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

Â We will focus on estimating free cash flows using the indirect method,

Â which requires us first to calculate the net income.

Â Once we have FCF, 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 its product development group

Â create superior customer value propositions.

Â We look at this as a stand alone 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 this business and

Â diligence platform is $500,000.

Â This cost will be depreciated over five years which means the annual

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

Â Some employees will need to be trained to work on the business intelligence

Â platform for which the company will incur a one time cost of $100,000.

Â The company has office space that it doesn't use and is renting it out.

Â It has an annual rent of $100,000 on this office space.

Â However, if it starts using the business intelligence platform, it will need to

Â use this office space to house the business intelligence platform and

Â 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 the business intelligence platform will increase

Â revenues by $500,000 in the first year.

Â Which will then grow at 15% per year over the next two years, and

Â at half that rate over the following two years.

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

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

Â Cost of good sold will be a constant 65%of revenues and additional selling general

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

Â Which will increase at the inflation rate of 3% a year after that.

Â Now, uncertainty will affect only the revenues and COGS, and

Â none of the other costs related to the project.

Â The increased revenues will need to be supported by additional investments

Â of $200,000 in inventories, $125,000 in accounts receivable,

Â and $180,000 in accounts payable.

Â Introducing the business intelligence platform, we'll reduce some of

Â the companies existing marketing cost 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 a five year horizon,

Â after which FCFs are expected to increase at a constant 5% a year forever.

Â The company will annual interest expenses

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

Â The company has a tax rate of 35%, and

Â a weighted-average cost of capital of 10% per year.

Â Should the FCMG 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

Â 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 that increase at 7.5% a year over the remaining

Â two years to 710,844 and 764,157 respectively.

Â COGS are 65% of revenues in each year.

Â You can see that, annual COGS on the spreadsheet.

Â SG&A, $150,000 in the first year, which then increase at 3.8% 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 costs of $500,000 are depreciated over five years.

Â Annual depreciation costs are 500,000 divided by 5, 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 a net income for each year.

Â Now that you have calculated the net income we can make adjustments to it

Â to arrive the FCS.

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

Â Next, we need to add back after tax interest expense as it is a financing and

Â 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 after tax rental income.

Â Next, we add the positive side effect of savings and marketing costs.

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

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

Â Making all these adjustments to net income yields us the annual operating cash flows

Â which you can again see on the spreadsheet.

Â Next, we determine the time zero cost, hardware and software costs are $500,000.

Â One time training cost at $100,000, which on an after tax basis $65,000.

Â The project requires an increase in inventory and

Â an account receivable of $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 company's delaying some

Â of its cash payments.

Â So we need to add $180,000,

Â adding all these time zero cashflows yields year FCF of negative $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 glowing perpetuity.

Â The year six FCF is the year five FCF

Â of 70,688 times 1 plus 0.5.

Â The period of this growing perpetuity is 70,688 times 1 plus 0.05 divided

Â by 0.1 minus 0.05, 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 did all our FCFs,

Â we can calculate the projects NPV using a discount rate of 10%.

Â This comes to $510,770.

Â Remember that this is only one possibility and

Â that there is only a 50% chance of this happening.

Â There's a 50% chance that the additional revenues are lower as are its growth rate.

Â The only differences in this case are lower first year revenues of $300,000,

Â and it going 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 sale scenario comes to a $-934,007.

Â Putting the two possibilities together,

Â there is a 50% chance that the NPV is a positive 510,770,

Â and a 50% chance that the NPVs 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 negative $211,618.

Â Since, we have a negative NPV, the company should reject this project.

Â In this video, we have looked at a detailed example of estimating FCFs and

Â calculating NPV.

Â However, these FCFs depend on a number of projections and assumptions we make.

Â Which of these impact the NPV the most?

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