Intermediate

Corporate Finance
F305
Capital Budgeting

Professor:
Burcu Esmer
 Firm Objective
Maximize Value

Capital Financing Payout

Budgeting Decision Decision
Decision Maximize firm Return excess
Invest in projects value through cash to investors
that add value optimal capital to maximize
to the firm structure shareholder wealth

2
 Capital Budgeting
Decision
Invest in projects that add
value to the firm

Value projects using cash Discount cash flows using a

flows, reflecting the timing discount rate that reflects
and magnitude of cash the risk of the project and
flows and all side effects cost of capital

3
Capital Budgeting
• FCF is a general concept that can be applied to different
scopes of valuations
• First application: Making capital investment decisions
• Decision as to which real assets should the firm acquire?
• Firms have a finite capacity to purchase productive assets
• Is an investment issue, different from how a project is
financed
• What is the implication?
• Major project evaluation methods
• NPV, IRR, and Payback

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5
To Start: What is an investment/project?

• An investment/project can range the spectrum from big to small,

money making to cost saving:
• Major strategic decisions to enter new areas of business or new
markets.
• Acquisitions of other firms are projects as well, notwithstanding
attempts to create separate sets of rules for them.
• Decisions on new ventures within existing businesses or
markets.
• Decisions that may change the way existing ventures and
projects are run.
• Decisions on how best to deliver a service that is necessary for
the business to run smoothly.

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 Typical Project
Initial cost
Cfi‘s : cash flows
or “outlay”
net of additional costs.
Terminal CF
C0 CF1 CF2 CF3 + CFN

r=?
0 1 2 3 N

Terminal cash flow includes

Appropriate discount rate
“Salvage Value” + other
cash flows resulting from
the termination of the
project.
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 General Process
1. Est. cash flows (project costs and benefits)
see A,B,& C below
2. Determine project risk (risk of CFs) and find discount
rate, r (cost of capital for project).
3. Analyze using suitable method (NPV, IRR,...)
4. Make decision.

B C
Terminal CF
+
C0 CF1 CF2 CF3
CF4

A r=?
0 1 2 3 N
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 Example I
As CFO of Amtrak you are deciding whether to build an
airline division. You estimate the new airline will cost
$6.92 billion to start and produce free cash flow to the
firm of $1.2 billion every year for 25 years. At the end of
the project’s life the terminal value will be 0. You
calculated the appropriate discount rate for the airline is
10.3%. Should you build the airline?

-6.92 1.2 1.2 1.2 1.2+0

0 1 2 3 25

r = 10.3% 9
 Solution to Example I
Do the benefits outweigh the costs? Bring all relevant cash flows to
the present to make cash flows time consistent. Sum the PV of all
cash flow. If costs outweigh the benefits then NPV<0 and if benefits
outweigh costs then NPV>0.

-6.92 1.2 1.2 1.2 1.2+0

r = 10.3%
0 1 2 3 25

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NPV Rule
Using appropriate discount rate bring all cash flows to the
present and sum up. If costs outweigh the benefit then
NPV<0. If benefits outweigh the costs NPV>0

N N
CFt CFt
NPV   t or  t  Cost 0
t  0 (1  r ) t 1 (1  r )

Accept project if NPV > 0

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 IRR: Internal Rate of Return
What is the rate of return that makes the costs exactly equal to the
benefits (what rate of return will make the NPV=0)?

If discount rate is less than the IRR then project “hurdles” discount
rate, otherwise we should reject the project.

Example II:

-6.92 1.2 1.2 1.2 1.2+0

IRR = ?
0 1 2 3 25

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 Solution to Example II
-6.92 1.2 1.2 1.2 1.2+0

IRR = ?
0 1 2 3 25

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 IRR Rule
Find the discount rate that makes a
project’s NPV = 0. If that rate hurdles the
project’s WACC then accept, else reject
the project.
N N
CFt CFt
0 t or  t  Cost 0
t  0 (1  IRR ) t 1 (1  IRR )

Accept project if IRR > discount rate

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Estimating Project Cash Flows

•Include relevant after-tax cash flows

•General rule for including/excluding cash
flow in analysis:
•Is the cash flow incremental (i.e. does it
only occur if we accept the project)?
• Yes - Include in project!
• No - Ignore it!

