chapter 9 - capital budget

Capital budgeting

is how a company decides which long-term projects or investments to pursue.

Capital budget

is a list of possible projects the company plans to take on in the next period.

Capital budgeting process

1. Create a List of Projects:

◦ Firms list possible investment opportunities.

◦ They forecast each project’s future revenues and costs.

2. Analyze Projects:

◦ Firms decide which projects to accept using capital budgeting techniques.

◦ The goal: determine how each project affects the firm’s cash flow and value.

3. Forecast Cash Flows:

◦ Projects have different types of cash flows:

‣ Initial Outlay: Upfront costs (e.g., buying equipment, R&D costs, increase in working capital).

‣ Ongoing Cash Flows: Revenues, operating costs, taxes, and changes in working capital during operation.

‣ Terminal Cash Flows: Ending cash flows (e.g., selling equipment, shutdown costs, recovery of working capital).

Initial outlay

Upfront costs (e.g., buying equipment, R&D costs, increase in working capital).

Ongoing cash flows

Revenues, operating costs, taxes, and changes in working capital during operation

Terminal cash flows

Ending cash flows (e.g., selling equipment, shutdown costs, recovery of working capital).

earnings vs. cash flows

Earnings are not the same as cash flows.

• To make decisions, we must convert earnings into cash flows and find the project’s Net Present Value (NPV).

Define incremental earnings

the change in profits caused by the specific project.

Operating Expenses vs. Capital Expenditures

• Operating Expenses (Opex):

◦ Used up in the current year (e.g., marketing, redesign, maintenance).

◦ Counted as expenses immediately in Year 0.

◦ Example: $50,000 redesign cost → expense in Year 0.

• Capital Expenditures (CapEx):

◦ Long-term investments in equipment or property.

◦ Not expensed right away — instead depreciated over time.

◦ Example: $1,020,000 machine → depreciated

Incremental Earnings Before Interest & Taxes (EBIT)

EBIT = incremental revenue - incremental cost - Depreciation

How to compute incremental tax

• Use the marginal corporate tax rate

Income tax = EBIT x tax rate

Incremental Earnings (Net income)

Combination of incremental EBIT and tax rate

• incremental earnings = (incremental revenue - incremental cost - depreciation) x (1 - tax rate)

• This is the formula used to calculate incremental earnings that help determine cash flow and NPV

Tax shield

A depreciation tax shield is the tax savings a firm gets because depreciation is a deductible expense.
Formula: Depreciation × Tax Rate.
It increases cash flow without requiring a cash outlay

Pro Forma Statement

• A pro forma statement is a forecasted financial statement showing expected results under specific assumptions — not actual data.

• When EBIT (Earnings Before Interest and Taxes) is negative,

it means the project reports an accounting loss for that year.

• Even with negative EBIT, taxes are still relevant because:

◦ The loss can offset taxable income from other projects.

◦ This creates a tax saving, known as a tax shield.

When analyzing a capital budgeting decision, we do not include interest expenses in the project’s incremental earnings.

Why?

• Interest comes from how the project is financed (with debt or equity), not from the project’s actual performance.

• Capital budgeting focuses on whether the project itself is profitable, not how it’s paid for.

How We Evaluate Projects

• We assume the company uses no debt to finance the project.

• This means we calculate earnings as if it were all financed by equity (no interest costs).

• This is called the unlevered net income — it’s the project’s net income before considering any interest expenses.

Difference between earnings and cash flows

Earnings show accounting profit, but cash flow shows how much money the firm actually has to spend. for capital budgeting decisions, we measure how a project changes the firm’s cash position, not its earnings.

• Incremental Free Cash Flow (FCF):

The extra cash available from a project after accounting for operating expenses, taxes, and investments.

From Incremental Earnings → Free Cash Flow

To convert incremental earnings into free cash flow, make these adjustments:

1. Add back non-cash expenses (like depreciation).
→ These lower earnings but don’t reduce cash.

2. Subtract capital expenditures (CapEx)
→ These are real cash outflows to buy or upgrade equipment.

3. Adjust for changes in net working capital (if any)
→ Example: increases in inventory or accounts receivable use cash.

Capital Expenditures and Depreciation

Capital Expenditures (CapEx)
→ The cost of new equipment or investments must be counted as cash outflows.

