[MUSIC]

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

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

which requires us first to calculate the net income.

Once we have FCF, we will compute the project's NPV.

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

a sophisticated analytics platform that will help its product development group

create superior customer value propositions.

We look at this as a stand alone project and

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

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

The initial hardware and software costs for this business and

diligence platform is $500,000.

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

depreciation and amortization expenses will be $100,000.

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

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

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

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

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

use this office space to house the business intelligence platform and

the team that will operate it.

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

There's a 50% chance that the business intelligence platform will increase

revenues by $500,000 in the first year.

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

at half that rate over the following two years.

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

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

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

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

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

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

none of the other costs related to the project.

The increased revenues will need to be supported by additional investments

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

and $180,000 in accounts payable.

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

the companies existing marketing cost by $50,000 in the first year.

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

We will look at a five year horizon,

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

The company will annual interest expenses

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

The company has a tax rate of 35%, and

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

Should the FCMG go ahead with the business intelligence platform?

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

Since there is uncertainty about the revenues,

we will build separate Excel spreadsheets for the two possibilities.

The first step is to build the income statement and

determine the additional net income.

All cells in yellow are numbers that we input.

Cells not highlighted in yellow contain formulas.

We calculate the net income by starting with revenues.

Revenues are $500,000 in the first year,

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

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

Revenues that increase at 7.5% a year over the remaining

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

COGS are 65% of revenues in each year.

You can see that, annual COGS on the spreadsheet.

SG&A, $150,000 in the first year, which then increase at 3.8% a year after that.

The numbers are all in the Excel spreadsheet.

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

The hardware and software costs of $500,000 are depreciated over five years.

Annual depreciation costs are 500,000 divided by 5, which is $100,000.

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

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

which gives us earnings before tax.

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

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

to arrive the FCS.

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

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

not an operations related cash flow.

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

we need to subtract out after tax rental income.

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

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

This added back on an after tax basis every year.

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

which you can again see on the spreadsheet.

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

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

The project requires an increase in inventory and

an account receivable of $200,000 and $125,000 respectively.

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

The increase in accounts payable would be an inflow as the company's delaying some

of its cash payments.

So we need to add $180,000,

adding all these time zero cashflows yields year FCF of negative $580,000.

Finally, we calculate the terminal value of the project.

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

This is a glowing perpetuity.

The year six FCF is the year five FCF

of 70,688 times 1 plus 0.5.

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

by 0.1 minus 0.05, which gives us $1.484 million.

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

Now that we did all our FCFs,

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

This comes to $510,770.

Remember that this is only one possibility and

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

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

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

and it going at 5% a year after that.

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

everything else stays the same.

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

Putting the two possibilities together,

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

and a 50% chance that the NPVs a -934,007.

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

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

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

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

calculating NPV.

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

Which of these impact the NPV the most?

[MUSIC]