Capital Budgeting
Evaluation of projects
NPV rule = Gold standard of capital budgeting
We need to compute:
FCF1 FCF2
+
+
NPV = FCF0 +
2
1 + r (1 + r )
Where:
r: Appropriate discount rate for the project
FCFt: Free cash flow generated by the project at year t
FCF = EBIT (1 - c )
+ Depreciation
Increases in Net Working Capital
Capital expenditures
Why?
Because they are reflected in the discount rate
1
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
2
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
3
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
4
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
5
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
6
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
7
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
8
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
9
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
10
28.00
(16.80)
11.20
(1.52)
(1.90)
7.78
(2.72)
5.06
Solution
Earnings Forecasts
Sales Revenue
COGS
Gross profit
SG&A
Depreciation
EBIT
Income tax
Incremental earnings
Add: Depreciation
Minus: CAPEX
Minus: Increases in NWC
Free Cash Flows
1
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
2
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
3
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
4
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
5
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
6
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
7
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
8
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
9
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
7.451
10
28.00
(16.80)
11.20
(0.76)
(1.90)
8.54
(2.99)
5.55
1.90
10.00
17.451
(19.00)
(10.00)
(29.000)
13%
-29 6.593805 5.835226 5.163917 4.569838 4.044104 3.578853 3.167127 2.802767 2.480325 5.140861
14.37682
Positive or negative
B. Externalities
Real-world complications
Robustness checks
Linksys
HomeNet : New product
$300,000 feasibility study to assess its potential
Should this cost be factored into the NPV computation?
Step 1:
For each year in the life of the project:
Compute incremental earnings defined as EBIT(1-),
Also called unlevered net income in textbook
Step 2:
For each year in the life of the project:
Make necessary adjustments to go from earnings to cash flows
1. Revenue Estimates
Annual Sales = 100,000 units/year
Per Unit Price = $260
2. Cost Estimates
Up-Front R&D = $15,000,000
Operating expense
T ime 0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
Annual sales?
COGS?
SG&A?
Depreciation?
Tax impact?
T ime 0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
2
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
3
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
4
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
Time
Incremental earnings forecast
Sales
Cost of Goods Sold
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income tax (40%)
Incremental earnings
Time 0
1
2
3
4
5
- 26,000,000 26,000,000 26,000,000 26,000,000
- (11,000,000) (11,000,000) (11,000,000) (11,000,000)
- 15,000,000 15,000,000 15,000,000 15,000,000
(2,800,000) (2,800,000) (2,800,000) (2,800,000)
(15,000,000)
(1,500,000) (1,500,000) (1,500,000) (1,500,000) (1,500,000)
(15,000,000) 10,700,000 10,700,000 10,700,000 10,700,000 (1,500,000)
6,000,000
(4,280,000) (4,280,000) (4,280,000) (4,280,000)
600,000
(9,000,000)
6,420,000
6,420,000
6,420,000
6,420,000
(900,000)
2. Capital expenditures
2.
3.
4.
Higher inventories
Potential need to hold more inventories of raw material and unfinished products
due to project
Higher receivables
Potential need to offer generous terms to customers (to make them switch to new
product)
Lower payables
New suppliers might not offer same terms of trade (worse trade credit)
T ime
Net Working Capital Forecast
Cash Requirements
Inventory
Receivables (15% of sales)
Payables (15%) of COGS
Net Working Capital
Increases in NWC
1
-
3,900,000
(1,650,000)
2,250,000
2,250,000
2
3,900,000
(1,650,000)
2,250,000
-
3
3,900,000
(1,650,000)
2,250,000
-
4
3,900,000
(1,650,000)
2,250,000
-
5
(2,250,000)
0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
(7,500,000)
(16,500,000)
1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000
2
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000
3
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000
4
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
1,500,000
5
(1,500,000)
(1,500,000)
600,000
(900,000)
1,500,000
(2,250,000)
5,670,000
7,920,000
7,920,000
7,920,000
2,250,000
2,850,000
NPV computation
Need a discount rate!
Suppose appropriate discount rate for project is 12%
What is the NPV of the project?
Should Linksys undertake it?
