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Chapter 7

Chapter 7. Fundamentals of Capital Budgeting. 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

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Chapter 7

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  1. Chapter 7 Fundamentals of Capital Budgeting

  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

  3. HomeNet’s Incremental Earnings Forecast

  4. The Opportunity Cost of HomeNet’s Lab Space

  5. The Opportunity Cost of HomeNet’s Lab Space

  6. HomeNet’s Incremental Earnings Forecast Including Cannibalization and Lost Rent

  7. Product Adoption and Price Changes

  8. Product Adoption and Price Changes

  9. 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

  10. Net Working Capital

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

  12. HomeNet’s Net Working Capital Requirements

  13. Change in NWC

  14. Net Working Capital with Changing Sales

  15. Free Cash Flow

  16. Free CF – alternative computation

  17. Computing HomeNet’s NPV

  18. Computing Accelerated Depreciation

  19. Examples of MACRS property classes: 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

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

  21. Computing Accelerated Depreciation

  22. Salvage Values

  23. Book Value of an Asset

  24. After-tax Salvage Values

  25. 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

  26. Adding Salvage Value to Free Cash Flow

  27. Adding Salvage Value to Free Cash Flow

  28. Continuation Value with Perpetual Growth

  29. Continuation Value with Perpetual Growth

  30. 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

  31. 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)

  32. 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.

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

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

  35. 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

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