Chapter 11

Cash Flow Estimation and

Risk Analysis
 Relevant Cash Flows
 Incorporating Inflation
 Types of Risk
 Risk Analysis
13-1
 CASH FLOW ESTIMATION

Why? Business Application

 Importance in Project  Determine Value : Based

Valuation on accurate CF
 Effects on Firm Valuation Projections
 Relevance of CF over  New vs. Replacement
Acctg Income Projects

 Incremental CF Basis
 Relevant CFs
 Depreciation & Tax
Effects
 Inflation & Risk
2
Capital Budgeting Analysis

 What Long-Term projects (Capital

Investments) should our company
undertake in order to generate additional
return (Value ($$)) to the owners
(Stockholders)??
 CFs are KEY, NOT Acctg Income!!
Consider Only Incremental CFs
 Compare Outflows to acquire vs. inflows
generated by operating project.
 If PV of inflows > PV of outflows, then
making $ and adding value.
 Accept if project generates positive NPV
 Incremental Cash Flow for a
5
Project
 Project’s incremental cash flow is:

Corporate cash flow with the project

Minus
Corporate cash flow without the project.
 Type of Costs
6

 Sunk Costs
 Incremental Costs
 Externalities
 Opportunity Costs
 Shipping and installation
 Financing Costs
 Taxes
 Proposed Project
13-7

 Total depreciable cost

 Equipment: $200,000
 Shipping and installation: $40,000
 Changes in working capital
 Inventories will rise by $25,000
 Accounts payable will rise by $5,000
 Effect on operations
 New sales: 100,000 units/year @ $2/unit
 Variable cost: 60% of sales
 Proposed Project
13-8

 Life of the project

 Economic life: 4 years
 Depreciable rate:33%(Y1), 45%(Y2), 15%(Y3),
and 7%(Y4).
 Salvage value: $25,000
 Tax rate: 40%
 WACC: 10%
 Determining Project Value
13-9

 Estimate relevant cash flows

 Calculating annual operating cash flows.
 Identifying changes in working capital.
 Calculating terminal cash flows: after-tax
0
salvage
1
value and
2
return of 3NWC. 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
 Initial Year Net Cash Flow
13-10

 Find NWC.
  in inventories of $25,000
 Funded partly by an  in A/P of $5,000
 NWC = $25,000 – $5,000 = $20,000
 Combine NWC with initial costs.
Equipment -$200,000
Installation -40,000
NWC -20,000
Net CF0 -$260,000
 Determining Annual Depreciation
13-11
Expense
Year Rate x Basis Deprec.
1 0.33 x $240 $ 79
2 0.45 x 240 108
3 0.15 x 240 36
4 0.07 x 240 17
1.00 $240
 Annual Operating Cash Flows
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1 2 3 4
Revenues
– Op. costs
– Deprec. expense
Operating income (BT)
– Tax (40%)
Operating income (AT)
+ Deprec. expense
Operating CF
(Thousands of dollars)
 Terminal Cash Flow
13-13

Recovery of NWC $20,000

Salvage value 25,000
Tax of SV (40%) -10,000
Terminal CF $35,000
 Should financing effects be
13-14
included in cash flows?

 No, dividends and interest expense should

not be included in the analysis.
 Financing effects have already been taken
into account by discounting cash flows at the
WACC of 10%.
 Deducting interest expense and dividends
would be “double counting” financing costs.
 Should a $50,000 improvement cost from the
previous year be included in the analysis?
13-15

 No, the building improvement cost is a sunk

cost and should not be considered.
 This analysis should only include incremental
investment.
 If the facility could be leased out for $25,000 per
year, would this affect the analysis?
13-16

 Yes, by accepting the project, the firm

foregoes a possible annual cash flow of
$25,000, which is an opportunity cost to be
charged to the project.
 The relevant cash flow is the annual after-tax
opportunity cost.
 A-T opportunity cost:
= $25,000(1 – T)
= $25,000(0.6)
= $15,000
 If the new product line decreases the sales of the
firm’s other lines, would this affect the analysis?
13-17

