0:08

In this video, we will look at a detailed capital budgeting example.

Â We will focus on estimating free cash flows using

Â the indirect method which requires us to first calculate the net income.

Â Once we have the FCFs,

Â we will compute the project's NPV.

Â Let's go back to the situation where an FMCG firm is considering investing in

Â a sophisticated analytics platform that will help

Â its product development group create superior customer value propositions.

Â We look at this as a standalone project and

Â not as a choice between two projects as we did earlier.

Â We will change some of the numbers and add more information.

Â The initial hardware and software costs for

Â this business intelligence platform is $500,000.

Â This costs will be depreciated over five years,

Â which means annual depreciation and amortization expenses will be $100,000.

Â Some employees will need to be trained to work on

Â the business intelligence platform for which

Â the company will incur a one-time cost of $100,000.

Â The company has office space that it isn't using and has rented it out.

Â It turns an annual rental of $100,000 on this office space.

Â However, if it starts using the business intelligence platform,

Â it will need to use this office space to house

Â the business intelligence platform and the team that will operate it.

Â There is uncertainty about how large the increase in revenues will be.

Â There's a 50% chance that

Â the business intelligence platform will increase revenues by $500,000 in the first year,

Â which will then grow at 15% per year over

Â the next two years and at half that rate over the following two years.

Â There's a 50% chance that revenues will increase only by $300,000 in the first year,

Â which will grow at a constant 5% a year after that.

Â Cost of goods sold will be a constant 65% of revenues, and additional selling,

Â general and administrative expenses will be $150,000 in the first year,

Â which will increase at an inflation rate of 3% a year after that.

Â The uncertainty will affect only the revenues and

Â COGS and none of the other costs related to the project.

Â The increased revenues will need to be supported by

Â additional investments of $200,000 in inventories,

Â $125,000 in accounts receivable and $180,000 in accounts payable.

Â Introducing the business intelligence platform will reduce some of

Â the company's existing marketing costs by $50,000 in the first year.

Â This saving will increase at an inflation rate of 3% a year after that.

Â We will look at the five-year horizon after which FCFs are

Â expected to increase at a constant 5% a year forever.

Â The company will incur annual interest expenses of

Â $50,000 on loans that the company has taken to fund this project.

Â The company has a tax rate of 35% and a weighted-average cost of capital of 10% per year.

Â Should the FMCG go ahead with the business intelligence platform?

Â Let's build the entire problem in an Excel spreadsheet.

Â Since there is uncertainty about the revenues,

Â we will build separate Excel spreadsheets for the two possibilities.

Â The first step is to build the income statement and determine the additional net income.

Â All cells in yellow are numbers that we input.

Â Cells not highlighted in yellow contain formulas.

Â We calculate the net income by starting with revenues.

Â Revenues are $500,000 in the first year,

Â which increases by 15% to $575,000 in the second year.

Â This is followed by a further increase of 15% to $661,250 in the third year.

Â Revenues then increase at 7.5% a year over the remaining two years to

Â $710,844 and $764,157, respectively.

Â COGS are 65% of revenues in each year.

Â You can see the annual COGS on the spreadsheet.

Â SG&A are $150,000 in the first year,

Â which then increase at 3% a year after that.

Â The numbers are all in the Excel spreadsheet.

Â Subtracting COGS and SG&A from revenues gives us the annual EBITDA.

Â The hardware and software cost of $500,000 are depreciated over 5 years.

Â Annual depreciation costs are $500,000 divided by five, which is $100,000.

Â Subtracting our depreciation cost from EBITDA gives us the EBIT for each year.

Â Next, we subtract the interest expense of $50,000 each year,

Â which gives us earnings before tax.

Â Paying taxes at 35% of EBT gives us the net income for each year.

Â Now that we have calculated the net income,

Â we can make adjustments to it to arrive at the FCFs.

Â The first step is to add back the depreciation cost as it is a non-cash expense.

Â Next, we need to add back

Â after-tax interest expense as it is a financing and not an operations-related cash flow.

Â Since starting the platform results in the loss of $100,000 in annual rental income,

Â we need to subtract out the after-tax rental income.

Â Next, we add the positive side effect of savings in marketing cost.

Â The company saves $50,000 in the first year and that grows at 3% a year.

Â This is added back on an after-tax basis every year.

Â Making all these adjustments to net income yields us the

Â annual operating cash flows which you can again see on the spreadsheet.

Â Next, we determine the time-zero cost.

Â Hardware and software costs are $500,000.

Â One-time training costs are $100,000,

Â which on an after-tax basis are $65,000.

Â The project requires an increase in inventory and accounts receivable of

Â $200,000 and $125,000, respectively.

Â These increases lead to outflows and hence they must be subtracted.

Â The increase in accounts payable would be an inflow as the

Â company's delaying some of its cash payments,

Â so we need to add $180,000.

Â Adding all these time-zero cash flows yields year-zero FCFs of -$580,000.

Â Finally, we calculate the terminal value of the project.

Â The FCFs are expected to grow at 5% a year beyond the fifth year forever.

Â This is a growing perpetuity.

Â The year-six FCF is the year-five FCF of $70,688 times 1+0.05.

Â The PV of this growing perpetuity is $70,688

Â times one plus point zero five divided by 0.1-0.05,

Â which gives us $1.484 million.

Â We add this to the year-five operating cash flow to get the year-five FCF.

Â Now that we have all FCFs,

Â we can calculate the project's NPV using a discount rate of 10%.

Â This comes to $510,770.

Â Remember that this is only one possibility and there is a 50% chance of this happening.

Â There is a 50% chance that additional revenues are lower,

Â as are its growth rate.

Â The only difference is, in this case,

Â are lower first-year revenues of $300,000 and it growing at 5% a year after that.

Â I'll let you create another spreadsheet changing only these two values,

Â everything else stays the same.

Â The NPV for the low-sales scenario comes to a -$934,007.

Â Putting the two possibilities together,

Â there's a 50% chance that the NPV is a

Â +$510,770 and a 50% chance that the NPV is a -$934,007.

Â The expected NPV of this project is 0.5 times $510,770

Â plus 0.5 times -$934,007, which is -$211,618.

Â Since we have a negative NPV,

Â the company should reject this project.

Â In this video, we have looked at

Â a detailed example of estimating FCFs and calculating NPV.

Â How are these FCFs depend on a number of projections and assumptions we make?

Â Which of these impact the NPV the most?

Â