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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 to first calculate the net income.

Once we have the FCFs,

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 standalone 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 intelligence platform is $500,000.

This costs will be depreciated over five years,

which means 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 isn't using and has rented it out.

It turns an annual rental 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 only by $300,000 in the first year,

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

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

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

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

The 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 will reduce some of

the company's existing marketing costs 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 the five-year horizon after which FCFs are

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

The company will incur 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 FMCG 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 then 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 the annual COGS on the spreadsheet.

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

which then increase at 3% 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 cost of $500,000 are depreciated over 5 years.

Annual depreciation costs are $500,000 divided by five, 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 the net income for each year.

Now that we have calculated the net income,

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

The first step is to add back the depreciation 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 the after-tax rental income.

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

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

This is 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 costs are $100,000,

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

The project requires an increase in inventory and accounts 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 cash flows yields year-zero FCFs of -$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 growing perpetuity.

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

The PV of this growing perpetuity is $70,688

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

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 have all FCFs,

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

This comes to $510,770.

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

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

as are its growth rate.

The only difference is, in this case,

are lower first-year revenues of $300,000 and it growing 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-sales scenario comes to a -$934,007.

Putting the two possibilities together,

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

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

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

plus 0.5 times -$934,007, which is -$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.

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

Which of these impact the NPV the most?