 Yes. The effect on other projects’ CFs is an

“externality.”
 Net CF loss per year on other lines would be
a cost to this project.
 Externalities can be positive (in the case of
complements) or negative (substitutes).
 Proposed Project’s Cash Flow Time Line
13-18

0 1 2 3 4

 Enter CFs into calculator CFLO register, and

enter I/YR = 10%.
 NPV = million
 IRR =
 Payback = 3.3 years
 What are the 3 types of project
13-19
risk?
 Stand-alone risk
 Corporate risk
 Market risk
 What is stand-alone risk?
13-20

 The project’s total risk, if it were operated

independently.
 Usually measured by standard deviation (or
coefficient of variation).
 However, it ignores the firm’s diversification
among projects and investor’s diversification
among firms.
 What is corporate risk?
13-21

 The project’s risk when considering the firm’s

other projects, i.e., diversification within the
firm.
 Corporate risk is a function of the project’s
NPV and standard deviation and its
correlation with the returns on other firm
projects.
 What is market risk?
13-22

 The project’s risk to a well-diversified investor.

 Theoretically, it is measured by the project’s
beta and it considers both corporate and
stockholder diversification.
 Which type of risk is most relevant?
13-23

 Market risk is the most relevant risk for

capital projects, because management’s
primary goal is shareholder wealth
maximization.
 However, since corporate risk affects
creditors, customers, suppliers, and
employees, it should not be completely
ignored.
 Which risk is the easiest to
13-24
measure?
 Stand-alone risk is the easiest to measure.
Firms often focus on stand-alone risk when
making capital budgeting decisions.
 Focusing on stand-alone risk is not
theoretically correct, but it does not
necessarily lead to poor decisions.
 Are the three types of risk
13-25
generally highly correlated?
 Yes, since most projects the firm undertakes
are in its core business, stand-alone risk is
likely to be highly correlated with its
corporate risk.
 In addition, corporate risk is likely to be
highly correlated with its market risk.
 What is sensitivity analysis?
13-26

 Sensitivity analysis measures the effect of

changes in a variable on the project’s NPV.
 To perform a sensitivity analysis, all variables
are fixed at their expected values, except for
the variable in question which is allowed to
fluctuate.
 Resulting changes in NPV are noted.
 What are the advantages and
disadvantages of sensitivity analysis?
13-27

 Advantage
 Identifies variables that may have the greatest
potential impact on profitability and allows
management to focus on these variables.
 Disadvantages
 Does not reflect the effects of diversification.
 Does not incorporate any information about the
possible magnitudes of the forecast errors.
 Perform a Scenario Analysis of the Project,
Based on Changes in the Sales Forecast
13-28

 Suppose we are confident of all the variable

estimates, except unit sales. The actual unit
sales are expected to follow the following
probability distribution:
Case Probability Unit Sales
Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000
 Scenario Analysis
13-29

 All other factors shall remain constant and

the NPV under each scenario can be
determined.

Case Probability NPV

Worst 0.25 ($27.8)
Base 0.50 15.0
Best 0.25 57.8
 Determining Expected NPV, NPV, and CVNPV
from the Scenario Analysis
13-30

E(NPV)  0.25(-$27.8)  0.5($15.0)  0.25($57.8)

 $15.0

NPV  [0.25(-$27.8  $15.0)2  0.5($15.0  $15.0)2

2 1/2
 0.25($57.8  $15.0) ]
 $30.3

CVNPV  $30.3/$15.0  2.0

 If the firm’s average projects have CVNPV ranging
from 1.25 to 1.75, would this project be of high,
average, or low risk?
13-31

 With a CVNPV of 2.0, this project would be

classified as a high-risk project.
 Perhaps, some sort of risk correction is
required for proper analysis.