Refer to HomeNet.xls (use FCFs worksheet; the spreadsheet available on the blackboard.

Modify model for projection of free cash flows from the Home Net project along the following dimensions:

1. Assume the equipment needed for the project is depreciated according to MACRS 5-year depreciation schedule:

5-year MACRS:

Year 0: 20%

Year 1: 32.0%

Year 2: 19.2%

Year 3: 11.52%

Year 4: 11.52%

Year 5: 5.76%

2. The equipment is sold at the end of year 4 for $0.5 m

3. One of every five customers expected to buy a Home Net device would have bought a Cisco router if Home Net devices were not available

4. In order to maintain constant number of units (100,000/year) sold over the duration of the project Cisco is planning to offer an introductory price of $250/unit in the first year, and going to reduce the price to $230/unit in the fourth year. In the second and the third year, as customers get to appreciate the new device, Cisco is hoping to be able to sell the gadgets for $260 per unit

5. Assume that the Net working capital is recovered as soon as the production is over (at the end of year 4)

6. Estimate NPV of the project assuming that rwacc = 12%

7. Change your assumption about cost of capital and try several values above and below the initial value of 12%. Construct NPV-sensitivity-to-rwacc graph (rwacc values must be on the X-axis, corresponding values of NPV on the Y-axis)

HomeNet Cannibalisation & Opportunity Cost

Main

FCFs

A B I Year Price per unit # of units Expected loss in sales of routers %%) Price per unit (router) Cost of Goods Sold Router/unit Cost of Goods Sold/unit Marketing Costs/year Opportunity Cost (Lab) New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate 0 260.00 0.00 0.00 100.00 60.00 110.00 0.00 0.00 7,500,000.00 0.00 F G H 1 2 3 260.00 260.00 260.00 100,000.00 100,000.00 100,000.00 0.25 0.25 0.25 100.00 100.00 100.00 60.00 60.00 60.00 110.00 110.00 110.00 2,800,000.00 2,800,000.00 2,800,000.00 200,000.00 200,000.00 200,000.00 0.00 0.00 0.00 0.20 0.20 0.20 260.00 100,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 5 260.00 0.00 0.25 100.00 60.00 110.00 0.00 0.00 0.00 0.20 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 23,500,000.00 23,500,000.00 23,500,000.00 23,500,000.00 0.00 0.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 0.00 0.00 14,000,000.00 14,000,000.00 14,000,000.00 14,000,000.00 0.00 0.00 3,000,000.00 3,000,000.00 3,000,000.00 3,000,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 -1,500,000.00 -6,000,000.00 3,800,000.00 3,800,000.00 3,800,000.00 3,800,000.00 -600,000.00 -9,000,000.00 5,700,000.00 5,700,000.00 5,700,000.00 5,700,000.00 -900,000.00 Cannibalization & Opp.cost main FCFS Complexities + A B E F G H I J Year Price per unit # of units Cost of Goods Sold/unit Marketing Costs/year New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate 2 260.00 260.00 260.00 260.00 260.00 0.00 100,000.00 100,000.00 100,000.00 100,000.00 110.00 110.00 110.00 110.00 110.00 0.00 2,800,000.00 2,800,000.00 2,800,000.00 2,800,000.00 7,500,000.00 0.00 0.00 0.00 0.00 0.20 0.20 0.20 0.20 260.00 0.00 110.00 0.00 0.00 0.20 0.00 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 26,000,000.00 26,000,000.00 26,000,000.00 26,000,000.00 0.00 0.00 11,000,000.00 11,000,000.00 11,000,000.00 11,000,000.00 0.00 15,000,000.00 15,000,000.00 15,000,000.00 15,000,000.00 0.00 0.00 2,800,000.00 2,800,000.00 2,800,000.00 2,800,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 10,700,000.00 10,700,000.00 10,700,000.00 10,700,000.00 -1,500,000.00 -6,000,000.00 4,280,000.00 4,280,000.00 4,280,000.00 4,280,000.00 -600,000.00 -9,000,000.00 6,420,000.00 6,420,000.00 6,420,000.00 6,420,000.00 -900,000.00 Cannibalization&Opp. Cost main FCFS Complexities + AB J K Year Price per unit # of units Expected loss in sales of routers (%%) Price per unit (router) Cost of Goods Sold Router/unit Cost of Goods Sold/unit Marketing Costs/year Opportunity Cost (Lab) New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate G H I 2 3 4 260.00 260.00 260.00 260.00 260.00 0.00 100,000.00 100,000.00 100,000.00 100,000.00 0.00 0.25 0.25 0.25 0.25 100.00 100.00 100.00 100.00 100.00 60.00 60.00 60.00 60.00 60.00 110.00 110.00 110.00 110.00 110.00 0.00 2,800,000.00 2,800,000.00 