Cash Flow Estimation and Risk

Analysis

 Relevant cash flows

 Incorporating inflation
 Types of risk
 Risk Analysis
06/22/23 Financial Management 11-1
 Learning Objectives
 You should understand relevant cash flows in evaluating
projects.
 You should be able to estimate the following cash flows:
 Cash flow from operations
 Cash flow from investments in working capitals
 Cash flow from salvage sales
 You should be able to understand risk in capital budgeting

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Incremental Cash Flow
 Project’s incremental cash flow:
Incremental cash flow cash flow
Cash Flow = with project - without project

 Ask yourself this question: Would the cash

flow still exist if the project does not exist?
If yes, do not include it in your analysis.
If no, include it.

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Proposed Project
 Total depreciable cost
 Equipment: $200,000
 Shipping: $10,000
 Installation: $30,000
 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
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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%

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11-6
 Determining project value
 Estimate relevant cash flows
 Calculating annual operating cash flows.
 Identifying changes in working capital.
 Calculating terminal cash flows.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
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 Initial year net cash flow
 Find Δ NOWC.
 ⇧ in inventories of $25,000


Funded partly by an ⇧ in A/P of $5,000
 Δ NOWC = $25,000 - $5,000 = $20,000
 Combine Δ NOWC with initial costs.

Equipment -$200,000
Installation -40,000
Δ NOWC -20,000
Net CF0 -$260,000
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MACRS
Modified Accelerated Cost Recovery System

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Determining annual
depreciation expense
Year Rate x Basis Depr
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

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 Annual operating cash flows
1 2 3 4
Revenues 200 200 200 200
- Op. Costs (60%) -120 -120 -120 -120
- Deprn Expense -79 -108 -36 -17
Oper. Income (BT) 1 -28 44 63
- Tax (40%) - -11 18 25
Oper. Income (AT) 1 -17 26 38
+ Deprn Expense 79 108 36 17
Operating CF 80 91 62 55

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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?
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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.

06/22/23 Financial Management 11-13

 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.

06/22/23 Financial Management 11-14

 If the facility could be leased out for
$25,000 per year, would this affect
the analysis? (Incremental Cost)
 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 were to
decrease 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).
 Cannibalization
The reduction of the sales of a company's own products as a
consequence of its introduction of another similar product .

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Proposed project’s cash flow time line
0 1 2 3 4

-260 79.7 91.2 62.4 54.7

Terminal CF → 35.0
89.7

 Enter CFs into calculator CFLO register,

and enter I/YR = 10%.
 NPV = -$4.03 million
 IRR = 9.3%
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 What is the project’s MIRR?
0 10% 1 2 3 4

-260.0 79.7 91.2 62.4 89.7

68.6
110.4
106.1
-260.0 374.8
PV outflows $374.8 TV inflows
$260 =
(1 + MIRR)4
MIRR = 9.6% < k = 10%, reject the project
06/22/23 Financial Management 11-18
 Evaluating the project:
Payback period
0 1 2 3 4

-260 79.7 91.2 62.4 89.7

Cumulative:
-260 -180.3 -89.1 -26.7 63.0

Payback = 3 + 26.7 / 89.7 = 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.

06/22/23 Financial Management 11-20

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.

06/22/23 Financial Management 11-21

 Annual operating cash flows, if
expected annual inflation = 5%
1 2 3 4
Revenues 210 220 232 243
Op. Costs (60%) -126 -132 -139 -146
- Deprn Expense -79 -108 -36 -17
- Oper. Income (BT) 5 -20 57 80
- Tax (40%) 2 -8 23 32
Oper. Income (AT) 3 -12 34 48
+ Deprn Expense 79 108 36 17
Operating CF 82 96 70 65

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

-260 82.1 96.1 70.0 65.1

Terminal CF → 35.0
100.1

 Enter CFs into calculator CFLO register,

and enter I/YR = 10%.
 NPV = $15.0 million.
 IRR = 12.6%.
06/22/23 Financial Management 11-23
What does “risk” mean in
capital budgeting?
 Uncertainty about a project’s future
profitability.
 Measured by σNPV, σIRR, beta.
 Will taking on the project increase the
firm’s and stockholders’ risk?
 Risk analysis in capital budgeting is usually
based on subjective judgments, not
historical data
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11-25
What are the 3 types of
project risk?
 Stand-alone risk
 Corporate risk
 Market (or beta) 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 investor’s diversification among firms.
 Measured by Standard Deviation σ and CV (Co-
efficient) of Variation of NPV, IRR & MIRR

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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 projects in the firm.
 Reflects the project’s effect on corporate earnings
stability.
 Considers firm’s other assets (diversification within
firm).
 Depends on project’s σ, and its correlation, ρ, with
returns on firm’s other assets.
 Measured by the project’s corporate beta.

