Cash Flow Estimation

and Risk Analysis

Chapter 12

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 Overview

Relevant Cash Flows

Types of Risk

Risk Analysis

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 Proposed Project

 Total depreciable cost

• Equipment: $200,000
• Shipping and installation: $40,000
 Changes in net operating 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

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 Proposed Project

 Life of the project

• Economic life: 4 years

• Depreciable life: MACRS 3-year class

 We are interested in cash flows and not accounting
income, so our focus is on tax depreciation not
depreciation used in firm’s financial reporting.
• Salvage value: $25,000
 Tax rate: 40%
 WACC: 10%

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 Determining Project Value

 Estimate relevant cash flows

• Calculating annual operating cash flows.
• Identifying changes in net operating working
capital.
• Calculating terminal cash flows: after-tax salvage
value and recovery of NOWC.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
FCF0 FCF1 FCF2 FCF3 FCF4

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 Initial Year Investment Outlays

 Find NOWC.
•  in inventories of $25,000
• Funded partly by an  in A/P of $5,000
• NOWC = $25,000 – $5,000 = $20,000
 Initial year outlays:
Equipment cost -$200,000
Installation -40,000
CAPEX -240,000
NOWC -20,000
FCF0 -$260,000

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 Determining Annual Depreciation 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

Due to the MACRS ½-year convention, a 3-year

asset is depreciated over 4 years.

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 Project Operating Cash Flows

(Thousands of dollars) 1 2 3 4
Revenues 200.0 200.0 200.0 200.0
– Op. costs 120.0 120.0 120.0 120.0
– Deprec. expense 79.2 108.0 36.0 16.8
EBIT 0.8 -28.0 44.0 63.2
– Tax (40%) 0.3 -11.2 17.6 25.3
EBIT(1 – T) 0.5 -16.8 26.4 37.9
+ Depreciation 79.2 108.0 36.0 16.8
EBIT(1 – T) + DEP 79.7 91.2 62.4 54.7

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 Terminal Cash Flows

(Thousands of dollars)
Salvage value $25
 Tax on SV (40%) 10
AT salvage value $15
+ NOWC 20
Terminal CF $35

FCF4 = EBIT(1 – T) + DEP – CAPEX – NOWC

= $54.7 + $35
= $89.7

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 Terminal Cash Flows

 Q. How is NOWC recovered?

 Q. Is there always a tax on SV?
 Q. Is the tax on SV ever a positive cash flow?

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 Should financing effects be 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.

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 Should a $50,000 improvement cost from the previous year be
included in the analysis?

 No, the building improvement cost is a sunk

cost and should not be considered.
 This analysis should only include incremental
investment.

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 If the facility could be leased out for $25,000 per year, would
this affect the analysis?

 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

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 If the new product line decreases the sales of the firm’s other
lines, would this affect the analysis?

 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).

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 Proposed Project’s Cash Flow Time Line

(Thousands of dollars)
0 1 2 3 4

-260 79.7 91.2 62.4 89.7

 Enter CFs into calculator CFLO register,

and enter I/YR = 10%.
NPV = -$4.03
IRR = 9.3%
MIRR = 9.6%
Payback = 3.3 years
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 If this were a replacement rather than a new project, would
the analysis change?

 Yes, the old equipment would be sold, and new

equipment purchased.
 The incremental CFs would be the changes from
the old to the new situation.
 The relevant depreciation expense would be the
change with the new equipment.
 If the old machine was sold, the firm would not
receive the SV at the end of the machine’s life.
This is the opportunity cost for the replacement
project.

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 What are the 3 types of project risk?

Stand-alone risk

Corporate risk

Market risk

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 What is stand-alone risk?

 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 investors’ diversification
among firms.

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 What is corporate risk?

 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.

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 What is market risk?

 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.

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 Which type of risk is most relevant?

 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.

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 Which risk is the easiest to 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.

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 Are the three types of risk 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.

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 What is sensitivity analysis?

 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.

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 What are the advantages and disadvantages of sensitivity
analysis?

 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 magnitude of the forecast errors.