2,800,000.00 2,800,000.00 0.00 200,000.00 200,000.00 200,000.00 200,000.00 7,500,000.00 0.00 0.00 0.00 0.00 0.20 0.20 0.20 0.20 5 260.00 0.00 0.25 100.00 60.00 110.00 0.00 0.00 0.00 0.20 0.00 0.00 0.00 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.40 HomeNet's Net Working Capital Requirements Cash Inventory Receivables (15% Sales) Payables (15% COGS) NWC Change in NWC 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3,525,000.00 3,525,000.00 3,525,000.00 3,525,000.00 0.00 0.00 1,425,000.00 1,425,000.00 1,425,000.00 1,425,000.00 0.00 0.00 2,100,000.00 2,100,000.00 2,100,000.00 2,100,000.00 0.00 0.00 2,100,000.00 0.00 0.00 0.00 -2,100,000.00 Sales 0.00 23,500,000.00 23,500,000.00 23,500,000.00 23,500,000.00 0.00 Cannibalization&Opp.Cost main FCFs Complexities + A B H LM HomeNet's Net Working Capital Requirements Cash Inventory Receivables (15% Sales) Payables (15% COGS) NWC Change in NWC 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3,525,000.00 3,525,000.00 3,525,000.00 3,525,000.00 0.00 0.00 1,425,000.00 1,425,000.00 1,425,000.00 1,425,000.00 0.00 0.00 2,100,000.00 2,100,000.00 2,100,000.00 2,100,000.00 0.00 2,100,000.00 0.00 0.00 0.00 -2,100,000.00 0.00 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 23,500,000.00 23,500,000.00 23,500,000.00 23,500,000.00 0.00 0.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 0.00 0.00 14,000,000.00 14,000,000.00 14,000,000.00 14,000,000.00 0.00 0.00 3,000,000.00 3,000,000.00 3,000,000.00 3,000,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 -1,500,000.00 -6,000,000.00 3,800,000.00 3,800,000.00 3,800,000.00 3,800,000.00 -600,000.00 -9,000,000.00 5,700,000.00 5,700,000.00 5,700,000.00 5,700,000.00 -900,000.00 Plus: Depreciation Less:Capital Expenditures (Equipm.) Less: change in NWC FCF 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 7,500,000.00 0.00 0.00 0.00 0.00 0.00 0.00 2,100,000.00 0.00 0.00 -2,100,000.00 -16,500,000.00 5,100,000.00 7,200,000.00 7,200,000.00 7,200,000.00 2,700,000.00 0.00 Cost of capital PV of CFS NPV 0.12 - 16,500,000.00 4,553,571.43 5,739,795.92 5,124,817.78 4,575,730.16 5,025,967.81 1,532,052.51 Cannibalization&Opp.Cost main FCFS Complexities H 3 AB C Year Price per unit # of units Expected loss in sales of routers (%%) Price per unit (router) Cost of Goods Sold Router/unit Cost of Goods Sold/unit Marketing Costs/year Opportunity Cost (Lab) New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate 0 260.00 0.00 0.00 100.00 60.00 110.00 0.00 0.00 7,500,000.00 0.00 F 1 260.00 100,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 G 2 260.00 125,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 260.00 125,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 260.00 50,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 260.00 0.00 0.25 100.00 60.00 110.00 0.00 0.00 0.00 0.20 0.00 0.20 0.00 0.00 0.00 0.00 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.40 0.40 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 23,500,000.00 29,375,000.00 29,375,000.00 11,750,000.00 0.00 0.00 9,500,000.00 11,875,000.00 11,875,000.00 4,750,000.00 0.00 0.00 14,000,000.00 17,500,000.00 17,500,000.00 7,000,000.00 0.00 0.00 3,000,000.00 3,000,000.00 3,000,000.00 3,000,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 9,500,000.00 13,000,000.00 13,000,000.00 2,500,000.00 -1,500,000.00 -6,000,000.00 3,800,000.00 5,200,000.00 5,200,000.00 1,000,000.00 -600,000.00 -9,000,000.00 5,700,000.00 7,800,000.00 7,800,000.00 1,500,000.00 -900,000.00 Cannibalization&Opp.Cost main FCFS Complexities Chapter 8 Fundamentals of Capital Budgeting 8.1 Forecasting Earnings A capital budget lists the projects and investments that a company plans to undertako during the coming year. To determine this list, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting. This process begins with forecasts of the project's future consequences for the firm. Some of these consequences wil affect the firm's revenues; others will affect its costs. Our ultimate goal is to determine the effect of the decision on the firm's cash flows, and evaluate the NPV of these cash flows assess the consequences of the decision for the firm's value. As we emphasized in Chapter 2. earnings are not actual cash flows. However, as a pract cal matter, to