Incremental cash flow with cash flow without

Cash Flow
= project - project

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Include all Indirect Effects
Side Effects
• A project can have positive or negative side effects
• An important negative side effect is erosion
• Erosion is the cash flow transferred to a new project from customers and
sales of other products of the firm
• It should be treated as a cost to the new project
• e.g. a hybrid sedan cannibalizing sales of existing sedans

• A positive side effect occurs when a new project increases the

revenues of an existing product
• e.g. Sale of printers boosting sales of printer accessories

Indirect Effect Rule:

You must include all indirect effects in your
analysis.
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 Sunk Costs
•Costs that have already occurred and cannot be removed
•Forget sunk costs
• Just because “we have come this far” does not mean that
we should continue to throw good money after bad
• Example: Imagine you paid full price to watch a highly
hyped movie. 10 minutes in to the movie, you realize it is
very bad and you are suffering from watching it. Are you
going to sit through the movie because you paid good
money for the ticket?
• In finance, the way to ask the question is: If this ticket
costs me nothing, then would I continue to watch?
Sunk Cost Rule:
Always ignore sunk costs. 17
Concorde fallacy

• You developed a new technology, and that you will need

to spend an additional $1 million to complete your
development. Assume now that a competitor has just
come up with a much better technology (that will make
yours obsolete). The subjects of this experiment were
asked to decide whether they would invest the extra
million, in light of this new information.
Would you invest the extra million and complete your
development?
What if I tell you that you already spent $9 million.
Would you take the investment?

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 Opportunity Costs

Opportunity Cost – Benefit or cash flow foregone as a

result of an action.

If the new project uses existing assets, the costs of these assets
should be included even if no money changes hands
By taking the new project, the firm forgoes opportunities for
using the assets

Opportunity Cost Rule:

Be sure to recognize the opportunity cost (that
which is foregone).

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Opportunity Costs

• Examples
• If you have a job offer from JP Morgan, and the other
offers you have are from Bank of America and from
Bloomington Credit Union. What is your opportunity cost
of accepting JP Morgan’s offer?

• If you invest $10,000 in a stock, and you could have left

the money in a bank account instead. What is your
opportunity cost of the decision to invest in stock?

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Investments in Working Capital
Net Working Capital (simplified version)

• Let’s assume that all items in current assets (CA) and

current liabilities (CL) are operation-related
• Net Working Capital (NWC) = CA – CL
• Only changes are relevant for the cash flow analysis
• Increases in NWC = Cash outflow
• Decreases in NWC = Cash inflow
• Project CFs need to be adjusted for:
• Changes (NOT the level) in NWC from year to year
• At the end of a project, we assume that the investment in NWC
is recovered either in whole or in part

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Financing costs

• Financing items (e.g. interest, dividends) should be

excluded, because
• Project should be evaluated based only on CFs generated
by project assets
• Capital budgeting decision is separate from the financing
decision

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Additional Considerations

1) Remember Terminal Cash Flows

2) Beware of Allocated Overhead Costs
3) We are interested in cash flows
4) We are interested in aftertax cashflow

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Detailed Project Analysis
• Involves the following steps

• Step 1: Build pro forma income statements

• Project revenues, costs & depreciation

• Step 2: Estimate changes in NWC and capital expenditure

• Depreciation
= (Cost – BV of Salvage)* Depreciation Rate
• Tax adjusted salvage value
= MV of Salvage – (MV of Salvage– BV of Salvage)* Tax rate

• Step 3: Compute project cash flow for every year

• Step 4: Compute NPV of the project (discounting all the cash

flows and sum up the present values)
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Computing project cash flows

Project CF = Project Operating CF – Increase in NWC

– Project capital spending

• where,

Project Operating CF = EBIT– Taxes+ Depreciation

We are
ignoring any
financing
Or: expenses
such as
interest
Project Operating CF = NI + Depreciation

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Example : Calculating Salvage Value

• Consider an asset that costs $490,000 and is depreciated straight-line

to zero over its seven-year tax life. The asset is to be used in a five-
year project; at the end of the project, the asset can be sold for
$165,000. If the relevant tax rate is 34 percent, what is the aftertax
cash flow from the sale of this asset?

