FINA 2303 Spring 2023

Chapter 9: Fundamentals of Capital Budgeting

Objective: To estimate cash flows to compute present value

 
𝐶𝐹
PV of cashflows
1 𝑟

Relevant Cash Flows

 Only include incremental cash flows, i.e., the cash flows affected by the project.

 Cash Flows that will occur regardless of whether the project is undertaken is NOT
relevant

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FINA 2303 Spring 2023

Asking the Right Questions

You should always ask yourself “Will this cash flow occur (or change) ONLY if we
accept the project?”

 If the answer is “yes”, it should be included in the analysis because it is

incremental cash flow

 If the answer is “no”, it should not be included in the analysis because it will
occur anyway

 If the answer is “part of it”, then we should include the part that occurs because
of the project

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FINA 2303 Spring 2023

Common Types of Cash Flows

 Sunk costs – costs that have accrued in the past, and cannot be changed
regardless of our decisions today.

 Opportunity costs – costs of best option forgone

 Side effects
o Positive side effects – benefits to other projects
o Negative side effects – costs to other projects

 Changes in net working capital (increase/decrease in cash & inventory

relative to the increase/decrease in current liabilities)

 Taxes – we are always interested in after-tax cash flow.

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FINA 2303 Spring 2023

Sunk Costs

Example: Firm X paid $100 to a consultant to analyze the feasibility of project A. The
consultant concludes that we have to spend another $150 to start the project. Suppose that
the project will generate cash flow $220 at the end of year 1 before being terminated.
Should we invest in this project? Assume interest rate = 0%

-150 + 220

t =0 t =1

$100 = Sunk costIt will not (and should not) affect your decision

NPV of accepting the project  -150 + 220/(1+0%) = +70 profit  invest

NPV of not accepting the project  0

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FINA 2303 Spring 2023

Even if you insisted to include the sunk cost in your analysis, it will not affect your
decision

NPV of accepting the project  -100-150 + 220/(1+0%) = -30

NPV of not accepting the project  -100

 NPV of accepting the project is higher than not accepting the project regardless of
your treatment on sunk costs.

 However, the best practice is to ignore sunk costs when you analyze the feasibility
of a project

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FINA 2303 Spring 2023

Externalities

 Our new project may have impact on other projects

 Cannibalization – a situation when sales of a firm’s new product displace sales of its
existing products.

 Example: If 25% of sales come from customers who would have purchased another
product of our company at $100 per unit. COGS of that product is 60 per unit. How
should you adjust your calculation based on this situation?
   

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FINA 2303 Spring 2023

 
Net Income   Cash Flow 
 
Assume Dell sold a $1,000 computer to a customer who paid all $1,000 in cash 
Note that the depreciation for the period is $100 
 
 
Income Statement  Cash Flows
Sales  $1,000  Cash from customer $1,000
Cost of goods sold  ‐500 Pays supplier ‐500
Selling expense  ‐100 Pays selling expense ‐100
Depreciation  ‐100 Pays tax  ‐102
      Operating profit (EBIT)  300 Assume no Capital Spending 0
Tax 34%  ‐102 Assume no other cash flows 0
      Net income  198 Cash flow 298
 
 
 
 
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FINA 2303 Spring 2023

 
What if Depreciation increases by 100? 
 
Income Statement  Cash Flows
Sales  $1,000  Cash from customer $1,000
Cost of goods sold  ‐500 Pays supplier ‐500
Selling expense  ‐100 Pays selling expense ‐100
Depreciation  ‐200 Pays tax  ‐68
      Operating profit (EBIT)  200 Assume no Capital Spending 0
Tax 34%  ‐68 Assume no other cash flows 0
      Net income  132 Cash flow 332
 
• Increase in Depreciation helps reduce tax  Increase cash flow 
• Cash Flow increase = 332‐298 = 34 
Cash Flow increase = Increase in Depreciation * Tax rate = 100 * 34% = 34 
 
• Depreciation Tax Shield = A reduction in tax that results from depreciation 
 
• Note: We have to pay cash for fixed assets earlier to have depreciation  
 
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FINA 2303 Spring 2023

Net Income   Cash Flow when transactions are not 100% cash 
 
Assume Dell sold a $1,000 computer to a customer who paid only $50 in cash 
and will pay the rest later (on credit). Account receivable increases by $950. 
Note that the depreciation for the period is $100 
 
Income Statement  Cash Flows
Sales  $1,000  Cash from customer 50
Cost of goods sold  ‐500 Pays supplier ‐500
Selling expense  ‐100 Pays selling expense ‐100
Depreciation  ‐100 Pays tax  ‐102
      Operating profit (EBIT)  300 Assume no Capital Spending 0
Tax 34%  ‐102 Assume no other cash flows 0
      Net income  198 Cash flow ‐652
 
Note: firms usually do not pay 100% cash to supplier (account payable). This 
and other issues will make cash flow calculations become more complicated 
   

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FINA 2303 Spring 2023

 
Free Cash Flow and PV 
 
𝐶𝐹
PV of cashflows  
1 𝑟
 
In this chapter, Cash Flow (CF) refers to FCFF. Our textbook simply refers to 
FCFF as Free Cash Flow, FCF. 
 
