Topic 1

Cash Flow
Estimation
and Risk
Analysis

11-1
Relevant Cash Flows

 Incremental cash flows

 only cash flows associated with the investment
 effects on the firms other investments must also be
considered
 With replacement projects, incremental cash flows
must be computed by subtracting existing project cash
flows from those expected from the new project.

11-2
Relevant VS Irrelevant Cash Flows

Relevant Cash Flows

Incremental cash flows that associated with investment

Eg: installation, removal, training cost

Changes in working capital :

Net working capital
Cash inflows, outflows and Opportunity cost (related to
cannibalization)
Incremental cash flows that effects on the firms’ other investments
Eg: externalities or cannibalization
Positive (compliment) and negative (substitutes)
Terminal Values : after-tax salvage values due to end of project,
recovery of net working capital
11-3
Relevant VS Irrelevant Cash Flows
 Irrelevant Cash Flows
 Sunk cost : advertising or R&D for
product idea, marketing

11-4
Relevant Cash Flows

 Categories of Cash Flows:

 Initial Cash Flows are cash flows resulting initially
from the project.
 Operating Cash Flows are the cash flows generated
by the project during its operation.
 Terminal Cash Flows result from selling the project.

11-5
Steps in
Forecasting
Project
Cash Flow

11-6
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 (operational costs): 60% of sales

11-7
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%

11-8
 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
11-9
 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
11-10
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
11-11
 Annual operating cash flows
1 2 3 4
Revenues 200 200 200 200
- Variable 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

11-12
Terminal net cash flow
Recovery of NOWC $20,000
Salvage value 25,000
Tax on SV (40%) -10,000
Terminal CF $35,000

11-13
Proposed project’s cash flow time line
0 1 2 3 4

-260 80 91 62 55.0
Terminal CF → 35.0
90.0

 WACC 10%.
 NPV = -$4,019

11-14
11-15
Q. How is NOWC recovered?
Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash
flow?

11-16
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.

11-17
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.

11-18
 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

11-19
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).

11-20
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.

11-21
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.

11-22
 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

11-23
Considering inflation:
Project net CFs, NPV, and IRR
0 1 2 3 4

-260 82 96 70.0 65
Terminal CF → 35
100

 WACC 10%.
 NPV = $14,771.6

11-24
11-25
END OF TOPIC 1

11-26