Capital expenditure are depreciated because they are long term expenses like equipment, machine, etc.

• Depreciation is not a cash outflow, but it affects taxes.

• Depreciation lowers taxable income, which reduces taxes, creating a tax shield.

• So, after-tax profit is lowered by depreciation, but since no cash is actually spent, we add it back.

Difference between incremental earnings and incremented free cash flow (FCF):

Incremental earnings ≈ accounting net income
Incremental free cash flow = the actual cash the project adds or removes from the firm.

Steps to Calculate Free Cash Flow

1. Start with Incremental Earnings
(already includes taxes and depreciation).

2. Add Back Depreciation
→ Depreciation lowers earnings but does not use cash.

3. Subtract Capital Expenditures (CapEx)
→ The cost of new equipment or investments must be counted as cash outflows.

Net working capital (NWC)

It’s actually money that the company must keep inside the business to make operations run smoothly. it’s money tied up in running the project’s operations.

Net Working Capital (NWC)=Current Assets−Current Liabilities

=Cash+Inventory+Receivables−Payables

Why does NWC matter?

• NWC represents short-term assets needed for daily operations.

Changes in NWC affect a project’s cash flow:

What does it mean when NWC increases and decreases?

When NWC increases, more cash is tied up → cash outflow

When NWC decreases, cash is freed up → cash inflow

What does NWC > 0 and NWC < 0 interpret to

• ΔNWC > 0 → subtract (uses cash)

• ΔNWC < 0 → subtracting a negative adds (frees cash)

What is the true Free cash flow formula

FCF=Incremental Earnings+Depreciation−CapEx−NWC

What is the difference between these 2 formulas:

1. incremental earning + depreciation - capital expenditure

2. Incremental Earnings+Depreciation−Capital expenditure−NWC

The second formula subtracts ΔNWC, which accounts for changes in Net Working Capital.
Including ΔNWC gives the true Free Cash Flow, because it captures cash tied up in inventory, receivables, and payables.
The first formula ignores working capital and is therefore incomplete.

What part of the FCF formulas is the unlevered net income after tax

(Revenues−Costs−Depreciation)×(1−Tax Rate)

Define depreciation tax shield and depreciation tax shield =

• Definition: The tax savings from deducting depreciation.
Tax Shield=Depreciation×Tax Rate

Why Depreciation Increases Cash Flow

Even though depreciation reduces earnings, it:

• Lowers taxes, and

• Doesn’t use real cash.
That’s why it’s added back when computing Free Cash Flow.

What do you use to calculate NPV?

Once we forecast all incremental free cash flows, we can find the project’s Net Present Value (NPV) by discounting them at the project’s cost of capital (the required rate of return).

When deciding on a project, include all changes in the firm’s cash flows that happen because of the project.
That means:

• Include cash flows the firm gains or loses because of the project.

• Include effects on other parts of the business.

• Ignore anything that doesn’t actually change cash flows.

Define opportunity costs

• Definition: The value of what you give up when using a resource for one project instead of another.

• Even if the firm already owns the resource, it’s not free — it could have been sold or used elsewhere.

Define Idle Assets and why they are important in incremental free cash flows

• People often assume idle assets (unused land, old machines, etc.) have no cost.

• But if they could be sold or rented, that value is still an opportunity cost.

• Always include the potential rental, sale, or use value as part of incremental cash flows.

Define project externalities

• Definition: Side effects (positive or negative) that a project has on the firm’s other products.

Define canibalization

when a new product or project reduces the sales or cash flows of an existing product from the same company.
It represents the lost revenue caused by customers switching from the old offering to the new one.

Define sunk cost

• Definition: Costs that have already been paid or will be paid no matter what you decide.

• They should NOT affect your decision, because they can’t be recovered.

Fixed overhead expenses

• These are costs that keep happening whether or not you do the project (like CEO salary or office rent).

• Don’t include them unless the project causes extra (over and above) overhead expenses.

• Example: hiring an additional manager just for the project = include it.

Should you continue a project when money has been put into it like research and development?

• Don’t continue a project just because “we already spent so much.”

• Decisions should depend only on future costs and benefits.