FCF3
FCF5
FCF1 FCF2
FCF4
+
+
+
+
1 + r (1 + r ) 2 (1 + r ) 3 (1 + r ) 4 (1 + r ) 5
= 16.5M + 5.06 M + 6.31M + 5.64 M + 5.03M + 1.62 M
= 7.16 M > 0
NPV = FCF0 +
1.
2.
As a consequence:
1.
2.
Be careful: Rent revenues would have been taxed at 40% (=80K per year)
Foregone after-tax incremental earnings of $120K per year ($200K-$80K)
Where can we reflect this extra cost in our pro-forma forecasting?
Effect of cannibalization:
Sales = $23.5M instead of $26M
COGS = $9.5M instead of $11M
Time
Time 0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
1
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
2
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
3
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
4
5
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000) (1,500,000)
9,500,000 (1,500,000)
(3,800,000)
600,000
5,700,000
(900,000)
2. Capital expenditures
1.
2.
3.
4.
T ime 0
1
-
3,525,000
(1,425,000)
2,100,000
2,100,000
2
3,525,000
(1,425,000)
2,100,000
-
3
3,525,000
(1,425,000)
2,100,000
-
3,525,000
(1,425,000)
2,100,000
- (2,100,000)
0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
(7,500,000)
(16,500,000)
1
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
(2,100,000)
5,100,000
2
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
7,200,000
3
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
7,200,000
4
5
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000) (1,500,000)
9,500,000 (1,500,000)
(3,800,000)
600,000
5,700,000
(900,000)
1,500,000
1,500,000
7,200,000
2,100,000
2,700,000
NPV computation
Suppose as before that appropriate discount
rate for project is 12%
What is the NPV of the project?
Should Linksys undertake it?
FCF3
FCF5
FCF1 FCF2
FCF4
+
+
+
+
NPV = FCF0 +
2
3
4
1 + r (1 + r )
(1 + r ) (1 + r )
(1 + r ) 5
= 16.5MM + 4.55MM + 5.74 MM + 5.12 MM + 4.58MM + 1.53MM
= 5.03MM > 0
Real-world complications
Robustness checks
Further assumptions:
1.
2.
3.
4.
5.
10 years
No salvage value
38%
Option 1: Renting
Timing
Rent
Effect on EBIT
Effect on taxes
Effect on incremental earnings
Effect on FCF*
Cost of capital
PV
NPV
0
-
1
(54,000)
(54,000)
20,520
(33,480)
(33,480)
2
(54,000)
(54,000)
20,520
(33,480)
(33,480)
3
(54,000)
(54,000)
20,520
(33,480)
(33,480)
4
(54,000)
(54,000)
20,520
(33,480)
(33,480)
5
(54,000)
(54,000)
20,520
(33,480)
(33,480)
6
(54,000)
(54,000)
20,520
(33,480)
(33,480)
7
(54,000)
(54,000)
20,520
(33,480)
(33,480)
8
(54,000)
(54,000)
20,520
(33,480)
(33,480)
9
(54,000)
(54,000)
20,520
(33,480)
(33,480)
10
(54,000)
(54,000)
20,520
(33,480)
(33,480)
9%
(214,863)
(30,716)
(28,179)
(25,853)
(23,718)
(21,760)
(19,963)
(18,315)
(16,802)
(15,415)
(14,142)
Maintenance
Depreciation
Effect on EBIT
Effect on taxes
Effect on incremental earnings
Add: Depreciation
Minus: CAPEX
Effect on FCF*
(160,000)
(160,000)
Cost of capital
PV
NPV
9%
(160,000)
(211,780)
Annual depreciation:
Over 7 years, straight line
fully depreciated
22,857
1
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
2
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
3
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
4
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
5
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
6
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
7
(24,000)
(22,857)
(46,857)
17,806
(29,051)
22,857
8
(24,000)
(24,000)
9,120
(14,880)
-
9
(24,000)
(24,000)
9,120
(14,880)
-
10
(24,000)
(24,000)
9,120
(14,880)
-
(6,194)
(6,194)
(6,194)
(6,194)
(6,194)
(6,194)
(6,194)
(14,880)
(14,880)
(14,880)
(5,683)
(5,214)
(4,783)
(4,388)
(4,026)
(3,693)
(3,388)
(7,468)
(6,851)
(6,285)
Maintenance
Other costs/benefits
Depreciation
Effect on EBIT
Effect on taxes
Effect on incremental earnings
Add: Depreciation
Minus: CAPEX
Effect on FCF*
(260,000)
(284,180)
Cost of capital
PV
NPV
9%
(284,180)
(233,038)
Annual depreciation:
Over 7 years, straight line
fully depreciated
(39,000)
14,820
(24,180)
37,143
1
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
2
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
3
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
4
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
5
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
6
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
7
(19,000)
14,000
(37,143)
(42,143)
16,014
(26,129)
37,143
8
(19,000)
14,000
(5,000)
1,900
(3,100)
-
9
(19,000)
14,000
(5,000)
1,900
(3,100)
-
10
(19,000)
14,000
(5,000)
1,900
(3,100)
-
11,014
11,014
11,014
11,014
11,014
11,014
11,014
(3,100)
(3,100)
(3,100)
10,105
9,271
8,505
7,803
7,159
6,567
6,025
(1,556)
(1,427)
(1,309)
NPV rule
Given same revenues across each project
Maximizing NPV of project = Minimizing NPV of costs
1. Option 1:
2. Option 2:
3. Option 3:
Choose option 2!