derive the forecasted cash flows of a project financial managers often begir by forecasting carnings. Thus, we begin by determining the incremental carnings of project that is, the amount by which the firm's earnings are expected to change as a result of the investment decision. Then, in Section 8.2. we demonstrate how to use the incremer tal earnings to forecast the cash flows of the project. Let's consider a hypothetical capital budgeting decision faced by managers of the router division of Cisco Systems, a maker of networking hardware, Cisco is considering the develop ment of a wireless home networking appliance, called HomeNet. that will provide both the hardware and the software necessary to run an entire home from any Internet connection. In addition to connecting computers and smartphones, HomeNet will control Internet-based telepresence and phone systems, home entertainment systems, heating and air-conditioning units, major appliances, security systems, office equipment, and so on. Cisco has alreach conducted an intensive, $300,000 feasibility study to assess the attractiveness of the new product Revenue and Cost Estimates We begin by reviewing the revenue and cost estimates for HomeNet. HomeNet's target market is upscale residential "smart" homes and home offices. Based on extensive marker- ing surveys, the sales forecast for HomeNet is 100.000 units per year. Given the pace ct technological change, Cisco expects the product will have a four-year life. It will be soli through high-end electronics stores for a retail price of S375. with an expected wholesale price of S260. Developing the new hardware will be relatively inexpensive, as existing technologies can be simply repackaged in a newly designed, home-friendly box. Industrial design teams will make the box and its packaging aesthetically pleasing to the residential mal- ket. Cisco expects total engineering and design costs to amount to S5 million. Once the design is finalized, actual production will be outsourced at a cost (including packaging of S110 per unit. In addition to the hardware requirements. Cisco must build a new software application to allow virtual control of the home from the Web. This software development project requires coordination with each of the Web appliance manufacturers and is expected to take a dedicated team of 50 software engineers a full year to complete. The cost of a soft- ware engincer (including benefits and related costs) is S200.000 per year. To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Cisco must also install new equipment that will require an upfront investment of $7.5 million, The software and hardware design will be completed, and the new equipment will be A B I Year Price per unit # of units Expected loss in sales of routers %%) Price per unit (router) Cost of Goods Sold Router/unit Cost of Goods Sold/unit Marketing Costs/year Opportunity Cost (Lab) New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate 0 260.00 0.00 0.00 100.00 60.00 110.00 0.00 0.00 7,500,000.00 0.00 F G H 1 2 3 260.00 260.00 260.00 100,000.00 100,000.00 100,000.00 0.25 0.25 0.25 100.00 100.00 100.00 60.00 60.00 60.00 110.00 110.00 110.00 2,800,000.00 2,800,000.00 2,800,000.00 200,000.00 200,000.00 200,000.00 0.00 0.00 0.00 0.20 0.20 0.20 260.00 100,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 5 260.00 0.00 0.25 100.00 60.00 110.00 0.00 0.00 0.00 0.20 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 23,500,000.00 23,500,000.00 23,500,000.00 23,500,000.00 0.00 0.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 0.00 0.00 14,000,000.00 14,000,000.00 14,000,000.00 14,000,000.00 0.00 0.00 3,000,000.00 3,000,000.00 3,000,000.00 3,000,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 -1,500,000.00 -6,000,000.00 3,800,000.00 3,800,000.00 3,800,000.00 3,800,000.00 -600,000.00 -9,000,000.00 5,700,000.00 5,700,000.00 5,700,000.00 5,700,000.00 -900,000.00 Cannibalization & Opp.cost main FCFS Complexities + A B E F G H I J Year Price per unit # of units Cost of Goods Sold/unit Marketing Costs/year New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate 2 260.00 260.00 260.00 260.00 260.00 0.00 100,000.00 100,000.00 100,000.00 100,000.00 110.00 110.00 110.00 110.00 110.00 0.00 2,800,000.00 