Chapter 7:

Cash Flow Estimation

and Risk Analysis

Financial management

Free cash flow

OCF (Operating Cash Flow)

Assume that the firm invests in fixed assets and net operating
working capital only at t=0

After the initial investments, the project will hopefully produce

positive cash flows over its operating life.

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 Salvage value
Once the project is completed, the company sells the project’s
fixed assets and NOWC and receives cash.

The price received for selling fixed asset is salvage value.

The company will also have to pay taxes if the asset’s salvage
value exceeds its book value.

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Salvage value

Book value = The initial price for the asset – The asset’s total
accumulated depreciation

If the company sold the asset for less than its book value, the
taxes paid would be negative (the firm would receive a tax
credit)

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 Salvage value
Example

Karsted Air Services is now in the final year of a project. The

equipment originally cost $29 million, of which 75% has been
depreciated. Karsted can sell the used equipment today for $8
million, and its tax rate is 35%. What is the equipment’s after-
tax salvage value?

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Salvage value
Example

Equipment’s original cost

Depreciation (75%)
Book value
Gain on sale
Tax on gain
After-tax salvage value
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 Timing of cash flows
We generally assume that all cash flows occur at the end of the
year.

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Incremental cash flows

Incremental cash flows will occur if and only if the firm takes on a
project.
You should always ask yourself “Will this cash flow occur ONLY if we
accept the project?”
➢ If the answer is “yes”, it should be included in the analysis because it is
incremental

➢ If the answer is “no”, it should not be included in the analysis because

it will occur anyway
➢ If the answer is “part of it”, then we should include the part that occurs
because of the project

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 Two types of projects
1. Expansion projects: the firm makes an investment
2. Replacement projects: the firm replaces existing
assets, generally to reduce costs
Replacement analysis is complicated because almost all
of the cash flows are incremental
We must find the incremental cash flows and use them in
a “regular” NPV analysis to decide whether to replace the
asset or to continue using it
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Sunk costs
Sunk costs - A cash outlay that has already been incurred and
that cannot be recovered regardless of whether the project is
accepted or rejected.
→Sunk costs are not relevant in the capital budgeting analysis.

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 Sunk costs
Example:
A firm spent $2 million to investigate a potential new store and
obtain the permits required to build it.
→ $2 million would be a sunk cost—the money is gone, and it
won’t come back regardless of whether or not the new store is
built.

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Opportunity costs
Opportunity costs - The best return that could be earned on
assets the firm already owns if those assets are not used for the
new project.

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 Opportunity costs
Example: HD owns land with a market value of $2 million.
▪ If HD decides to build the new store, that land will be used for it.
▪ If HD decides not to build the new store, the land could be sold,
and HD will receive a cash flow of $2 million.
→ This $2 million is an opportunity cost—something that HD would
not receive if the land was used for the new store.
→ The $2 million must be charged to the new project.

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Externalities
Externalities are effects on the firm or the environment that are
not reflected in the project’s cash flows

1. Negative within-firm externalities (Cannibalization)

2. Positive within-firm externalities

3. Environmental externalities

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 Externalities
1. Negative within-firm externalities (Cannibalization)

The situation when a new project reduces cash flows that the firm would
otherwise have had.

Example:

When a retailer opens new stores that are too close to their existing
stores, this takes customers away from their existing stores.

→ Those lost cash flows should be charged as a cost when analyzing the
proposed new store.
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Externalities
2. Positive within-firm externalities

A new project also can be complementary to an old one, in which case

cash flows in the old operation will be increased when the new one is
introduced.

Example:

Apple’s iPod was a profitable product, but when Apple made an

investment in another project, its iTunes music store, that investment
boosted sales of the iPod.

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 Analysis of an Expansion Project
Example: Allied is considering introducing a new health-food
product with summarized information
Initial investment
Equipment: $900,000
∆ Inventory: $175,000
∆ Accounts payable: $75,000
→ ∆NOWC: $100,000

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Analysis of an Expansion Project

Effect on operations

▪ Sales: 2,685,000; 2,600,000; 2,525,000 and 2,450,000 units

in 4 years @ $2 each

▪ Fixed cost: $2,000,000 each year

▪ Variable cost: $1.018; $1.078; $1.046 and $1.221 per unit in

4 years

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 Analysis of an Expansion Project
▪ Depreciation method: accelerated

▪ Salvage value: $50,000

▪ Recover ∆NOWC: $100,000

▪ Tax rate: 40%

▪ WACC: 10%

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Analysis of an Expansion Project

Cash flows are divided into three components

1. The initial investments required at t = 0

2. The operating cash flows received over the life of the project

3. The terminal cash flows realized when the project is completed

0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
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 Analysis of an Expansion Project
Initial year net cash flow

Find Δ NOWC
◼ ⇧ in inventories of $175
◼ Funded partly by an ⇧ in A/P of $75
→ Δ NOWC = $175 - $75 = $100
Combine Δ NOWC with initial costs
Capex -$900
Δ NOWC -100
→ Net CF0 -$1,000

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Analysis of an Expansion Project

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 Analysis of an Expansion Project

Year 1 2 3 4
Rate 33% 45% 15% 7%
Depreciation 297,000 405,000 135,000 63,000
Acc. Depreciation 297,000 702,000 837,000 900,000

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Analysis of an Expansion Project