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 Evaluating Projects with Unequal Lives

 Machines A and B are mutually exclusive, and

will be repurchased. If WACC = 10%, which is
better?
Expected Net CFs
Year Machine A Machine B
0 ($50,000) ($50,000)
1 17,500 34,000
2 17,500 27,500
3 17,500 –
4 17,500 –

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 Solving for NPV with No Repetition

 Enter CFs into calculator CFLO register for both

projects, and enter I/YR = 10%.
• NPVA = $5,472.65
• NPVB = $3,636.36
 Is Machine A better?
• Need replacement chain and/or equivalent annual
annuity analysis

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 Replacement Chain

 Use the replacement chain to calculate an

extended NPVB to a common life.
 Since Machine B has a 2-year life and Machine A
has a 4-year life, the common life is 4 years.

0 1 2 3 4
10%

-50,000 34,000 27,500

-50,000 34,000 27,500
-22,500

NPVB = $6,641.62 (on extended basis)

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 Equivalent Annual Annuity

 Using the previously solved project NPVs, the

EAA is the annual payment that the project
would provide if it were an annuity.
 Machine A
• Enter N = 4, I/YR = 10, PV = -5472.65, FV = 0;
solve for PMT = EAAA = $1,726.46.
 Machine B
• Enter N = 2, I/YR = 10, PV = -3636.36, FV = 0;
solve for PMT = EAAB = $2,095.24.
 Machine B is better!

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 If expected inflation equals 5% is NPV biased?

 The discount rate already reflects the market’s

inflation expectation. Higher expected inflation
translates into higher nominal rates.

 Higher expected inflation may also lead to

changes in the CF forecasts (both the revenues
and costs are likely to increase). If those
changes have not been incorporated in the
analysis, then the NPV calculation is biased.

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 Project Operating Cash Flows, If Expected Inflation = 5%

(Thousands of dollars)
1 2 3 4
Revenues 210 220 232 243
– Op. costs (60%) 126 132 139 146
– Depreciation 79 108 36 17
EBIT 5 -20 57 80
– Tax (40%) 2 -8 23 32
EBIT(1 – T) 3 -12 34 48
+ Depreciation 79 108 36 17
EBIT(1 – T) + DEP 82 96 70 65

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 Considering Inflation:
Project CFs, NPV, and IRR

(Thousands of dollars)
0 1 2 3 4

-260 82.1 96.1 70.0 65.1

35.0
FCFs -260 82.1 96.1 70.0 100.1

Enter CFs into calculator CFLO register, and

enter I/YR = 10%.
MIRR = 11.6%.
NPV = $15.0.
IRR = 12.6%. Payback = 3.1 years.

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 Perform a Scenario Analysis of the Project, Based on Changes
in the Sales Forecast

 Suppose we are confident of all the variable

estimates, except unit sales. The actual unit
sales are expected to follow the following
probability distribution:

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 Scenario Analysis

 All other factors shall remain constant and the

NPV under each scenario can be determined.

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 Determining Expected NPV, NPV, and CVNPV from the Scenario
Analysis

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
 0.25($57.8  $15.0) 2 ]1/2
 $30.3

CVNPV  $30.3/$15.0  2.0

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 If firm’s average projects’ CVNPV range is 1.25-1.75, would this
project have high, average, or low risk?

 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.

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 Is this project likely to be correlated with the firm’s business? How
would it contribute to the firm’s overall risk?

 We would expect a positive correlation with the

firm’s aggregate cash flows.
 As long as correlation is not perfectly positive
(i.e., ρ  1), we would expect it to contribute to
the lowering of the firm’s overall risk.

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 If the project had a high correlation with the economy, how would
corporate and market risk be affected?

 The project’s corporate risk would not be

directly affected. However, when combined with
the project’s high stand-alone risk, correlation
with the economy would suggest that market
risk (beta) is high.

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 If the firm uses a +/-3% risk adjustment for the cost of capital,
should the project be accepted?

 Reevaluating this project at a 13% cost of

capital (due to high stand-alone risk), the NPV
of the project is -$2.2.
 If, however, it were a low-risk project, we would
use a 7% cost of capital and the project NPV is
$34.1.

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 What subjective risk factors should be considered before a
decision is made?

 Numerical analysis sometimes fails to capture

all sources of risk for a project.
 If the project has the potential for a lawsuit, it is
more risky than previously thought.
 If assets can be redeployed or sold easily, the
project may be less risky than otherwise
thought.

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 End of Chapter 12

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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5