2,800,000.00 2,800,000.00 2,800,000.00 7,500,000.00 0.00 0.00 0.00 0.00 0.20 0.20 0.20 0.20 260.00 0.00 110.00 0.00 0.00 0.20 0.00 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 26,000,000.00 26,000,000.00 26,000,000.00 26,000,000.00 0.00 0.00 11,000,000.00 11,000,000.00 11,000,000.00 11,000,000.00 0.00 15,000,000.00 15,000,000.00 15,000,000.00 15,000,000.00 0.00 0.00 2,800,000.00 2,800,000.00 2,800,000.00 2,800,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 10,700,000.00 10,700,000.00 10,700,000.00 10,700,000.00 -1,500,000.00 -6,000,000.00 4,280,000.00 4,280,000.00 4,280,000.00 4,280,000.00 -600,000.00 -9,000,000.00 6,420,000.00 6,420,000.00 6,420,000.00 6,420,000.00 -900,000.00 Cannibalization&Opp. Cost main FCFS Complexities + AB J K Year Price per unit # of units Expected loss in sales of routers (%%) Price per unit (router) Cost of Goods Sold Router/unit Cost of Goods Sold/unit Marketing Costs/year Opportunity Cost (Lab) New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate G H I 2 3 4 260.00 260.00 260.00 260.00 260.00 0.00 100,000.00 100,000.00 100,000.00 100,000.00 0.00 0.25 0.25 0.25 0.25 100.00 100.00 100.00 100.00 100.00 60.00 60.00 60.00 60.00 60.00 110.00 110.00 110.00 110.00 110.00 0.00 2,800,000.00 2,800,000.00 2,800,000.00 2,800,000.00 0.00 200,000.00 200,000.00 200,000.00 200,000.00 7,500,000.00 0.00 0.00 0.00 0.00 0.20 0.20 0.20 0.20 5 260.00 0.00 0.25 100.00 60.00 110.00 0.00 0.00 0.00 0.20 0.00 0.00 0.00 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.40 HomeNet's Net Working Capital Requirements Cash Inventory Receivables (15% Sales) Payables (15% COGS) NWC Change in NWC 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3,525,000.00 3,525,000.00 3,525,000.00 3,525,000.00 0.00 0.00 1,425,000.00 1,425,000.00 1,425,000.00 1,425,000.00 0.00 0.00 2,100,000.00 2,100,000.00 2,100,000.00 2,100,000.00 0.00 0.00 2,100,000.00 0.00 0.00 0.00 -2,100,000.00 Sales 0.00 23,500,000.00 23,500,000.00 23,500,000.00 23,500,000.00 0.00 Cannibalization&Opp.Cost main FCFs Complexities + A B H LM HomeNet's Net Working Capital Requirements Cash Inventory Receivables (15% Sales) Payables (15% COGS) NWC Change in NWC 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3,525,000.00 3,525,000.00 3,525,000.00 3,525,000.00 0.00 0.00 1,425,000.00 1,425,000.00 1,425,000.00 1,425,000.00 0.00 0.00 2,100,000.00 2,100,000.00 2,100,000.00 2,100,000.00 0.00 2,100,000.00 0.00 0.00 0.00 -2,100,000.00 0.00 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 23,500,000.00 23,500,000.00 23,500,000.00 23,500,000.00 0.00 0.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 0.00 0.00 14,000,000.00 14,000,000.00 14,000,000.00 14,000,000.00 0.00 0.00 3,000,000.00 3,000,000.00 3,000,000.00 3,000,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 9,500,000.00 9,500,000.00 9,500,000.00 9,500,000.00 -1,500,000.00 -6,000,000.00 3,800,000.00 3,800,000.00 3,800,000.00 3,800,000.00 -600,000.00 -9,000,000.00 5,700,000.00 5,700,000.00 5,700,000.00 5,700,000.00 -900,000.00 Plus: Depreciation Less:Capital Expenditures (Equipm.) Less: change in NWC FCF 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 7,500,000.00 0.00 0.00 0.00 0.00 0.00 0.00 2,100,000.00 0.00 0.00 -2,100,000.00 -16,500,000.00 5,100,000.00 7,200,000.00 7,200,000.00 7,200,000.00 2,700,000.00 0.00 Cost of capital PV of CFS NPV 0.12 - 16,500,000.00 4,553,571.43 5,739,795.92 5,124,817.78 4,575,730.16 5,025,967.81 1,532,052.51 Cannibalization&Opp.Cost main FCFS Complexities H 3 AB C Year Price per unit # of units Expected loss in sales of routers (%%) Price per unit (router) Cost of Goods Sold Router/unit Cost of Goods Sold/unit Marketing Costs/year Opportunity Cost (Lab) New Equipment/year Depreciation schedule Software Development: Engineers Cost/engineer Design and Engineering Tax Rate 0 260.00 0.00 0.00 100.00 60.00 110.00 0.00 0.00 7,500,000.00 0.00 F 1 260.00 100,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 G 2 260.00 125,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 260.00 125,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 260.00 50,000.00 0.25 100.00 60.00 110.00 2,800,000.00 200,000.00 0.00 0.20 260.00 0.00 0.25 100.00 60.00 110.00 0.00 0.00 0.00 0.20 0.00 0.20 0.00 0.00 0.00 0.00 50.00 200,000.00 5,000,000.