CHAPTER 11

Cash Flow Estimation and

Risk Analysis

Relevant cash flows

Incorporating inflation
Types of risk
Risk Analysis
11-1

Proposed Project

Total depreciable cost

Changes in working capital

Equipment: $200,000
Shipping: $10,000
Installation: $30,000
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
11-2

Proposed Project

Life of the project

Economic life: 4 years

Depreciable life: MACRS 3-year class
Salvage value: $25,000

Tax rate: 40%

WACC: 10%

11-3

Determining project value

Estimate relevant cash flows

Calculating annual operating cash flows.

Identifying changes in working capital.
Calculating terminal cash flows.
1

Initial
Costs

OCF1

OCF2

OCF3

NCF0

NCF1

NCF2

NCF3

4
OCF4
+
Terminal
CFs
NCF4
11-4

Initial year net cash flow

Find NOWC.
in inventories of $25,000

Funded partly by an in A/P of $5,000

NOWC = $25,000 - $5,000 = $20,000

Combine NOWC with initial costs.

Equipment
Installation
NOWC
Net CF0

-$200,000
-40,000
-20,000
-$260,000
11-5

Determining annual
depreciation expense
Year
1
2
3
4
1.00

Rate
0.33
0.45
0.15
0.07
$240

x
x
x
x
x

Basis
$240
240
240
240

Depr
$ 79
108
36
17

Due to the MACRS -year convention, a

3-year asset is depreciated over 4 years.
11-6

Annual operating cash

flows
1

3
4
Revenues 200 200 200
- Op. Costs (60%) -120
- Deprn Expense
-79
Oper. Income (BT)
1
- Tax (40%)
-11
Oper. Income (AT)
1
+ Deprn Expense
79
Operating CF 80 91

200
-120 -120 -120
-108 -36 -17
-28
44 63
18 25
-17
26 38
108
36 17
62 55

11-7

Terminal net cash flow

Recovery of NOWC
$20,000
Salvage value
25,000
Tax on SV (40%) -10,000
Terminal CF $35,000
Q. How is NOWC recovered?
Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash
flow?
11-8

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.

11-9

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.

11-10

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
11-11

If the new product line were to

decrease the sales of the firms
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).

11-12

Cash flow estimation

methods
Dollar in Minus Dollars Out.

1.

Revenues expenses - taxes

Adjusted Accounting Profits

2.

After tax profit + depreciation

3.

Add Back Depreciation Tax Shield

1.

(Revenues Expenses)(1-t)+ tar rate

* Depreciation
11-13

Cash flows

A new project will generate sales

of $74 million, cost of $42 million,
and depreciation expense of $10
million in the coming year. The
firms tax rate is 35%. Calculate
cash flow for the year by using the
three methods of cash flow
estimation.
11-14

Operating cash flow

Tubby Toys estimates that its new

line of rubber ducks will generate
sales of $7 million, operating costs
of $4 million, and a depreciation
expense of $1 million. If the tax
rate is 35%, what is the firms
operating cash flow?
11-15

Proper cash flows

Quick computing currently sells 10 million

computer chips each year at a price of $20 per
chip. It is about to introduce a new chip, and it
forecasts annual sales of 12 million of these
improved chips at a price of 25$ each. However,
demand for the old chip will decrease, and sales
of the old chip are expected to fall to 3 million per
year. The old chip costs $6 each to manufacture,
and the new one will cost $8 each. What is the
proper cash flow use to evaluate the present
value of the introduction of the new chip?
11-16

Gross revenues from new chip = 12 million

$25 = $300 million
Cost of new chip = 12 million $8 = $96
million
Lost sales of old chip = 7 million $20 =
$140 million
Saved costs of old chip = 7 million $6 = $42
million
Increase in cash flow = ($300 $96) ($140
$42) = $106 million
11-17

Cash flows and working

capital

A firm had after-tax income last

year
of
$1.2
million.
Its
depreciation expenses were $0.4
million, and its total cash flow was
$1.2 million. What happened to net
working capital during the year?

11-18

Salvage value

Your firm purchased machinery with

a 7-year MACRS life for $10 million.
The project, however, will end after 5
years. If the equipment can be sold
for $4.5 million at the completion of
the project, and your firms tax rate
is 35%, what is the after-tax cash
flow from the sale of the machine?
11-19

New project evaluation.

The Dawn Co. is considering the purchase of new

machines in order to expand their business. The
machines have a useful life of five years.
The
required rate of return for the expansion is 17%. The
companys tax rate is 40%.
Purchase price of new machines
$450,000
Installation charges
$ 50,000
Increased revenues from expansion$200,000/year
before taxes
Salvage value at the end of the fifth year
$175,000
11-20

Required

What is the cash outflow at t = 0?

