Capital Budgeting

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Resources

• FCF Definition Slides, Risk Analysis Slides, HomeNet NPV Model (Excel)

Capital budgeting is the process of evaluating investments (determining NPV) to decide how to allocate capital budget. Incremental earnings are the additional earnings generated by an investment, calculated as the difference between the project’s cash flows and the cash flows without the project. This section focuses on how to determine free cash flow (FCF).

Determining Free Cash Flow

Free Cash Flow (FCF)

Free cash flow (FCF) is the cash generated by a project that is available to be distributed to all capital providers (debt and equity holders). This is not based on net income to avoid tax shield effects.

$$FCF=EBIT\cdot (1-t)+\text{Depreciation}-\text{Capital Expenditures}-\text{Change in Working Capital}$$

(note that $EBIT\cdot (1-t)$ is also called the unlevered net income and explained below)

Working capital is the difference between non-cash current assets and non-interest-bearing current liabilities. It represents the amount of capital tied up in the day-to-day operations of a business.

An alternative formula for FCF is: $FCF=EBIT\cdot (1-t)-\text{Incr. in Net Fixed Assets}-\text{Incr. in Net Working Capital}$, where the increase in net fixed assets is the capital expenditures minus depreciation.

Net Present Value (NPV)

NPV aggregates the present value of all future cash flows generated by a project, discounted at the project’s cost of capital. A positive NPV indicates that the project is expected to generate more value than it costs, while a negative NPV suggests that the project may not be financially viable.

$$NPV=\sum _{t=0}^n\frac{FC{F}_t}{(1+r{)}^t}-\text{Initial Investment}$$

Relevant Cash Flows

The income statement alone is not sufficient to determine FCF, as it includes non-cash expenses (e.g., depreciation) and does not account for changes in working capital or capital expenditures. Therefore, adjustments are necessary to calculate FCF from the income statement, depending on the stakeholder group.

First, an unlevered net income is calculated by adding back interest expenses to the net income, which represents the cash flow available to all capital providers. Then, adjustments for non-cash expenses (e.g., depreciation) and changes in working capital and capital expenditures are made to arrive at the FCF.

Unlevered Net Income

Unlevered net income represents a project’s theoretical income if it had no debt and therefore no interest expenses. It’s used to evaluate a project solely on its operations.

$$\begin{array}{rl}\text{Unlevered Net Income}& =(\text{Sales}-\text{COGS}-\text{Operating Expenses}-\text{Depreciation})\cdot (1-\text{Tax Rate})\\ & =EBIT\cdot (1-{\tau }_c)\end{array}$$

Cannibalization (Erosion)

The loss of sales in a firm’s existing product line due to the introduction of a new product. The unlevered net income only includes the incremental effect on the firm.
$\text{Incremental Revenue}={\text{Sales}}_{\text{New}}-{\text{Lost Sales}}_{\text{Existing}}$

Opportunity Cost and Sunk Costs

Opportunity cost is the value of the next best alternative that is foregone when a decision is made. Sunk costs are costs that have already been incurred and cannot be recovered. When evaluating a project, only incremental cash flows should be considered, which means that sunk costs should be ignored, while opportunity costs should be included in the analysis.

Working Capital

The Net Working Capital of a firm is simply its current assets minus its current liabilities. This helps measure liquidity, as it indicates how much capital is tied up in the day-to-day operations of the business.

When calculating FCF, changes in working capital are important because they represent the cash that is either tied up or released from operations. An increase in working capital (e.g., more inventory or accounts receivable) represents a use of cash, while a decrease in working capital (e.g., more accounts payable) represents a source of cash.

Assessing Risk

The risk of a project in the context of capital budgeting is its chance of generating a negative NPV. Three basic methods are presented here:

Break-Even Analysis

The break-even analysis computes the level of a parameter that results in an NPV of zero. This can be used to determine the minimum sales volume, price, or cost reduction required for a project to be viable. For example, the break-even sales volume can be calculated by setting the NPV formula to zero and solving for the sales volume.

Sensitivity Analysis

The sensitivity analysis reveals how the NPV changes when a single parameter is varied while keeping all other parameters constant. This helps identify which parameters have the most significant impact on the project’s viability and can guide management in focusing their attention on the most critical factors.

Scenario Analysis

The scenario analysis evaluates the NPV under different realistic combinations of parameters to understand how changes in multiple factors simultaneously affect the project’s viability. This can involve creating best-case, worst-case, and base-case scenarios to capture a range of possible outcomes and their implications for decision-making.