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.40 0.40 Sales COGS Gross Profit Selling, General, Admin. Expnenses Research and Development Depreciation EBIT Income Tax NI (Unlevered) 0.00 23,500,000.00 29,375,000.00 29,375,000.00 11,750,000.00 0.00 0.00 9,500,000.00 11,875,000.00 11,875,000.00 4,750,000.00 0.00 0.00 14,000,000.00 17,500,000.00 17,500,000.00 7,000,000.00 0.00 0.00 3,000,000.00 3,000,000.00 3,000,000.00 3,000,000.00 0.00 15,000,000.00 0.00 0.00 0.00 0.00 0.00 0.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 -15,000,000.00 9,500,000.00 13,000,000.00 13,000,000.00 2,500,000.00 -1,500,000.00 -6,000,000.00 3,800,000.00 5,200,000.00 5,200,000.00 1,000,000.00 -600,000.00 -9,000,000.00 5,700,000.00 7,800,000.00 7,800,000.00 1,500,000.00 -900,000.00 Cannibalization&Opp.Cost main FCFS Complexities Chapter 8 Fundamentals of Capital Budgeting 8.1 Forecasting Earnings A capital budget lists the projects and investments that a company plans to undertako during the coming year. To determine this list, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting. This process begins with forecasts of the project's future consequences for the firm. Some of these consequences wil affect the firm's revenues; others will affect its costs. Our ultimate goal is to determine the effect of the decision on the firm's cash flows, and evaluate the NPV of these cash flows assess the consequences of the decision for the firm's value. As we emphasized in Chapter 2. earnings are not actual cash flows. However, as a pract cal matter, to derive the forecasted cash flows of a project financial managers often begir by forecasting carnings. Thus, we begin by determining the incremental carnings of project that is, the amount by which the firm's earnings are expected to change as a result of the investment decision. Then, in Section 8.2. we demonstrate how to use the incremer tal earnings to forecast the cash flows of the project. Let's consider a hypothetical capital budgeting decision faced by managers of the router division of Cisco Systems, a maker of networking hardware, Cisco is considering the develop ment of a wireless home networking appliance, called HomeNet. that will provide both the hardware and the software necessary to run an entire home from any Internet connection. In addition to connecting computers and smartphones, HomeNet will control Internet-based telepresence and phone systems, home entertainment systems, heating and air-conditioning units, major appliances, security systems, office equipment, and so on. Cisco has alreach conducted an intensive, $300,000 feasibility study to assess the attractiveness of the new product Revenue and Cost Estimates We begin by reviewing the revenue and cost estimates for HomeNet. HomeNet's target market is upscale residential "smart" homes and home offices. Based on extensive marker- ing surveys, the sales forecast for HomeNet is 100.000 units per year. Given the pace ct technological change, Cisco expects the product will have a four-year life. It will be soli through high-end electronics stores for a retail price of S375. with an expected wholesale price of S260. Developing the new hardware will be relatively inexpensive, as existing technologies can be simply repackaged in a newly designed, home-friendly box. Industrial design teams will make the box and its packaging aesthetically pleasing to the residential mal- ket. Cisco expects total engineering and design costs to amount to S5 million. Once the design is finalized, actual production will be outsourced at a cost (including packaging of S110 per unit. In addition to the hardware requirements. Cisco must build a new software application to allow virtual control of the home from the Web. This software development project requires coordination with each of the Web appliance manufacturers and is expected to take a dedicated team of 50 software engineers a full year to complete. The cost of a soft- ware engincer (including benefits and related costs) is S200.000 per year. To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Cisco must also install new equipment that will require an upfront investment of $7.5 million, The software and hardware design will be completed, and the new equipment will be