Fundamentals of Capital Budgeting

Capital Budgeting Process
A capital budget lists the projects and investments that a company plans to undertake during future years. This is the first step in the capital budgeting process, making a list. To be able to create this list a firm must use the capital budgeting process: analyze alternate projects and decide which ones to accept. The goal of this is to determine the effect of the final decision to accept or reject a project on the firm’s cash flows. A positive NPV (net present value) of an investment will give additional wealth to the firm. This process is quite subjective and relays on different experts within the firm to come up with estimates based on historical data. The usual starting point to using these estimates to determine the incremental earnings: the amount by which earnings are expected to change as a result of an investment decision. This forecast tells how the decision will affect the firm’s reported profits from an accounting perspective.
Remember: earnings are not actual cash flows.
Because of this, the actual cash flows (CF) need to be examined. The NPV of the cash flows to be able to decide if it should be undertaken. Being able to compute the cash flow consequences of and investment is important because 1. Financial managers often begin by forecasting earnings, 2. Accounting information is often the only information that is readily available.
Forecasting Incremental Earnings

Operating expenses v. capital expenditures

Most projects today can’t be done without some form of upfront investment; these are considered operating expenses in the year that they are incurred. Another expense that might be incurred when undertaking a project is capital expenses; these are investments in plant, property, or equipment. These expenses are indirectly accounted for by depreciation. The simplest form is straight-line depreciation where the assets cost is divided equally over its life.
Remember: depreciation expensed do not correspond to actual cash outflows.
Incremental revenue & cost estimates

This is the process of forecasting future revenues and costs, which can be challenging. The best practitioners go about this by collecting as much information as possible before actually starting the forecast. Some important things to consider when doing this are:
1. New products tend to have lower initial sales. Sales will then accelerate, plateau, and finally decline as the product nears obsolescence or faces increased competition.
2. The average selling price and cost of production will generally change over time. Inflation tends to increase the price but superior technologies tend to lower the price.
3. For most industries, competition tends to reduce profit margins over time.
When trying to get to a final cash flow projection, revenue and cost estimates should be incremental – only account for additional sales and costs generated by the project. Because we now understand incremental revenue and costs and depreciation, we can find incremental earnings before interest and taxes (EBIT):
Incremental EBIT = Incremental revenue – Incremental costs – Depreciation

This is the final expense that is accounting for. The rate that should be used in the firm’s marginal corporate tax rate: tax rate a firm will pay on an incremental dollar of pre-tax income. So the incremental income tax expense is:
Incremental tax = EBIT * Marginal corporate tax rate.
Incremental earnings forecast

Once all the revenues, costs, and expense have been determined, we can finally compile an incremental earnings forecast. This can be done either in a spreadsheet or done directly as follows:
Incremental earnings = (Incremental revenues –Incremental cost – Depreciation) *(1 – Tax Rate) Pro Forma StatementThis is the spreadsheet that is made when finding incremental earnings. It’s called pro forma because it is not based on actual data but rather depicts the firm’s financials under a given set of hypothetical assumptions.
Taxes and negative EBIT
A negative EBIT may not be as bad as many people think it is. There are still tax savings even with a negative EBIT. This is because tax savings come from the depreciation expense.

Interest Expense
When evaluating a capital budgeting decision do not include interest expenses, generally. Most interest expense comes from the financing of the project and not the project itself. Because of this projects are evaluated as if the company will not use any debt to finance the project – unlevered net income.

Determining Incremental Free Cash Flow (FCF) Because earnings do not represent actual cash flows, they cannot be used to buy goods, pay employees, fund new investments, or pay dividends to shareholders, only cash can do these things. The project’s incremental FCF is the incremental effect of a project on a firm’s available cash.
Calculating FCF from earnings
To determine FCF from incremental earnings, we must adjust for non-cash charges and cost of capital.

Capital expenditures & depreciation
Because depreciation is not a cash expense, it shouldn’t be included in an increment FCF analysis, so it is added back into incremental earnings. Doing this recognizes the fact that the firm still has the cash flow from depreciation – no cash left the firm due to it.

Net working capital (NWC)
Remember, net working capital is the difference between current assets and current liabilities. The main components of NWC are cash, inventory, receivables, and payables. So:

NWC = Current assets – Current liabilities
=Cash + Inventory + Receivables - Payables

Most projects will require investment in NWC, or the firm may need to maintain a minimum cash balance to meet unexpected expenditures. Customers may not pay for their purchased good immediately, but sales are immediately counted as part of earnings – firm doesn’t receive any actual cash. A trade credit is the difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions. More simply, trade credit is the credit a firm extends to its customers. The importance of NWC is that it reflects a short-term investment that ties up cash flow that could be used elsewhere. However, only changes in NWC impact cash flows. We find changes in NWC by:
Changes in NWC in year t = NWCt – NWCt-1
To arrive at the incremental FCF, this change in NWC must be subtracted from the incremental earnings.