Free Cash Flow to Firm (FCFF)   =   Cash flows to all investors  
 
Free Cash Flow to Firm (FCFF)   =   Cash flow to bondholders (creditors) 
                               + Cash flow to stockholders (owners) 
 
 
Cash flow to creditors = Interest paid – Net new borrowing 
 
Cash flow to stockholders = Dividends paid – Net new equity raised 
         

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FINA 2303 Spring 2023

Pro Forma Statements and Cash Flow

 Capital budgeting relies heavily on pro forma (projected) accounting statements,
particularly income statements

 Computing cash flows  all numbers are the changes, i.e., incremental Cash flows.

 “Unlevered” indicates that we compute FCFF as if the firm has no interest-bearing

liabilities. We compute this way because we will use Weighted Average Cost of
Capital as the discount rate. This type of discounted cash flow model is called
WACC approach.

Unlevered Free cash flow to firm (FCFF) = EBIT - $ taxes

+ Depreciation
- Changes in net working capital
- Capital expenditure

Incremental earnings = Revenue - Operating costs - Depreciation - $ taxes

(Unlevered net income)
= EBIT - $ taxes

= EBIT (1- tax rate)

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FINA 2303 Spring 2023

Note:

 When evaluating a capital budgeting decision, we generally do not include interest

expense

 Any incremental interest expenses will be related to the firm’s decision regarding
how to finance the project

 Here we wish to evaluate the project on its own, separate from the financing
decision.

 If your company has debt, to compute FCFF you must ignore the debt & interest expenses
and compute incremental earnings = unlevered net income = EBIT (1- tax rate)

 Firms typically calculate a project’s cash flows under the assumption that the project is
financed only with equity. Any adjustments for debt financing are reflected in the discount
rate, not the cash flows.

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FINA 2303 Spring 2023

Unlevered FCFF = Incremental earnings

+ Depreciation
- Changes in net working capital
- Capital spending

Unlevered FCFF = Revenue - Operating costs – Depreciation - $ taxes

+ Depreciation
- Changes in net working capital
- Capital spending

Unlevered FCFF = (Revenue - Operating costs – Depreciation) × (1-tax rate)

+Depreciation
- Changes in net working capital
- Capital spending

Unlevered FCFF = (Revenue - Operating costs) × (1-tax rate)

- Changes in net working capital
- Capital spending
+ (Depreciation × Tax Rate)

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FINA 2303 Spring 2023

Depreciation
 The method for calculating depreciation expenses used for capital budgeting should
be the same method used for computing depreciation expenses for tax purposes

 Depreciation itself is a non-cash expense; consequently, it is only relevant because it

affects taxes

 Straight-line depreciation

 Depreciation per year = (Initial cost – expected salvage value) / number of years

 salvage value = the estimated value of an asset at the end of its useful life

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FINA 2303 Spring 2023

After-tax Salvage
 If you sell the asset at a price different from the book value of the asset, then there is
a tax effect

 Book value = initial cost – accumulated depreciation

 After-tax cash flow from asset sale = Sale Price – {Tax rate × (Sale Price – book value)}

Profit or Loss

Market Price
when we sell the
machine

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FINA 2303 Spring 2023

Example: Depreciation and After-tax Salvage

 You purchase equipment for $100,000 including delivery and installation fee. The
equipment will be depreciated according to five-year straight-line depreciation and
its salvage value is expected to be zero at the end of year 5.

