Chapter 8: Fundamentals of Capital Budgeting
- Capital budgeting is the process of analyzing investment opportunities and deciding which
ones to accept.
- The NPV rule is the most accurate and reliable method for allocating the firm’s resources
so as to maximize its value
8.1 Forecasting Earnings
- A capital budget lists the projects and investments that a company plans to undertake
during the coming year.
- Capital budgeting is the process of determining this list.
- Incremental earnings are the amount by which the firm’s earnings are expected to change
as a result of the investment decision.
● Revenues and Cost Estimate
○ The company estimates how much each step of creating a product will cost, how
much it will sell, and how many units.
● Incremental Earnings Forecast
○ Income tax is placed on the EBIT
○ Cost of Goods Sold is the cost of producing those goods.
● Capital Expenditures and Depreciation
, ○ Cash expenses are not directly listed as expenses when calculating earnings,
instead, a fraction of the cost is deducted as depreciation.
○ Straight-line depreciation is a method used where the asset’s cost is divided
equally over its estimated useful life.
○ Earnings are not an accurate representation of cash flows because of depreciation
expenses.
● Interest Expenses
○ When evaluating capital budgeting we generally do not include interest expenses.
○ We don’t include any debt.
○ Unleverd net income of a project is an income that does not include any interest
expenses associated with debt.
● Taxes
○ The firm’s marginal corporate tax rate is the tax rate it will pay on an incremental
dollar of pre-tax income.
Income Tax = EBIT x tc
○ The firm is charged with taxes even in year 0 if it earns taxable income elsewhere.
○ Launching a new project and investing money reduces taxes for a firm.
● Unlevered Net Income Calculation
○ A project’s unlevered net income is equal to its incremental revenues less costs
and depreciation, evaluated on an after-tax basis.
● Indirect Effects on Incremental Earnings
- Capital budgeting is the process of analyzing investment opportunities and deciding which
ones to accept.
- The NPV rule is the most accurate and reliable method for allocating the firm’s resources
so as to maximize its value
8.1 Forecasting Earnings
- A capital budget lists the projects and investments that a company plans to undertake
during the coming year.
- Capital budgeting is the process of determining this list.
- Incremental earnings are the amount by which the firm’s earnings are expected to change
as a result of the investment decision.
● Revenues and Cost Estimate
○ The company estimates how much each step of creating a product will cost, how
much it will sell, and how many units.
● Incremental Earnings Forecast
○ Income tax is placed on the EBIT
○ Cost of Goods Sold is the cost of producing those goods.
● Capital Expenditures and Depreciation
, ○ Cash expenses are not directly listed as expenses when calculating earnings,
instead, a fraction of the cost is deducted as depreciation.
○ Straight-line depreciation is a method used where the asset’s cost is divided
equally over its estimated useful life.
○ Earnings are not an accurate representation of cash flows because of depreciation
expenses.
● Interest Expenses
○ When evaluating capital budgeting we generally do not include interest expenses.
○ We don’t include any debt.
○ Unleverd net income of a project is an income that does not include any interest
expenses associated with debt.
● Taxes
○ The firm’s marginal corporate tax rate is the tax rate it will pay on an incremental
dollar of pre-tax income.
Income Tax = EBIT x tc
○ The firm is charged with taxes even in year 0 if it earns taxable income elsewhere.
○ Launching a new project and investing money reduces taxes for a firm.
● Unlevered Net Income Calculation
○ A project’s unlevered net income is equal to its incremental revenues less costs
and depreciation, evaluated on an after-tax basis.
● Indirect Effects on Incremental Earnings