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Solution to Example

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Hidden Valley Case
• Case introduction
• Step 1. Building pro forma income statements
• Project revenues, costs, and depreciation
• Step 2. Estimate changes in NWC and capital expenditure
• Depreciation = (Cost – BV of Salvage)* Depreciation Rate
• Cash from salvage value = MV of Salvage - (MV - BV of Salvage)*Tax Rate
Note: Tax consequences when the project is scrapped at the end of the horizon
Market value = Book value => no taxes
Market value > Book value => Tax on capital gain
Market value < Book value => Tax shield on capital loss

• Step 3. Estimate project cash flows

• Step 4. Compute NPV of the project and IRR
• Step 5. Apply NPV rule

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 Big Example
As CFO of Hidden Valley you are considering building a new salad
dressing factory. The initial cost to build the factory is $1 billion. You
plan to use straight line depreciation and depreciate the factory to a
book value of 0. The factory will last 5 years and have a salvage value
of $250 million. Sales from the factory are expected to be 1.25 billion
each year for the next 5 years and costs (other than depreciation) are
60% of revenues. Additional capital expenditures of $50 million will be
required at the end of each of for the next 5-years (i.e., at t=1,2,3,4 and
5). Inventories and A/P will immediately rise by $20 million and $5
million respectively and remain at these levels until returning back to
original levels at the end of the project (t=5). A/R will rise by $100
million after the 1st year (i.e., at t=1) and remain at that level until falling
back to original levels at the end of the project’s life (t=5). If the cost of
capital (WACC) for the project is 15%, the marginal tax rate is 40%
and the capital gains tax rate is 36%, what are the project’s NPV and
IRR?

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 Time Line

1.) InitCost A-t SV

2a.) OPCF0 OPCF1 OPCF2 OPCF3 OPCF4 OPCF5

2b.) -CapEx1 -CapEx2 -CapEx3 -CapEx4 -CapEx5
2c.) -DWC0 -DWC1 -DWC2 -DWC3 -DWC4 -DWC5

2.) FCFF0 FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

3.) Other0 Other1 Other2 Other3 Other4 Other5

0 1 2 3 4 5
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 Step 1
“The initial cost to build the factory is $1 billion, the factory will last 5 years and
have a salvage value of $250 million. You plan to use straight line depreciation
and depreciate the factory to a book value of 0. ...the capital gains tax rate is
36%?”

0 1 2 3 4 5 31
 Step 2a: Operating Cash Flow
Revenues
Costs
- Dep
EBIT
- Tax
EBIT(1-t)
+ DEP
OCF

0 1 2 3 4 5 32
 Step 2b: Additional Capital
Expenditures
“Additional capital expenditures of $50 million will be required at the end
of each of for the next 5-years (i.e., at t=1,2,3,4 and 5).”

0 1 2 3 4 5

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 Step 2c: Change in working capital
“Inventories and A/P will immediately rise by $20 million and $5 million
respectively and remain at these levels until returning back to original levels
at the end of the project (t=5). A/R will rise by $100 million after the 1st
year (i.e., at t=1) and remain at that level until falling back to original levels
at the end of the project’s life (t=5).”

D A/R
D Inv.
D A/P

D WC

0 1 2 3 4 5
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 Put it all together

Estimate FCFF
0 1 2 3 4 5
Revenue - 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000
- Costs - 750,000 750,000 750,000 750,000 750,000
- Dep - 200,000 200,000 200,000 200,000 200,000
EBIT - 300,000 300,000 300,000 300,000 300,000
-Tax - 120,000 120,000 120,000 120,000 120,000
EBIT(1-t) - 180,000 180,000 180,000 180,000 180,000
+ Dep - 200,000 200,000 200,000 200,000 200,000
- CapExp - 50,000 50,000 50,000 50,000 50,000
- DWC 15,000 100,000 - - - (115,000)
FCFF (15,000) 230,000 330,000 330,000 330,000 445,000