 Suppose that you sell the equipment for 50,000 at the end of year 3. Compute the
after-tax cash flow from the asset sale

 Assume marginal tax rate = 40%

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FINA 2303 Spring 2023

Straight-line Depreciation

 Depreciation = (100,000 – 0) / 5 = 20,000 every year for 5 years

Year Beginning Book Value Depreciation Ending Book Value

1 100000 20000 80000
2 80000 20000 60000
3 60000 20000 40000
4 40000 20000 20000
5 20000 20000 0

 BV at the end of year 3 = 100,000 – 3(20,000) = 40,000

 After-tax cash flow from asset sale = 50,000 - 0.4(50,000 – 40,000) = 46,000

 If we sell equipment for 30,000 instead of 50,000

After-tax cash flow from asset sale = 30000 – 0.4(30,000 – 40,000) = 34,000

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FINA 2303 Spring 2023

Depreciation Tax Shield

Depreciation tax shield = the tax savings that result from the ability to deduct
depreciation

 If tax rate = 40%

 Every $1 dollar of depreciation reduces tax by $0.4

 Depreciation tax shield = Depreciation × tax rate

 If tax rate rises, the benefit of depreciation tax shield also rises

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FINA 2303 Spring 2023

Net Working Capital

Net Working Capital = Current Assets – Current Liabilities

Net Working Capital = Cash + Inventory + Account Receivables – Account Payables

 Increase NWC  Assets increase faster than liabilities  Reduce Cash Flows

 Initial increase in inventory and cash reserve usually occurs at time 0 (prior to first sale)

 Here, we do not include short-term (interest-bearing) financing such as notes payable or

short-term debt because they represent financing decisions

 Here, we are analyze the project without the influence of financing decisions

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FINA 2303 Spring 2023

Cash Flows of a Typical Project

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FINA 2303 Spring 2023

Example: Shark Attractant Project (see Excel Spreadsheet)

 Projected sales = 50,000 cans of shark attractant per year

 Revenue per can = $4
 Cost per can = $2.5
 Fixed cost (including rent on facility) = $12,000 per year
 Product life = 3 years.
 Equipment = $90,000 (100% depreciated over the three year period straight line)
 Salvage value = 0
 Net working capital at the beginning = $20,000
 Net working capital at the end of final year = $0
 Tax rate = 34%
 Cost of capital = 20%

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FINA 2303 Spring 2023

Replacement Decisions
 Should we replace existing equipment?

 For old equipment

o After-tax cash flow from selling the old equipment

 New Equipment
o Cost of the new equipment
o Increase production and incremental revenue
o More efficient, lower costs

 Depreciation effects

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FINA 2303 Spring 2023

Example: Replacement Problem (See Excel)

Original Machine
 Initial cost = 100,000
 Annual depreciation = 10000
 Purchased 5 years ago
 Book Value today = 50,000
 Market price of m/c today = 65,000
 Market price of m/c in 5 years = 10,000

New Machine
 Initial cost = 150,000
 5-year life
 Salvage in 5 years = 0
 Cost savings = 50,000 per year
 5-year straight-line depreciation

Assume
 Cost of capital = 10%
 Tax rate = 40%

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FINA 2303 Spring 2023

Example: Cost Cutting (See Excel)

 Your company is considering a new computer system that will initially cost $1
million.

 It will save $300,000 a year in management costs with no impact on revenue.

 The system is expected to last for five years and will be depreciated using 4-year
straight-line.

 Our accountant determines that the book value of the equipment will be zero at the
end of year four.

 However, our financial analyst expects that we can sell the machine for $50,000 at
the end of year 5.

 There is no impact on net working capital. The marginal tax rate is 40%. Cost of
capital is 8%.

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FINA 2303 Spring 2023

More Examples

Wilbert's, Inc. paid $90,000, in cash, for a piece of equipment three years ago. Last year,
the company spent $10,000 to update the equipment with the latest technology. The
company no longer uses this equipment in its current operations and has received an offer
of $50,000 from a firm who would like to purchase it. Wilbert's is debating whether to
sell the equipment or to expand its operations such that the equipment can be used. When
evaluating the expansion option, what value, if any, should Wilbert's assign to this
equipment as an initial cost of the project?

CF0 = $50,000

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FINA 2303 Spring 2023

Kurt's Kabinets is looking at a project that will require $80,000 in fixed assets and
another $20,000 in net working capital. The project is expected to produce sales of
$110,000 with associated costs of $70,000. The project has a 4-year life. The company
uses straight-line depreciation to a zero book value over the life of the project. The tax
rate is 35%. What is the incremental earnings for this project?

Tax = .35  [$110,000 - 70,000 - ($80,000  4)] = $7,000;

Incremental earnings = Sales – Cost – Depreciation – Tax = 110000 – 70000 – 20000 –

7000 = 13000

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FINA 2303 Spring 2023

Matty's Place is considering the installation of a new computer system that will cut
annual operating costs by $11,000. The system will cost $48,000 to purchase and install.
This system is expected to have a 5-year life and will be depreciated to zero using
straight-line depreciation. What is the incremental amount of the earnings before interest
and taxes for this project?