Calculating FCF directly
This shorthand formula is:

FCF = (Revenues – Costs – Depreciation) * (1 – Tax rate) + Depreciation – CapEX – Change in NWC
= (Revenues – Costs) * (1 – Tax rate) – CapEx – Change in NWC + Tax rate * Depreciation
In the second equation, the last term (tax rate * depreciation) is called the depreciation tax shield. This shield is the tax savings that results from the ability to deduct depreciation. This gives depreciation a positive impact on FCF.

Calculating the NPV
This is the ultimate goal of forecasting the incremental FCF. To find NPV, we must discount the FCF at ht appropriate cost of capital. The PV of the FCF in year t (FCFt) is:

PV(FCFt) = FCFt / (1+r)^t
= FCFt * 1 / (1+r)^t

Other Effects on Incremental FCF
Opportunity costs

Opportunity cost is the value a resource could have provided in its best alternative use. Because this value is lost when the resource is used by another project, it should be included as an incremental cost of the project.

Project externalities
Project externalities are indirect effects of a project that may increase or decrease the profits of other business activities of the firm. This is where a situation called cannibalization occurs. Cannibalization is when sales of a firm’s new product displace sales of one of its existing products.

Sunk Costs
Sunk costs are any unrecoverable cost for which a firm is already liable. These are costs that have been or will be paid regardless of the decision whether or not to proceed with the project. These should not be included because they are not incremental in nature. A good rule to remember is if your decision does not affect a cash flow, then the cash flow should not affect your decision.

Fixed overhead expenses
These expenses are a type of sunk cost. Overhead expenses are those expenses associated with activities that are not directly attributable to a single business activity but instead affect many different areas of a corporation. These expenses are often allocated to the different business activities for accounting purposes. Only additional overhead expenses that arise because of the decision to take on the project should be included in the FCF analysis.

Past research and development expenditures
These are another type of sunk costs, which should not be included in the FCF assessment. This is because these are obligations that must be paid regardless of whether if project is accepted or rejected.

Adjusting FCF
The following sections discuss a number of complications that can arise when estimating a project’s FCF.

Timing of cash flows
The previous discussions assume that cash flows occur at annual intervals, this is not the case in regular business practices. The greater the number of cash flows per year, the greater the accuracy that is found.

Accelerated depreciation
Depreciation contributes positively to the firm’s cash flow through the depreciation tax shield. This means it is in the firm’s best interest to use the most accelerated method of depreciation that is allowable for tax purposes. This will increase the PV of the investment. MACRS depreciation does just that.

Liquidation or salvage value
The salvage value is the amount of money that can be received when outdated or unwanted equipment can be sold for scrap. In the calculation of FCF, the liquidation value is included. Any capital gain earned on the sale is taxed as income.

Capital gain = Sale price –Book value
Book value = purchase price – Accumulated depreciation.
The project’s FCF must be adjusted to account for the after-tax cash flow that results in:

After-tax cash flow from asset sale = Sale price – (Tax rate * Capital gain)

Tax carryforwards
This is the last adjustment to FCF that is discussed. A tax carryforward is the ability of the firm to carry losses back or forward to offset the taxes they owe. A carryback can go back 2 years, and a carryforward can go as far as 20 years.

Replacement decisions
Replacement decisions are when the financial manager must decide whether to replace an existing piece of equipment. The new piece may result in incremental revenue or may only more efficient and lower costs.

Analyzing the Project
This is where the financial managers must evaluate the projects and make the decision that maximizes the NPV. The most difficult part of capital budgeting is deciding how to estimate the cash flows and cost of capital. Because of these uncertainties, methods have been developed that assess the importance of this uncertainty and identify the drivers of value of the project.

Sensitivity analysis
The sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. This is done on a one-to-one basis, where one assumption is compared to eh NPV. The assumptions with the largest effect on NPV deserves the greatest scrutiny during the estimation process, during managing the project, and after the project starts.

Break-even analysis
The break-even point is the level for which an investment has an NPV of zero. An analysis of the break-even point give the level at which each parameter calculated equals zero. This is done on spreadsheet since doing so would be tedious by hand. An accounting break-even analysis would be something like an EBIT break-even for sales. This the level of sales for which the project’s EBIT is zero.

Units sold = (SG&A + Depreciation) / (Sale price – Cost per unit)
Scenario analysis

A scenario analysis is like a sensitivity analysis except that it determines how the NPV varies as a number of the underlying assumptions are changed simultaneously. This changes multiple parameters at the same time.

Real Options in Capital Budgeting
A real option is the right, but not the obligation, to make a particular business decision. This means a firm can choose to only accept any changes that would increase the NPV of a project. This allows a firm to choose only the most attractive alternative after new information has been learned.

Option to delay
An option to delay is the option to time a particular investment, this is almost always present. This means that as new information becomes available, a firm may choose to delay a project to reap additional benefits.

Option to expand
An option to expand starts with limited production and expand only if the project is successful. This would be a firm that started with a project in a small market and wait to see if the product is successful it can then choose to expand later.

Option to abandon
An option to abandon allows an investor to cease making investments in a project. Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful. If something developments in the market that causes a great negative impact on the NPV of the firm’s project.