Annual operating cash flows (thousands of dollars)
1 2 3 4
Sales 5,370 5,200 5,050 4,900
- Variable Costs 2,735 2,803 2,640 2,992
- Fixed Costs 2,000 2,000 2,000 2,000
- Depreciation 297 405 135 63
EBIT 338 -8 275 -155
- Tax (40%) 135 -3 110 -62
EBIT(1 – T) 203 -5 165 -93
+ Depreciation 297 405 135 63
OCF 500 400 300 -30
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 Analysis of an Expansion Project
Terminal net cash flow
Recovery of NOWC $100

Salvage value (SV) 50

Tax on SV (40%) -20

Terminal CF 130

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Analysis of an Expansion Project

Terminal net cash flow

0 1 2 3 4

-1000 500 400 300 -30

Terminal CF → 130
◼ NPV = $78.82 CF4 100

◼ IRR = 14.489%

◼ MIRR = 12.106%

◼ Payback = 2.33 years

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 Analysis of an Expansion Project
Effect of different depreciation rates
Accelerated vs straight-line method

CFs in the early years from straight-line method would be lower

and in the later years would be higher => lower NPV
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Analysis of an Expansion Project

Cannibalization

If the project reduces the after-tax cash flows of another

division by $50 per year, would this affect the analysis?

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 Analysis of an Expansion Project

Opportunity costs

If the project uses some equipment the company now

owns and that equipment would be sold for $100, after
taxes, would this affect the analysis?

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Analysis of an Expansion Project

Sunk costs

Suppose the firm had spent $150 on a marketing study

to estimate potential sales. Should the $150 be charged
to the project when determining its NPV for capital
budgeting purpose?

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 Unequal Project Lives

If two projects

(1) have significantly different lives

(2) are mutually exclusive

(3) can be repeated

→ The “regular” NPV method may not indicate the better

project.

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Unequal Project Lives

Example
A firm is choosing between 2 mutually exclusive projects
C and F

0 1 2 3 4 5 6

C (40,000) 8,000 14,000 13,000 12,000 11,000 10,000

F (20,000) 7,000 13,000 12,000

WACC: 12%
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 Unequal Project Lives

NPV-C = 6,491

NPV-F = 5,155

IRR-C = 17.5%

IRR-F = 25.2%

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Unequal Project Lives

Two methods for making the adjustment

1. Replacement Chain

2. Equivalent Annual Annuity (EAA)

→ Both methods always result in the same decision.

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 Unequal Project Lives

1. Replacement Chain

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.

The NPVs over this life are then compared, and the
project with the higher common-life NPV is chosen.

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Unequal Project Lives

1. Replacement Chain

0 1 2 3 4 5 6
F (20,000) 7,000 13,000 12,000
(20,000) 7,000 13,000 12,000
Total (20,000) 7,000 13,000 (8,000) 7,000 13,000 12,000

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 Unequal Project Lives

1. Replacement Chain

NPV-C = 6,491

NPV-F = 8,824

IRR-C = 17.5%

IRR-F = 25.2%

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Unequal Project Lives

2. Equivalent Annual Annuity (EAA) Method

A method that calculates the annual payments that a

project will provide if it is an annuity.

When comparing projects with unequal lives, the one

with the higher equivalent annual annuity (EAA) should
be chosen.

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 Unequal Project Lives

2. Equivalent Annual Annuity (EAA) Method

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Risk Analysis
Three separate and distinct types of risk

1. Stand-Alone Risk

2. Corporate (Within-Firm) Risk

3. Market (Beta) Risk

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 Risk Analysis
1. Stand-Alone Risk

The risk an asset would have if it were a firm’s only asset

and if investors owned only one stock.

It is measured by the variability of the asset’s expected

returns.

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Risk Analysis
2. Corporate (Within-Firm) 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 returns.

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 Risk Analysis
3. Market (Beta) Risk

Considers both firm and stockholder diversification.

It is measured by the project’s beta coefficient.

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Risk Analysis

What type of risk is most relevant?

Market risk is theoretically the most relevant because

management’s primary goal is shareholder wealth
maximization but it is also the most difficult to estimate.

Usually calculate stand-alone risk and then consider the

other two risk measures in a qualitative manner.

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 Risk Analysis

Risk-Adjusted Cost of Capital

The cost of capital appropriate for a given project,

given the riskiness of that project.

The greater the risk, the higher the cost of capital.

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Risk Analysis

Risk-Adjusted Cost of Capital

▪ Average-risk projects: WACC

▪ Higher-risk projects: WACC + % risk adjustment

▪ Lower-risk projects: WACC - % risk adjustment

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 Stand-alone Risk

Three techniques to assess stand-alone risk

1. Sensitivity analysis

2. Scenario analysis

3. Monte Carlo simulation

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Sensitivity analysis

Percentage change in NPV resulting from a given

percentage change in an input variable, other things
held constant.

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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 Sensitivity analysis

Advantage Disadvantages

Identifies variables that may Does not reflect the effects of

have the greatest potential diversification
impact on profitability and Does not incorporate any
allows management to focus information about the possible
on these variables magnitudes of the forecast
errors

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Sensitivity analysis

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 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

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Scenario analysis
▪ Base-Case Scenario - An analysis in which all inputs
are set at their most likely values

▪ Worst-Case Scenario - An analysis in which all inputs

are set at their worst reasonably forecasted values

▪ Best-Case Scenario - An analysis in which all inputs

are set at their best reasonably forecasted values

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 Scenario analysis

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Monte Carlo Simulation

A risk analysis technique in which probable future events

are simulated on a computer, generating estimated rates of
return and risk indexes

Monte Carlo simulation, so named because this type of

analysis grew out of work on the mathematics of casino
gambling, is a sophisticated version of scenario analysis

Here the project is analyzed under a large number of

scenarios, or “runs.”

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