Chapter 7

Fundamentals of Capital Budgeting

7-2

Forecasting Earnings

• Indirect Effects on Incremental Earnings – Opportunity Costs– Project Externalities

• Common Mistake: The Opportunity Cost of an Idle Asset • Sunk Costs and Incremental Earnings

– Fixed Overhead Expenses– Past Research and Development Expenditures

7-3

7-4

HomeNet’s Incremental Earnings Forecast

7-5

The Opportunity Cost of HomeNet’s Lab Space

7-6

The Opportunity Cost of HomeNet’s Lab Space

7-7

HomeNet’s Incremental Earnings Forecast Including Cannibalization and Lost Rent

7-8

Product Adoption and Price Changes

7-9

Product Adoption and Price Changes

7-10

Determining Free Cash Flow and NPV

• Calculating the Free Cash Flow from Earnings – Capital Expenditures and Depreciation– Net Working Capital (NWC)

• Calculating the NPV• Further Adjustments toFree Cash Flow

– Accelerated Depreciation– Liquidation or Salvage Value– Terminal or Continuation Value

7-11

Net Working Capital

7-12

Calculation of HomeNet’s Free Cash Flow (Including Cannibalization and Lost Rent)

7-13

HomeNet’s Net Working Capital Requirements

7-14

Change in NWC

7-15

Net Working Capital with Changing Sales

7-16

Free Cash Flow

7-17

Free CF – alternative computation

7-18

Computing HomeNet’s NPV

7-19

Computing Accelerated Depreciation

7-20

3-year property - includes small tools, houses, and assets used in research and development activities (assets with a class life of 4 years or less)

5-year property - includes automobiles, trucks, computers and peripheral equipment, and office machines (assets with a class life of 4-10 years)

7-year property - includes office furniture and fixtures, agriculture equipment, oil exploration and development equipment, railroad track, manufacturing equipment, and any property not designated by law as being in any other class (assets with a class life of 10-16 years)

10-year property - includes railroad tank cars, mobile homes, boilers, and certain public utility property (assets with a class life of 16-20 years)

15-year property - includes roads, shrubbery, and certain low-income housing (assets with a class life of 20-25 years)

20-year property - includes waste-water treatment plants and sewer systems (assets with a class life of more than 25 years)

27.5 year property - includes residential rental property

31.5 year property - includes nonresidential real property

Examples of MACRS property classes:

7-21

MACRS Depreciation Table Showing the Percentage of the Asset’s Cost That May Be Depreciated Each Year Based on Its Recovery Period

7-22

Computing Accelerated Depreciation

7-23

Salvage Values

7-24

Book Value of an Asset

7-25

After-tax Salvage Values

NPV -- dealing with salvage values

• Ristorante Roma is considering opening a new property in Fort Worth. The new restaurant requires an initial investment of $200,000 in fixed assets, which will be depreciated using straight-line method to zero over their ten-year life. The fixed assets will be used for five years, and then sold for $120,000. If the tax rate is 34%, what is the after-tax salvage value of the asset?

Sale of asset: $120,000

Book value of the asset: $100,000

Book gain $20,000

Taxes, at 34% $6,800

7-27

Adding Salvage Value to Free Cash Flow

7-28

Adding Salvage Value to Free Cash Flow

7-29

Continuation Value with Perpetual Growth

7-30

Continuation Value with Perpetual Growth

Replacement Projects

• Suppose you consider replacing your old computer, which you bought two years ago for $2,400. You can sell it today for $900. The new computer will cost you $3,200, and will provide cost savings of $600 a year over the next four years. Both the new and the old machine are depreciated over four years, straight-line. The tax rate is 34%, and the cost of capital is 12%. Should you replace the computer?

• Also see Chapter 7 / Problem 12

Year 0 1 2 3 4 Cost savings $600 600 600 600 -Depreciation on new machine 800 800 800

800 +Forgone depreciation on old machine 600 600 0 0 Cost savings before taxes $400 400 (200)

(200) -Taxes at 34% 136 136 (68) (68) Cost Savings after taxes $264 264 (132)

(132) +Depreciation on new machine 800 800 800

800 -Forgone depreciation on old machine 600 600 0 0 Operating CF $464 $464 $668 $668 Sale of old machine $900 Book value $1,200 Book loss ($300) Tax credit, at 34% $102 After-tax salvage value $1,002 Purchase of new machine ($3,200) Net CF -$2,198 $464 $464 $668

$668 PV, at 12% ($2,198) $414 $370 $475

$425

NPV ($513.8)

Equivalent annual costs

• Projects with different lives

You want to install a new software. You have the following two offers:

• Package A costs $100 to purchase and $10 to maintain. Its license must be renewed every two years.

• Package B costs $140 to purchase and $8 to maintain. It must be renewed every three years.

• Your discount rate is 10%. Ignore taxes.

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

Equivalent annual cost =present value of costs

annuity factor

• Present Values:

PV(A) = - $100 - $10 / 1.1 - $10 / 1.12 = - $117.36

PV(B) = -$140 - $8 / 1.1 - $8 / 1.12 - $8 / 1.13 = -$159.89

• Equivalent Annual Costs:

• Annuity factor, 2 years, 10% = 1.7355

• Annuity factor, 3 years, 10% = 2.4869

• EAC(A) = -$117.36 / 1.7355 = -$67.62

• EAC(B) = -$159.89 / 2.4869 = -$64.29