Inital Outlay (1,000,000)

FCFF (15,000) 230,000 330,000 330,000 330,000
445,000
Terminal CF 160,000
FINAL TIME LINE $ (1,015,000) $ 230,000 $ 330,000 $ 330,000 $ 330,000 $ 605,000

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 Find NPV
(numbers are $mills not 000s – time line space considerations)

-1,015 230 330 330 330 605

0 1 2 3 4 5

230 330 330 330 605

NPV15%  1,015   2  3  4 
(115
. ) (115
. ) (115
. ) (115. ) (115. )5

 $140.978 million

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Additional Considerations

• Sunk Costs
• Opportunity costs (of assets in place)
• Externalities
• Inflation?

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Sunk Costs

Hidden Valley plans to use a building that it owns for its

new factory. The building was built at a cost of $250,000
which we did not include in the initial cost of the project.
Should we include it?

NO! Whether we accept or reject the project this cost is

sunk. I.e. the cost of the building has been incurred and
does not depend on whether we accept or reject the
project. It is not an incremental cash flow!

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Opportunity Costs
Hidden Valley plans to use a building it owns for its new
factory. It could rent the building instead for $15,000 per
year (FCFF equivalent). Does this affect our project
decision?

0 1 2 3 4 5

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 Externalities
The new bottled salad dressing will have sales of $1.25 billion, but some
of those sales (equivalent to $10,000 in FCFF) will come from consumers
who switch from buying Hidden Valley's existing dry packet salad
dressing. Does this affect our decision to produce bottled dressing?

0 1 2 3 4 5

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 Add in the relevant CFs
Inital Outlay (1,000,000)
FCFF (15,000) 230,000 330,000 330,000 330,000 445,000
Terminal CF 160,000
Opp. Cost 0 (15,000) (15,000) (15,000) (15,000) (15,000)
Externalities 0 (10,000) (10,000) (10,000) (10,000) (10,000)
FINAL TIME LINE $ (1,015,000) $ 205,000 $ 305,000 $ 305,000 $ 305,000 $ 580,000

NPV $57,174.39
IRR 17.03%

Assumptions
WACC Project 15%
Dep (S-L down to 0) $ 200,000
Marginal Tax Rate 40%
Cap Gains Tax Rate 36%

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Effects of Inflation

Does our cost of capital have inflation?

YES! So we need to make sure our cash flows that are

affected by inflation have inflation impounded into them!

For example what if our prices for the salad dressing will
rise by inflation each year?

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 Project with inflation:

Assume the price of our new bottled salad dressing will rise by 3% each year (inflation).

Estimate FCFF
0 1 2 3 4 5
Revenue - 1,250,000 1,287,500 1,326,125 1,365,909 1,406,886
- Costs - 750,000 772,500 795,675 819,545 844,132
- Dep - 200,000 200,000 200,000 200,000 200,000
EBIT - 300,000 315,000 330,450 346,364 362,754
-Tax - 120,000 126,000 132,180 138,545 145,102
EBIT(1-t) - 180,000 189,000 198,270 207,818 217,653
+ Dep - 200,000 200,000 200,000 200,000 200,000
- CapExp - 50,000 50,000 50,000 50,000 50,000
- DWC 15,000 100,000 - - - (115,000)
FCFF (15,000) 230,000 339,000 348,270 357,818 482,653

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Where else is inflation missing?
Inital Outlay (1,000,000)
FCFF (15,000) 230,000 339,000 348,270 357,818
482,653
Terminal CF 160,000
Opp. Cost 0 (15,000) (15,450) (15,914) (16,391) (16,883)
Externalities 0 (10,000) (10,300) (10,609) (10,927) (11,255)
FINAL TIME LINE $ (1,015,000) $ 205,000 $ 313,250 $ 321,748 $ 330,500 $ 614,515

NPV $106,164.01
IRR 18.69%

Assumptions
WACC Project 15%
Dep (S-L down to 0) $ 200,000
Marginal Tax Rate 40%
Cap Gains Tax Rate 36%
Infaltion 3%

If prices rise so will effect of product cannibalization.

Rent will also increase with inflation
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