What are the deprecation deductions if the machines fall
in the MACRS five-year class?
What is the book value of the machines at the end of
year five?
What is the taxable gain/loss from the sale of the
machines at the end of the useful life if they are sold for
the estimated salvage value?
What is the tax on the sale of the machines at the end of
year five ?
What is the terminal year non-operating cash flow (cash
proceeds from the sale)?
11-21

Proposed projects cash flow time

line
0

-260

79.7

91.2

3
62.4
Terminal CF

4
54.7
35.0
89.7

Enter CFs into calculator CFLO

register, and enter I/YR = 10%.

NPV = -$4.03 million

IRR = 9.3%
11-22

What is the projects

MIRR?
0
-260.0

10%

79.7

91.2

62.4

-260.0
PV outflows

$260 =

$374.8
(1 + MIRR)4

4
89.7
68.6
110.4
106.1
374.8
TV inflows

MIRR = 9.6% < k = 10%, reject the project

11-23

Evaluating the project:

Payback period
0

-260

79.7

91.2

62.4

89.7

-89.1

-26.7

63.0

Cumulative:
-260

-180.3

Payback = 3 + 26.7 / 89.7 = 3.3 years.

11-24

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
machines life. This is the opportunity
cost for the replacement project.
11-25

What if there is expected

annual inflation of 5%, is NPV
biased?

Yes, inflation causes the discount

rate to be upwardly revised.
Therefore, inflation creates a
downward bias on PV.
Inflation should be built into CF
forecasts.

11-26

Annual operating cash flows, if

expected annual inflation = 5%
1
Revenues
210
Op. Costs (60%)
-126
- Deprn Expense
-79
- Oper. Income (BT)
5
- Tax (40%)
2
Oper. Income (AT)
3
+ Deprn Expense
79
Operating CF
82

2
3
4
220 232 243
-132 -139 -146
-108 -36 -17
-20
57
80
-8
23
32
-12
34
48
108
36
17
96
70
65
11-27

Considering inflation:
Project net CFs, NPV, and
IRR
0
1
2
3
4
-260

82.1

96.1

70.0
Terminal CF

65.1
35.0
100.1

Enter CFs into calculator CFLO

register, and enter I/YR = 10%.

NPV = $15.0 million.

IRR = 12.6%.
11-28

What are the 3 types of

project risk?

Stand-alone risk
Corporate risk
Market risk

11-29

What is stand-alone risk?

The projects total risk, if it were

operated independently.
Usually measured by standard
deviation (or coefficient of variation).
However, it ignores the firms
diversification among projects and
investors diversification among
firms.
11-30

What is corporate risk?

The projects risk when

considering the firms other
projects, i.e., diversification
within the firm.
Corporate risk is a function of
the projects NPV and standard
deviation and its correlation with
the returns on other projects in
the firm.
11-31

What is market risk?

The projects risk to a welldiversified investor.

Theoretically, it is measured by
the projects beta and it
considers both corporate and
stockholder diversification.

11-32

Which type of risk is most

relevant?

Market risk is the most relevant

risk for capital projects, because
managements primary goal is
shareholder wealth maximization.
However, since total risk affects
creditors, customers, suppliers,
and employees, it should not be
completely ignored.
11-33

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.
11-34

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.

11-35

What is sensitivity
analysis?

Sensitivity analysis measures the

effect of changes in a variable on
the projects 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.
11-36

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 magnitudes of the
forecast errors.
11-37

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:
Case
Worst
Base
Best

Probability Unit Sales

0.25
75,000
0.50
100,000
0.25
125,000
11-38

Scenario analysis

All other factors shall remain constant and

the NPV under each scenario can be
determined.
Case
Worst
Base
Best

Probability
NPV
0.25
($27.8)
0.50
$15.0
0.25
$57.8

11-39

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

CVNPV = $30.3 /$15.0 = 2.0.

= [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.

11-40

If the firms average projects have

CVNPV ranging from 1.25 to 1.75,
would this project be of high,
average,
or lowofrisk?
With a CV
2.0, this project
NPV

would be classified as a high-risk

project.
Perhaps, some sort of risk
correction is required for proper
analysis.

11-41

Is this project likely to be correlated

with the firms business? How would
it contribute to the firms overall
risk?

We would expect a positive correlation

with the firms aggregate cash flows.
As long as correlation is not perfectly
positive (i.e., 1), we would expect it
to contribute to the lowering of the
firms total risk.

11-42

If the project had a high

correlation with the economy, how
would corporate and market risk
be affected?

The projects corporate risk would not

be directly affected. However, when
combined with the projects high standalone risk, correlation with the economy
would suggest that market risk (beta) is
high.

11-43

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 standalone 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.
11-44

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.
11-45

What is 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.
Simulation software packages
are often add-ons to spreadsheet
programs.
11-46