Earnings before interest and taxes = $11,000 - ($48,000  5) = $1,400

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Example: Shark Attractant

Sales volume
Revenue per unit
Cost per unit
Fixed cost (rental & Mkt)
Product life
Equipment
Equipment life
Salvage value
NWC at beginning
NWC at the end of final year
Tax rate
Cost of Capital

Pro Forma incremental income statement
Year
0 1 2 3
Sales
Variable costs
Fixed costs
Depreciation
EBIT
Taxes 
Incremental earnings

 Net Working Capital = Current Assets ‐ Current Liabilites = Cash + Inventory + Receivables ‐ Payables
 Note: Do not include short‐term interest‐bearing financing such as notes payable & short‐term debt here
Year
0 1 2 3
NWC 
Change in NWC <‐‐ Sum of change NWC
        = 0
Unlevered Net Income = Incremental earnings = Revenue ‐ Operating costs ‐ Depreciation ‐ Tax = EBIT * (1‐tax rate)
Free Cash Flow = Incremental Earnings + Depreciation ‐ Changes in Net Working Capital ‐ Capital Spending 
Year
0 1 2 3
Incremental earnings
 + Depreciation
 ‐ Change in NWC
 ‐ Capital Spending
Incremental Free Cash Flows

NPV 
IRR

NPV ‐‐ Sales Volume and Cost of Capital
Cost of Capital
0 12% 16% 20% 24% 28%
               30,000
               40,000
Sales Volume                50,000
               60,000
               70,000
Example: Cost cutting
Your company is considering a new computer system that will initially cost $1 million. 
It will save $300,000 a year in management costs. 
The system is expected to last for five years and will be depreciated using 4‐year Straight‐line
Book value of the equipment = 0 at the end of year 4
We expect to sell the machine for $50,000 at the end of year 5. 
There is no impact on net working capital. The marginal tax rate is 40%. Cost of capital is 8%.

Initial Cost
Savings
Tax Rate
Expected Salvage
Cost of Capital

Depreciation Schedule
Year 0 1 2 3 4 BV year 5
Percentage 25.00% 25.00% 25.00% 25.00%
Depreciation Expense

Pro Forma incremental income statement
Year 0 1 2 3 4 5
Increase in Savings
Depreciation
Increase in EBIT
Taxes (0.4 × EBIT)
Incremental earnings

Unlevered Net Income = Incremental earnings = Revenue ‐ Operating costs ‐ Depreciation ‐ Tax = EBIT * (1‐tax rate)
Free Cash Flow = Incremental Earnings + Depreciation ‐ Changes in Net Working Capital ‐ Capital Spending 
Year
0 1 2 3 4 5
Incremental earnings
 + Depreciation
 ‐ Change in NWC
 ‐ Capital Spending
Incremental FCFs

NPV
IRR
Example: Replacement Problem

Original Machine Original Machine

 Initial cost = 100,000 Initial Cost
 Annual depreciation = 10000 Annual Depreciation
 Book Value today = 50,000 Book Value now
 Mkt price of m/c today = 65,000 Today can sell m/c at
 Mkt price of m/c in 5 years = 10,000 In  year 5 can sell m/c at

New Machine New Machine

 Initial cost = 150,000 Initial cost 
 5-year life Life (Year)
 Salvage in 5 years = 0 in year 5 can sell m/c at
 Cost savings = 50,000 per year Cost savings
 5-year straight line depreciation

 Required return = 10% Required return

 Tax rate = 40% Tax Rate

Remember that we are interested in incremental cash flows
If we buy the new machine, then we will sell the old machine
If we sell the old machine now, then we cannot sell the old machine later

Pro Forma incremental income statement
Year 0 1 2 3 4 5
Increase in Savings
Depreciation
  New
  Old
Incremental Depre
Increase in EBIT
Increase Taxes 
Incremental earnings

Net capital stpending
Year 0
Cost of new machine =
After-tax cash flow from selling the old machine =
Incremental net capital spending =
Year 5
After-tax salvage on old machine =

Unlevered Net Income = Incremental earnings = Revenue ‐ Operating costs ‐ Depreciation ‐ Tax = EBIT * (1‐tax rate)
Free Cash Flow = Incremental Earnings + Depreciation ‐ Changes in Net Working Capital ‐ Capital Spending 
Year
0 1 2 3 4 5
Incremental earnings  
 + Depreciation
 ‐ Change in NWC
 ‐ Capital Spending
Incremental FCFs

NPV