CHAPTER 13

Capital Budgeting:
Estimating Cash Flows and
Analyzing Risk
Topics
Estimating cash flows:
• Relevant cash flows
• Working capital treatment

How do project cash flows as calculated

in this chapter affect a firm’s corporate
free cash flow?
How does a proposed project’s estimated
NPV affect the value of the firm?
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 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 Project’s
aversion business
risk

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Incremental Cash Flow for a
Project
• Project’s incremental cash flow is:

Corporate cash flow with the project

Minus
Corporate cash flow without the
project.

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Cash flows in detail
I. The cash flow effect of asset
purchases and depreciation

II. Changes in net operating working

capital

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Cash flows in detail
III. Treatment of Financing Costs
 Should you subtract interest expense
or dividends when calculating CF?
 NO.
• We discount project cash flows with a cost
of capital that is the rate of return
required by all investors (not just
debtholders or stockholders), and so we
should discount the total amount of cash
flow available to all investors.
• They are part of the costs of capital. If we
subtracted them from cash flows, we
would be double counting capital costs
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Cash flows in detail
IV. 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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Cash flows in detail
V. Incremental costs (Opportunity
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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Cash flows in detail
VI. 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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Proposed Project Data
 $200,000 cost + $10,000 shipping
+ $30,000 installation.
 Economic life = 4 years.
 Salvage value = $25,000.
 MACRS 3-year class. (Modified
Accelerated Cost Recovery System:
the current tax depreciation
system)
Continued…
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Proposed Project Data (2)

 Annual unit sales 1,250.

 Unit sales price $200.
 Unit costs $100.
 Net working capital:
• NWCt 12%(Salest1)
 Tax rate 40%.
 Project cost of capital 10%.

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What is an asset’s
depreciable basis?

Basis = Cost
+ Shipping
+ Installation
$240,000

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Annual Depreciation Expense
(Thousands of Dollars)

(Initial
Year % Deprec.
Basis)
1 0.3333 $240 $80.0
2 0.4445 106.7
3 0.1481 35.5
4 0.0741 17.8
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 Annual Sales and Costs

Year 1 Year 2 Year 3 Year 4

Units 1,250 1,250 1,250 1,250

Unit
$200 $206 $212.18 $218.55
Price
Unit
$100 $103 $106.09 $109.27
Cost
$250,00 $257,50 $265,22 $273,18
Sales
0 0 5 8
$125,00 $128,75 $132,61 $136,58
Costs
0 0 3 814
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 Why is it important to include
inflation when estimating cash
flows? (1)
• Nominal r real r. The cost of capital, r, includes a premium
for inflation.

• Nominal CF real CF. This is because nominal cash flows

incorporate inflation.

• If you discount real CF with the higher nominal r, then your

NPV estimate is too low.

• Nominal CF should be discounted with nominal r, and real

CF should be discounted with real r.

• It is more realistic to find the nominal CF (i.e., increase cash

flow estimates with inflation) than it is to reduce the
nominal r to a real r.
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 Operating Cash Flows

Year 1 Year 2 Year 3 Year 4

Sales $250,000 $257,500 $265,225 $273,188
Costs 125,000 128,750 132,613 136,591
Deprec. 79,992 106,680 35,544 17,784
EBIT $ 45,008 $ 22,070 $ 97,069 $118,807
Taxes 18,003 8,828 38,827 47,523
(40%)
EBIT(1 – T) $ 27,005 $ 13,242 $ 58,241 $ 71,284
+ Deprec. 79,992 106,680 35,544 17,784
Net Op. CF $106,997 $119,922 $ 93,785 $ 89,068

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 Investments in Net Working
Capital (NWC)
CF Due to
NWC Investment
Sales (% of sales) in NWC
Year 0 $30,000 $30,000
$250,00
Year 1 30,900 900
0
Year 2 257,500 31,827 927
Year 3 265,225 32,783 956
Year 4 273,188 0 32,783
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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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 Net Cash Flows for Years 1-4

Year 0 Year 1 Year 2 Year 3 Year 4

Init. -$240,000 0 0 0 0
Cost
Op. CF 0 $106,997 $119,92 $93,78 $89,068
2 5
NWC CF -$30,000 -$900 -$927 -$955 $32,782

Salvage 0 0 0 0 $15,000
CF
Net CF -$270,000 $106,097 $118,99 $92,83 $136,850
5 0

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 Project Net CFs Time Line

0 1 2 3 4

(270,000)106,097 118,995 92,830 136,850

Enter CFs in CFLO register and I/YR

10.
NPV $88,010.
IRR 23.9%.
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 What is the project’s
payback? ($ thousands)

0 1 2 3 4

(270) 106 119 93 137

Cumulative:
(270) (164) (45) 48 185

Payback = 2 + $45/$93 = 2.5 years.

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What if you terminate a project
before the asset is fully
depreciated?
• Basis Original basis Accum.
deprec.

• Taxes are based on difference

between sales price and tax basis.
Cash flow = Sale – Taxes
from sale proceeds paid

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Annual Depreciation Expense
(Thousands of Dollars)
(Initial =
Year % X
Basis) Deprec.
1 0.3333 $240 $80.0

2 0.4445 106.7

3 0.1481 35.5

4 0.0741 17.8

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Example: If Sold After 3
Years for $25 ($ thousands)
• Original basis = $240.
• After 3 years, basis = $17.8
remaining.
• Sales price = $25.
• Gain or loss = $25 – $17.8 = $7.2.
• Tax on sale = 0.4($7.2) = $2.88.
• Cash flow = $25 – $2.88 = $22.12.

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Example: If Sold After 3
Years for $10 ($ thousands)
• Original basis $240.
• After 3 years, basis $17.8 remaining.
• Sales price $10.
• Gain or loss $10 $17.8 $7.8.
• Tax on sale 0.4($7.8) $3.12.
• Cash flow sales price taxes paid on sale
• Cash flow $10 ($3.12) $13.12.
• Sale at a loss provides a tax credit, so
cash flow is larger than sales price!
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