FIN222 Lecture Notes - Lecture 7: Sunk Costs, Capital Budgeting, Marginal Cost
LECTURE 7.
FUNDAMENTALS
OF CAPITAL
BUDGETING
Capital Budgeting
Process
Capital budgeting process: the process of analysing investment opportunities and
deciding which one to accept.
Incremental earnings: the amount by which a firm’s earnings are expected to
change as a result of an investment action
We use NPV rule to evaluate capital budgeting decisions, making decisions that
maximise NPV.
When deciding to accept or reject a project, we accept ones with positive NPV
Forecasting
Incremental
Earnings
Operating
expenses vs.
Capital
expenditures
Operating expenses: some up-front investment (i.e. marketing survey, develop a
prototype, launch or advertising campaign)
Capital expenditures: investments in property, plant, or equipment
Straight-line Depreciation Method: Asset’s cost is divided equally over
its depreciable life.
**Note: Capital expenditures are not listed as
expense when calculating earnings because a fraction
of the costs is deducted as depreciation
Incremental
revenue and
cost
estimates
Only focus on the incremental (additional) sales and costs generated by the
projects, not the total sales and costs.
Incremental earning (before tax):
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠 (𝐸𝐵𝐼𝑇)
= 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 – 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 – 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Incremental earning forecast (after tax):
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 =
(𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 – 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 – 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) 𝑥 (1 – 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)
Taxes
Incremental income tax expense:
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 = 𝐸𝐵𝐼𝑇 𝑥 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚’𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
Determining
Incremental FCFs
Converting
from
earnings to
FCFs
Capital expenditures and Depreciation
Deducting then adding back
depreciation
$
Incremental Gross Profit
1,000,00
Depreciation
-200,000
**Note: Depreciation is not a cash expense that paid
by a firm, only a method used for accounting; hence,
we do not include depreciation in the CF forecast.
However, depreciation reduces our taxable earnings,
meaning reduces our taxes. Taxes are CFs, so
depreciation must be accounted.
Document Summary
Capital budgeting process: the process of analysing investment opportunities and deciding which one to accept. Incremental earnings: the amount by which a firm"s earnings are expected to change as a result of an investment action. We use npv rule to evaluate capital budgeting decisions, making decisions that maximise npv. When deciding to accept or reject a project, we accept ones with positive npv. Operating expenses: some up-front investment (i. e. marketing survey, develop a prototype, launch or advertising campaign) Capital expenditures: investments in property, plant, or equipment. Straight-line depreciation method: asset"s cost is divided equally over its depreciable life. Only focus on the incremental (additional) sales and costs generated by the projects, not the total sales and costs. Incremental earning (before tax): (cid:1866)(cid:1855)(cid:1870)(cid:1857)(cid:1865)(cid:1857)(cid:1866)(cid:1872)(cid:1853)(cid:1864) (cid:1857)(cid:1853)(cid:1870)(cid:1866)(cid:1866)(cid:1859)(cid:1871) (cid:1854)(cid:1857)(cid:1858)(cid:1867)(cid:1870)(cid:1857) (cid:1866)(cid:1872)(cid:1857)(cid:1870)(cid:1857)(cid:1871)(cid:1872) (cid:1853)(cid:1866)(cid:1856) (cid:1872)(cid:1853)(cid:1876)(cid:1857)(cid:1871) (cid:4666)(cid:1831)(cid:1828)(cid:1846)(cid:4667) = (cid:1866)(cid:1855)(cid:1870)(cid:1857)(cid:1865)(cid:1857)(cid:1866)(cid:1872)(cid:1853)(cid:1864) (cid:1844)(cid:1857)(cid:1874)(cid:1857)(cid:1866)(cid:1873)(cid:1857) (cid:1866)(cid:1855)(cid:1870)(cid:1857)(cid:1865)(cid:1857)(cid:1866)(cid:1872)(cid:1853)(cid:1864) (cid:1855)(cid:1867)(cid:1871)(cid:1872)(cid:1871) (cid:1830)(cid:1857)(cid:1868)(cid:1870)(cid:1857)(cid:1855)(cid:1853)(cid:1872)(cid:1867)(cid:1866) Incremental income tax expense: (cid:1866)(cid:1855)(cid:1867)(cid:1865)(cid:1857) (cid:1872)(cid:1853)(cid:1876)=(cid:1831)(cid:1828)(cid:1846) (cid:1876) (cid:1872) (cid:1857) (cid:1858)(cid:1870)(cid:1865)"(cid:1871) (cid:1865)(cid:1853)(cid:1870)(cid:1859)(cid:1866)(cid:1853)(cid:1864) (cid:1855)(cid:1867)(cid:1870)(cid:1868)(cid:1867)(cid:1870)(cid:1853)(cid:1872)(cid:1857) (cid:1872)(cid:1853)(cid:1876) (cid:1870)(cid:1853)(cid:1872)(cid:1857)