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What is market risk?
 The project’s risk to a well-diversified investor.
(Reflects the project’s effect on a well-diversified stock
portfolio.)

 Theoretically, it is measured by the project’s beta and it

considers both corporate and stockholder diversification.
 Depends on project’s σ and correlation with the stock
market.
 Measured by the project’s market beta

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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 total risk affects
creditors, customers, suppliers, and
employees, it should not be
completely ignored.

06/22/23 Financial Management 11-30

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.

06/22/23 Financial Management 11-31

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.

06/22/23 Financial Management 11-32

How is each type of risk used?
 Market risk is theoretically best in most situations.
 However, creditors, customers, suppliers, and
employees are more affected by corporate risk.
 Therefore, corporate risk is also relevant.
 Stand-alone risk is easiest to measure, more intuitive.
 Core projects are highly correlated with other assets,
so stand-alone risk generally reflects corporate risk.
 If the project is highly correlated with the economy,
stand-alone risk also reflects 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 is sensitivity analysis?
 Shows how changes in a variable such
as unit sales affect NPV or IRR.
 Answers “what if” questions, e.g. “What
if sales decline by 30%?”
 Each variable is fixed except one.
Change this one variable to see the
effect on NPV or IRR.

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11-36
 Sensitivity Graph

Unit Sales
NPV
(000s)

88 Salvage

-30 -20 -10 Base 10 20 3011-3737

Results of Sensitivity Analysis
 Steeper sensitivity lines show greater
risk. Small changes result in large
declines in NPV.
 Unit sales line is steeper than salvage
value or r, so for this project, should
worry most about accuracy of sales
forecast.

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Pros and Cons of sensitivity
analysis
 Pros
 Gives some idea of stand-alone risk.
 Identifies dangerous variables.
 Gives some breakeven information.
 Identifies variables that may have the greatest potential
impact on profitability and allows management to focus on
these variables
 Cons
 Does not reflect diversification.
 Says nothing about the likelihood of change in a variable, i.e.
a steep sales line is not a problem if sales won’t fall.
 Ignores relationships among variables.
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What is scenario analysis?
 Examines several possible situations,
usually worst case, most likely case,
and best case.
 Provides a range of possible outcomes.

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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:

Case Probability Unit Sales

Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000

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Scenario analysis
 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

06/22/23 Financial Management 11-42

Are there any problems with
scenario analysis?
 Only considers a few possible out-
comes.
 Assumes that inputs are perfectly
correlated--all “bad” values occur
together and all “good” values occur
together.
 Focuses on stand-alone risk, although
subjective adjustments can be made.

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06/22/23 Financial Management 11-44
 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.

06/22/23 Financial Management 11-45
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?
 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.

06/22/23 Financial Management 11-46

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 total risk.

06/22/23 Financial Management 11-47

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.

06/22/23 Financial Management 11-48

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.

06/22/23 Financial Management 11-49

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.

06/22/23 Financial Management 11-50

What is a simulation analysis?
 A computerized version of scenario analysis which uses
continuous probability distributions.
 Computer selects values for each variable based on
given probability distributions.
 NPV and IRR are calculated.
 Process is repeated many times (1,000 or more).
 End result: Probability distribution of NPV and IRR
based on sample of simulated values.
 Generally shown graphically.

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How to decide the project
risk?
 Sensitivity, scenario, and simulation analyses do not
provide a decision rule. They do not indicate
whether a project’s expected return is sufficient to
compensate for its risk.
 Sensitivity, scenario, and simulation analyses all
ignore diversification. Thus they measure only
stand-alone risk, which may not be the most relevant
risk in capital budgeting.
 A numerical analysis may not capture all of the risk
factors inherent in the project, so manager use
subjective judgments to adjust the risk.
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