Chapter 13

Cash Flow Estimation and Risk

Analysis

Relevant Cash Flows

Incorporating Inflation
Types of Risk
Risk Analysis
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Cash Flow v. Accounting Income

■ Differences between net cash flows and net

accounting income:
• Depreciation expense
• Depreciation rate
• Working capital

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 Cash Flow v. Accounting Income

■ PV of cash flows, not accounting income, is the basis

of a firm's value.
■ For capital budgeting, the key item is the project's cash
flows, not its accounting income.

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Timing of Cash Flows
■ As daily cash flows can be costly, annual cash flows
would be sufficient to analyze capital budgeting.
■ All cash flows are assumed to be happened at the end
of the year.

Incremental Cash Flows

• Incremental CFs: flows that will occur if and only if some
specific event occurs.
• In a project, the incremental CFs will be cash invested,
or equipment and working capital needed

13-4
Replacement Projects
■ Expansion v. replacement projects:
• Expansion projects - where the firm makes an
investment
• Replacement projects - where the firm replaces
existing assets to reduce costs.
■ Replacement analysis can be complicated as all of the
cash flows are incremental
• Found by subtracting the new cost numbers from
the old numbers.
Sunk Costs
■ Sunk cost is an outlay that was incurred in the past
and cannot be recovered in the future regardless of
whether the project under consideration is accepted.
■ Sunk costs are not relevant in the capital budgeting
analysis.
■ Sunk costs may lead to bad decision if they are
incorrectly included in the investment decision making.
Opportunity Costs
■ Opportunity cost is the best return that can be earned
on assets the firm already owns if those assets are not
used for the new project.
Externalities
• Externalities - an effect on the firm or the environment
that is not reflected in the project's cash flows.
• Three types of externalities:
• negative within-firm externalities (cannibalization)
• positive within-firm externalities
• environmental externalities
 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
return of NOWC.

0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
FCF0 FCF1 FCF2 FCF3 FCF4
13-8
Analysis of an Expansion Project

13-9
Analysis of an Expansion Project

13-10
Analysis of a Replacement Project

13-11
Analysis of a Replacement Project

13-12
Analysis of a Replacement Project

13-13
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.

13-15
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.

13-17
 Measuring Stand-Alone Risk

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.

13-18
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.

12-19
Sensitivity Graph

12-20
Sensitivity Graph

12-21
Scenario Analysis

■ Scenario analysis - a risk analysis technique in which

“bad” and “good”sets of financial circumstances are
compared with a most likely, or base-case, situation.

• base-case scenario

• worst case scenario

• best-case scenario

■ Assumption - All other factors shall remain constant

and the NPV under each scenario can be determined.

13-22
 Scenario Analysis

13-23
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 Scenario Analysis

13-24
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Monte Carlo Simulation
■ Monte carlo simulation - a risk analysis technique in
which probable future events are simulated on a
computer, generating estimated rates of return.

■ Simulation can generate thousands of NPVs under

thousands of scenarios.

■ As it is very complex, monte carlo simulation can be

performed by using specific software.

13-25
Within-Firm and Beta Risk
■ Within-firm risk (corporate risk) - risk considering the
firm's diversification but not stockholder diversification.

• it is measured by a project's effect on uncertainty

about the firm's expected future return.

■ Beta risk (market risk) - risk considering both firm and

stockholder diversification.

• it is measured by the project's beta coefficient.

13-26
Within-Firm and Beta Risk
■ Within-firm and beta risk are usually being mitigated
subjectively, rather than quantitatively.

■ It is problematic to measure diversification's effects on

risk, as the firm need the correlation coefficient between
a project's returns and returns on the firm's other assets,
which require historical data.

• historical data are not exist for new project.

13-27
Unequal Project Lives
■ Two aproaches for making the adjustment:

• Replacement chain (common life) - a method of

comparing projects with unequal lives that assumes
that each project can be repeated as many times as
necessary to reach a common life.

• Equivalent annual annuities (EAA) - a method that

calculates the annual payments that a project will
provide if it is an annuity.

13-28
Unequal Project Lives

13-29
Unequal Project Lives

13-30
Unequal Project Lives

13-31