Chapter 8
Fundamentals of Capital Budgeting
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
8.1 Forecasting Earnings (Slide 6)
• Revenue and Cost Estimates (Slides 7–8)
• Incremental Earnings Forecast (Slide 9)
– Capital Expenditures and Depreciation (Slide 10)
• Table 8.1 HomeNet’s Incremental Earnings Forecast
• Example 8.1 Taxing Losses for Projects in Profitable Companies (Slides 14–15)
• PowerPoint Alternative Example 8.1 (Slides 16–18)
• Indirect Effects on Incremental Earnings (Slide 19)
– Opportunity Costs
• Example 8.2 The Opportunity Cost of HomeNet’s Lab Space (Slides 20–21)
• Table 8.2 HomeNet’s Incremental Earnings Forecast (Including Cannibalization and Lost
Rent) (Slide 26)
• Sunk Costs and Incremental Earnings (Slides 27–30)
8.2 Determining Free Cash Flow and NPV (Slide 34)
• Calculating the Free Cash Flow from Earnings (Slides 35–38)
– Capital Expenditures and Depreciation (Slides 35–36)
• Table 8.3 Calculation of HomeNet’s Free Cash Flow (Including Cannibalization and Lost
Rent)
8.3 Choosing Among Alternatives (Slides 45–50)
8.4 Further Adjustments to Free Cash Flow (Slide 51)
– Other Non-Cash Items (Slide 51)
– Timing of Cash Flows (Slide 51)
– Accelerated Depreciation (Slide 51)
• Example 8.5 Computing Accelerated Depreciation (Slides 52–53)
• PowerPoint Alternative Example 8.5 (Slides 54–55)
• Example 8.8 Tax Loss Carryforwards (Slides 69-70)
• Global Financial Crisis: The American Recovery and Reinvestment Act of 2009
8.5 Analyzing the Project (Slides 71-)
• Break-Even Analysis (Slides 71–72)
• Table 8.7 HomeNet IRR Calculation (Slide 71)
• Table 8.8 Break-Even Levels for HomeNet (Slide 72)
• Sensitivity Analysis (Slide 73)
32 Berk/DeMarzo • Corporate Finance, Fourth Edition
II. Learning Objectives
8.2 Explain why opportunity costs must be included in cash flows, while sunk costs and interest
expense must not.
8.4 Calculate free cash flows for a given project.
8.6 Describe the appropriate selection of discount rate for a particular set of circumstances.
III. Chapter Overview
8.1 Forecasting Earnings
The chapter teaches the concept of forecasting earnings by considering a hypothetical capital
budgeting decision faced by managers of the Linksys division of Cisco. The project is called
HomeNet. The issues addressed are summarized here:
• The company has already conducted a feasibility study, which cost $300,000.
• The lab equipment will be depreciated straight line over a five-year period.
The net income from the project is in Table 8.1 Spreadsheet. Following are additional issues
addressed in this section of the chapter:
• Interest income is not included—the investment decision is separate from the financing
Berk/DeMarzo • Corporate Finance, Fourth Edition 33
• Fixed overhead expenses should be included only if they are in addition to those that would
8.2 Determining Free Cash Flow and NPV
This section shows how to convert net income to free cash flow. Free cash flow is calculated directly
by using the following formula:
Free Cash Flow
Unlevered Net Income
8.3 Choosing Among Alternatives
Because not launching a project produces an additional NPV of zero for the firm, launching a project
is the best decision for the firm, if its NPV is positive. In many situations, however, we must compare
8.4 Further Adjustments to Free Cash Flow
We must also consider tax carryforwards and carrybacks when calculating NPV, which allow
8.5 Analyzing the Project
Finally, several tools are available to analyze the project’s sensitivity to assumptions used in deriving
the cash flows. Break-even analysis can be done for each input. This involves solving for the break-
34 Berk/DeMarzo • Corporate Finance, Fourth Edition
Chapter 8 Appendix MACRS Depreciation
This appendix shows the way in which an asset is categorized into a recovery class and the
calculation of depreciation using MACRS.
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 8 have spreadsheet versions of the problems available: 5, 7, 10,
11, 13, 14, 15, 22, 24, and 25.