CHAPTER 12

Cash Flow Estimation and

Risk Analysis

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1
 The Big Picture:
Project Risk Analysis

Project’s Cash
Flows (CFt)

CF CF CF
NPV = + + ··· + N −
(1 1+ r )1 (1 2+ r)2 (1 + r)N
Initial cost

Market Project’s
interest debt/equity
Project’s risk-
rates capacity
adjusted
cost of capital
Market (r)
risk
aversion Project’s
business
risk
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 Topics
 Conceptual Issues in Cash Flow
Estimation
 Analysis of an Expansion Project
 Replacement Analysis
 Risk analysis in Capital Budgeting
 Measuring Stand-Alone Risk
 Within-Firm and Beta Risk
 Unequal Project Lives
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 Learning Outcome
 Identify “relevant” cash flows that
should and should not be included in a
capital budgeting analysis.

 Explain how risk is measured and use

this measure to adjust the firm’s
WACC.

 Correctly calculate the NPV of mutually

exclusive projects that have unequal4
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 Conceptual Issues in Cash
Flow Estimation
 Free Cash Flow vs Accounting Income

 EBIT(1-T) = NOPAT = The amount of cash

generated from existing operations
 Capital Expenditures = The amount of
Cash the company plans to spend on Fixed
Assets

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 Conceptual Issues in Cash
Flow Estimation
 Timing of Cash Flows
 Incremental Cash Flows
 Replacement Projects
 Sunk Costs
 Opportunity Costs Associated With Assets the
Firm Owns
 Externalities
 Negative With-in-Firm Externalities
 Positive With-in-Firm Externalities
 Environmental Externalities
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 Conceptual Issues in Cash
Flow Estimation
 Timing of Cash Flows
 Incremental Cash Flows
 Replacement Projects
 Sunk Costs
 Opportunity Costs Associated With Assets the
Firm Owns
 Externalities
 Negative With-in-Firm Externalities
 Positive With-in-Firm Externalities
 Environmental Externalities
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Sunk Costs?
 Suppose $100,000 had been spent last
year to improve the production line site.
Should this cost be included in the
analysis?

 NO. This is a sunk cost. Focus on

incremental investment and operating
cash flows.

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Incremental Costs?
 Suppose the plant space could be
leased out for $25,000 a year. Would
this affect the analysis?
 Yes. Accepting the project means we will
not receive the $25,000. This is an
opportunity cost, and it should be
charged to the project.
 A.T. opportunity cost = $25,000 (1 – T)
= $15,000 annual cost.

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Externalities
 If the new product line would decrease
sales of the firm’s other products by
$50,000 per year, would this affect the
analysis?
 Yes. The effects on the other projects’
CFs are “externalities.”
 Net CF loss per year on other lines
would be a cost to this project.
 Externalities will be positive if new
projects are complements to existing
assets, negative if substitutes.
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Salvage Cash Flow at t = 4
(000s)
Salvage Value $25
Book Value 0
Gain or loss $25
Tax on SV 10
Net Terminal CF $15

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 Analysis of an Expansion
Project
Click on the below link:

Chapter 12 Blank.xlsx

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 Expansion Project Analysis
EFFECT OF DIFFERENT DEPRECIATION RATES

CANNIBALIZATION

OPPORTUNITY COSTS

SUNK COSTS

OTHER CHANGES TO THE INPUTS

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Replacement Analysis

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Replacement Analysis

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Replacement Analysis

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Replacement Analysis

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Replacement Analysis

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Replacement Analysis

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 Replacement Analysis
Summarized Information
New Machine:
Cost 8000
Change in NOWC 1500
Life 6 Years
Depreciation 20% 32% 19% 12% 11% 6%
Salvage Value 800
Increase in Sales 1000
Decrease in Cost 1500

Old Machine:
Cost 0
Book Value 2100
Life 6 Years
Salvage Value 500
Depreciation Straight Line 350 each year
Current Salvage Value 2500
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 CF0 CF1 CF2 CF3 CF4 CF5 CF6
Part I: New Machine
Cost -8000
ΔNOWC -1500
SV Old 2340
Increase in Sales 1000 1000 1000 1000 1000 1000
Decrease in Cost -1500 -1500 -1500 -1500 -1500 -1500
Depreciation 1600 2560 1520 960 880 480
Total Cost 100 1060 20 -540 -620 -1020
EBIT 900 -60 980 1540 1620 2020
Tax 0.4 360 -24 392 616 648 808
EBIT(1-T)+DEP 2140 2524 2108 1884 1852 1692
Salvage Value 480
ΔNOWC 1500
-7160 2140 2524 2108 1884 1852 3672
Part II: Old Machine
Cost 0
Sales 0 0 0 0 0 0
Cost 0 0 0 0 0 0
Depreciation 350 350 350 350 350 350
Total Cost 350 350 350 350 350 350
EBIT -350 -350 -350 -350 -350 -350
Tax -140 -140 -140 -140 -140 -140
EBIT(1-Tax)+DEP 140 140 140 140 140 140
Salvage Value 300
0 140 140 140 140 140 440
Part III: Incremental Cash Flows
-7160 2000 2384 1968 1744 1712 3232
Part IV: NPV Calculation
WACC 11%
NPV 1908.47
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 Unequal Project Lives
 Projects with significantly different lives
 NPV method may not indicate a better
project if:
 Project have different lives
 Mutually Exclusive
 Repetitive
 Two Methods
 Replacement Chain Method
 Equal Annual Annuity (EAA) Method
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Unequal Project Lives