Sunk cost fallacy

spending on a losing project because they don’t want prior money to be “wasted.”

cash flows are often shown once per year, but in real life, they happen throughout the year.

• It’s common to estimate free cash flow annually, but sometimes firms use:

◦ Quarterly forecasts → for moderate accuracy

◦ Monthly forecasts → for riskier projects or those in unstable environments

Define MACRS (Modified Accelerated Cost Recovery System).

The U.S. tax depreciation system that assigns assets to specific recovery periods and allows accelerated depreciation in the early years.

Why the IRS Uses MACRS

To encourage investment by allowing businesses to:

• Deduct asset costs faster

• Reduce taxable income in earlier years

• Improve cash flow

Define salvage value and what is another word for it?

• When an asset is no longer needed, it can sometimes be sold or scrapped for some value.

Another word is liquidation value

Do you add liquidation value (salvage value) in free cash flow calculations?

• Include the liquidation value of any asset being sold or disposed of.

What are Tax Loss Carryforwards?

• When a firm has negative pretax income, it creates a Net Operating Loss (NOL).

• NOLs can be used to offset future taxable income, reducing future taxes.

• Under the Tax Cuts and Jobs Act (2017), firms can use NOLs to offset up to 80% of taxable income each year, and unused amounts can be carried forward indefinitely.

Define replacement decision and what to include in the analysis

• Managers often decide whether to replace old equipment with newer, more efficient machines.

When evaluating replacement, consider:

• Salvage value (cash from selling the old machine)

• Cost of the new machine

• Operating cost savings

• Additional revenue from higher output

• Depreciation effects (new depreciation vs. old)

When analyzing a capital budgeting project, managers want to make decisions that maximize

NPV

Sensitivity analysis

is used to see how changes in those assumptions ( ex. Cash flows, cost of capital) affect NPV.

It isolates each assumption (like sales volume, sale price, or cost of goods) and measures how much NPV changes when that variable changes. This helps managers:

• Identify which assumptions are most important,

• Focus on refining the most sensitive ones, and

• Manage risk more effectively.

Which 2 assumptions have the biggest impact on NPV

Units sold and sales price per unit

Break-even analysis

• Definition:
Break-even analysis finds the level of a variable (like sales or cost) at which a project’s NPV = 0 — meaning the project neither gains nor loses value.

• Purpose:
It extends sensitivity analysis by showing how far an assumption (like cost of capital or units sold) can change before the project stops being profitable.

What is the difference between IRR and Break-Even Analysis?

• IRR is the discount rate that makes a project’s NPV = 0, showing the project’s rate of return.

• Break-even analysis finds the sales or output level where profit = 0 (revenue equals cost).

• IRR measures profitability, while break-even analysis measures the minimum performance needed to avoid losses, identifies the limits within which a project remains profitable.

Scenario analysis

Scenario analysis looks at the combined effect of changing multiple variables at once (unlike sensitivity analysis, which changes one variable at a time).
It helps managers see how different sets of assumptions — like price and sales volume together — affect NPV.

Define real options

• A real option is the right—but not the obligation—to take a future business action (like delaying, expanding, or abandoning a project).

• These options add flexibility, allowing managers to make better decisions as new information becomes available.

• Because you only act on the option if it increases NPV, real options add value to investment opportunities.

Types of real options

1. Option to Delay (Timing Option)

• The firm can wait before starting a project.

• Valuable when:

◦ Component prices might drop,

◦ Technology might improve, or

◦ Market demand could grow.

• Example: Cisco might delay the HomeNet launch until market conditions improve or costs fall.

• Goal: Invest later only if waiting increases NPV.

2. Option to Expand

• The firm can start small and expand if the product succeeds.

• Example: Cisco could release HomeNet in limited markets first, then expand globally if sales are strong.

• This reduces initial risk and gives flexibility to grow when demand is proven.

Goal: Expand production only if initial results are positive.

3. Option to Abandon

• The firm can stop or exit a project if it becomes unprofitable.

• Example: If a competitor releases a cheaper product, Cisco could abandon HomeNet, sell its equipment, and limit losses.

• This option reduces downside risk and protects the company from continuous negative cash flows.

Goal: Walk away to cut losses and recover value.

If you can build greater flexibility into your project you will increase its

NPV.