Suppose:
1. Current machine would now last 15 years
Assume same maintenance costs beyond year 10 (see Excel)
Now: NPV (costs) = $236K
How?
1. Take total NPV(costs) of a project
2. Compute equivalent annual cost over the life of project
Spread out total cost evenly over projects life
Annuity formula!
1
1
NPV(costs) PV(annuity) = EAC 1
r (1 + r ) N
NPV(costs)
EAC =
1
1
1
r (1 + r ) N
NPV1 (costs)
= 29,306
1
1
1
15
.09 (1 + .09)
NPV2 (costs)
= 36,312
EAC2 =
1
1
1
10
.09 (1 + .09)
Comparison of EACs
EAC1=29,306
EAC2>EAC1
EAC2>EAC1
10 11
EAC2>EAC1
1
EAC2>EAC1
15
Time 0
Time 0
1
10 11
EAC2=36,312
15
Real-world complications
Robustness checks
0
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(4,280,000)
6,420,000
0
(15,000,000)
(15,000,000)
(15,000,000)
1
26,000,000
(11,000,000)
15,000,000
(2,800,000)
(1,500,000)
10,700,000
(15,000,000)
(4,300,000)
(1,720,000)
12,420,000
Although the tax savings are of the same amount, the fact that they are
deferred in case 2 makes it slightly less interesting in present value (PV)
terms
At the end of a project ,we might sell the PP&E (equipment, etc.) related
to the project
=
Book Value
Profits from sale over the book value are called capital gains
1.
2.
(16,500,000) 5,100,000
(16,500,000) 5,100,000
7,200,000
7,200,000
7,200,000
7,200,000
7,200,000
7,200,000
2,700,000
480,000
3,180,000
Real-world complications
Robustness checks
Advanced analysis
Up to now, we have looked at a static case
Relied on many assumptions to get one NPV number
1. Break-even analysis
As it name suggests, the break-even level of an input is
the level that causes the NPV of the investment to
equal zero
Potential inputs:
#Units sold
Wholesale price per unit
COGS
Cost of capital
In that case you get the Internal Rate of Return (IRR)!
Etc.
(15,000,000)
(15,000,000)
6,000,000
(9,000,000)
(7,500,000)
(16,500,000)
Discount rate
PV
24%
(16,500,000)
NPV
(0)
1
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
2
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
3
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
4
23,500,000
(9,500,000)
14,000,000
(3,000,000)
(1,500,000)
9,500,000
(3,800,000)
5,700,000
1,500,000
5
(1,500,000)
(1,500,000)
600,000
(900,000)
1,500,000
(2,100,000)
5,100,000
7,200,000
7,200,000
7,200,000
2,100,000
2,700,000
4,109,119
4,674,009
3,765,894
3,034,217
916,762
2. Sensitivity analysis
Sensitivity Analysis:
1. NPV changes given a change in one of the
assumptions
2. Holding the other assumptions constant
Example:
Cost of capital
We just saw two cases:
1. Cost of capital: 12%
NPV = $5M
IRR
3. Scenario analysis
Is changing one parameter at a time realistic?
Usually the variables are interconnected
One of the best examples:
Price per unit and units sold move together!