Corporate Finance

Fifth Canadian Edition

Chapter 9
Fundamentals of Capital
Budgeting

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Chapter Outline
9.1 Forecasting Earnings
9.2 Determining Free Cash Flow and NPV
9.3 Choosing among Alternatives

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9.1 Forecasting Earnings
• Capital Budget
– Lists the investments that a company plans to
undertake
• Capital Budgeting
– Process used to analyze alternate investments and
decide which ones to accept
• Incremental Earnings
– The amount by which the firm’s earnings are expected
to change as a result of the investment decision

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Revenue and Cost Estimates (1 of 2)
• Example
– Spy Peripherals Incorporated (SPI) has completed a
$300,000 feasibility study to assess the attractiveness
of a new product, SPI Phone 86. The project has an
estimated life of four years.
– Revenue Estimates
 Sales = 100,000 units/year
 Per Unit Price = $260

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Revenue and Cost Estimates (2 of 2)
• Example
– Cost Estimates
 Up-Front R&D = $15,000,000
 Up-Front New Equipment = $7,500,000
– Expected life of the new equipment is 5 years
– Housed in existing lab
 Annual Overhead = $2,800,000
 Per Unit Cost = $110

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Table 9.1 The SPI Phone 86’s
Incremental Earnings Forecast

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Capital Expenditures and Capital Cost
Allowance (CCA) (1 of 3)
• The $7.5 million in new equipment is a cash expense,
but it is not directly listed as an expense when
calculating earnings. Instead, the firm deducts a
fraction of the cost of these items each year as
depreciation.
• CCA is a method specified by Canada Revenue
Agency (CRA)
• Under Canadian GAAP, CCA is usually not used but
for tax purposes, CCA is required
• It is very important for SPI to use CCA when it does
capital budgeting.
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Interest Expense
• In capital budgeting decisions, interest expense is
typically not included. The rationale is that the project
should be judged on its own, not on how it will be
financed.

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Taxes (1 of 2)
• Marginal Corporate Tax Rate
– The tax rate on the marginal or incremental dollar of
pre-tax income. Note: A negative tax is equal to a tax
credit.

Income Tax  EBIT c

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Taxes (2 of 2)
• Unlevered Net Income Calculation

Unlevered Net Income  EBIT (1  c )

 (Revenues  Costs  CCA) (1  c )

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Example 9.1 Taxing Losses for Projects
in Profitable Companies (1 of 2)
Problem
Kellogg Company plans to launch a new line of high-fibre,
gluten-free breakfast pastries. The heavy advertising
expenses associated with the new product launch will
generate operating losses of $15 million next year for the
product. Kellogg expects to earn pre-tax income of $460
million from operations other than the new pastries next
year. If Kellogg pays a 40% tax rate on its pre-tax income,
what will it owe in taxes next year without the new pastry
product? What will it owe with the new pastries?

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Example 9.1 Taxing Losses for Projects
in Profitable Companies (2 of 2)
Solution
Without the new pastries, Kellogg will owe $460 million ×
40% = $184 million in corporate taxes next year. With the
new pastries, Kellogg’s pre-tax income next year will be only
$460 million − $15 million = $445 million, and it will owe $445
million × 40% = $178 million in tax. Thus, launching the new
product reduces Kellogg’s taxes next year by $184 million −
$178 million = $6 million.

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Alternative Example 9.1 (1 of 3)
• Problem
– PepsiCo, Inc. plans to launch a new line of energy
drinks.
– The marketing expenses associated with launching the
new product will generate operating losses of $500
million next year for the product.
– Pepsi expects to earn pre-tax income of $7 billion from
operations other than the new energy drinks next year.
– Pepsi pays a 39% tax rate on its pre-tax income.

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Alternative Example 9.1 (2 of 3)
• Problem (cont’d)
– What will Pepsi owe in taxes next year without the new
energy drinks?
– What will it owe with the new energy drinks?

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Alternative Example 9.1 (3 of 3)
• Solution
– Without the new energy drinks, Pepsi will owe
corporate taxes next year in the amount of:
 $7 billion × 39% = $2.730 billion
– With the new energy drinks, Pepsi will owe corporate
taxes next year in the amount of:
 $6.5 billion × 39% = $2.535 billion
– Pre-Tax Income = $7 billion − $500 million = $6.5 billion
– Launching the new product reduces Pepsi’s taxes next
year by:
 $2.730 billion − $2.535 billion = $195 million.

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Indirect Effects on Incremental
Earnings
• Opportunity Cost
– The value a resource could have provided in its best
alternative use
– In the HomeNet project example, space will be required
for the investment. Even though the equipment will be
housed in an existing lab, the opportunity cost of not
using the space in an alternative way (e.g., renting it
out) must be considered.

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Example 9.2 The Opportunity Cost of
the SPI Phone 86’s Lab Space
Problem
Suppose the SPI Phone 86’s lab will be housed in
warehouse space that the company would have otherwise
rented out for $200,000 per year during years 1−4. How
does this opportunity cost affect the SPI Phone 86’s
incremental earnings?
Solution
In this case, the opportunity cost of the warehouse space is
the forgone rent. This cost would reduce the SPI Phone 86’s
incremental earnings during years 1−4 by $200,000 ×
(1−0.4) = $120,000 on an after-tax basis.
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Alternative Example 9.2 (1 of 2)
• Problem
– Suppose Pepsi’s new energy drink line will be housed
in a factory that the company could have otherwise
rented out for $900 million per year.
– How would this opportunity cost affect Pepsi’s
incremental earnings next year?

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Alternative Example 9.2 (2 of 2)
• Solution
– The opportunity cost of the factory is the forgone rent.
– The opportunity cost would reduce Pepsi’s incremental
earnings next year by:
 $900 million × (1 − .39) = $549 million.

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