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 Unequal Project Lives:
Replacement Chain
Method
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:
Equivalent Annual Annuities
(EAA)
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
 Replacement Chain and EAA methods
always result in same decision.
 Do we have to worry about unequal
life analysis for all projects that have
unequal lives?
 Not an issue if, Projects are independent
 No adjustment required if Mutually
exclusive projects are not repetitive

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Unequal Project Lives

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Unequal Project Lives
WACC 13%
Part I: Traditional Analysis
Machine 171-3
CF0 CF1 CF2 CF3 NPV 29,697.97
-171,000 85,000 85,000 85,000
Machine 356-6
CF0 CF1 CF2 CF3 CF4 CF5 CF6 NPV 53,349.10
-356,000 102,400 102,400 102,400 102,400 102,400 102,400
Part II: Replacement Chain Method
CF0 CF1 CF2 CF3 CF4 CF5 CF6 NPV 50,280.15
-171,000 85,000 85,000 85,000
-171,000 85,000 85,000 85,000
-171,000 85,000 85,000 -86,000 85,000 85,000 85,000
Part III: Equivalent Annual Annuities (EAA)
Machine 171-3 Machine 356-6
NPV -29,697.97 -53,349.10
N 3 6
I/Y 13% Answer: Select Machine 356-6 13%
FV 0 0
EAA $12,577.74 $13,345.45

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What three types of risk
are relevant in capital
budgeting?
 Stand-alone risk
 Corporate risk
 Market (or beta) risk

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Stand-Alone Risk
 The project’s risk if it were the
firm’s only asset and if investors
owned only one stock.
 Ignores both firm and shareholder
diversification.
 Measured by the variability of the
asset’s expected returns.

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Probability Density

Flatter distribution,
larger , larger
stand-alone risk.

0 E(NPV) NPV
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Corporate Risk
 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.

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Market Risk
 Reflects the project’s effect on a
well-diversified stock portfolio.
 Takes account of stockholders’
other assets.
 Depends on project’s σ and
correlation with the stock market.
 Measured by the project’s market
beta.
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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.
Continued…
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How is each type of risk
used?
 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?
 Shows how changes in a variable
such as unit sales affect NPV or
IRR.
 Each variable is fixed except one.
Change this one variable to see
the effect on NPV or IRR.
 Answers “what if” questions, e.g.
“What if sales decline by 30%?”
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 What is sensitivity
analysis?
 Here’s a list of the key inputs for
Project S:
 Equipment cost
 Change in net operating working capital
 Unit sales
 Sales price
 Variable cost per unit
 Fixed operating costs
 Tax rate
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38
Sensitivity Analysis

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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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What are the weaknesses
of
sensitivity analysis?
 Does not reflect diversification.

 Ignores relationships among

variables.

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Why is sensitivity analysis
useful?
 Gives some idea of stand-alone
risk.
 Identifies dangerous variables.
 Gives some breakeven information.

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 What is 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
 An analysis in which all the input variables are set at their

most likely values.

 Worst-Case Scenario
 An analysis in which all the input variables are set at their

worst reasonably Forecasted values.

 Best-Case Scenario
 An analysis in which all the input variables are set at their

best reasonably forecasted values.

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Scenario analysis

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Scenario analysis

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 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. 46
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 What is a simulation
analysis?
 A computerized version of scenario
analysis that uses continuous
probability distributions.

 Computer selects values for each

variable based on given probability
distributions.
(More...)
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 What is a simulation
analysis?
 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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Histogram of Results
18%

16%

14%

12%

10%

8%

6%

4%

2%

0% NPV
($475,145) ($339,389) ($203,634) ($67,878) $67,878 $203,634 $339,389 $475,145
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What are the advantages
of simulation analysis?
 Reflects the probability
distributions of each input.
 Shows range of NPVs, the
expected NPV, σNPV, and CVNPV.
 Gives an intuitive graph of the risk
situation.

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What are the
disadvantages
of simulation?
 Difficult to specify probability
distributions and correlations.
 If inputs are bad, output will be
bad:
“Garbage in, garbage out.”

(More...)
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What are the
disadvantages
of simulation?
 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.
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 Should subjective risk
factors be considered?
 Yes. A numerical analysis may not
capture all the risk factors inherent in
the project.

 For example, if the project has the

potential for bringing on harmful
lawsuits, then it might be riskier than
a standard analysis would indicate.
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Appendix 12A: Tax
Depreciation

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Appendix 12A: Tax
Depreciation

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 Self Test Questions and Problems
 End of Chapter Questions
 End of Chapter Problems

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