Cash Flow Estimation
and Risk Analysis
Chapter 12
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Overview
Relevant Cash Flows
Types of Risk
Risk Analysis
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Relationships Between Chapters
Main steps in the capital budgeting
process:
• Chapter 10: Determine the WACC
• Chapter 12: Determine relevant cash flows
• Chapter 11: Apply metrics NPV, IRR, etc.
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CF Structure
Cash flows are categorized into three types:
• Initial Costs (time 0)
• Yearly operating CFs (time 1,2,…,N)
• Terminal or Shut-Down CFs (time N)
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Recall “Free Cash Flow” from Chapter 3
FCF = [EBIT(1 – T) + Depr and amort] – [Capital expenditures + NOWC]
These comprise the annual These comprise the Initial Costs
after-tax OCFs (time 1,2,…,N) (time 0), and the Terminal or
Shutdown CFs (time N)
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What are the Relevant Cash Flows?
Consider each of the following:
Incremental Cash Flows
Opportunity Costs
Sunk Costs
Financing Costs
Externalities / Project Interactions
Impact of Depreciation
Tax on Capital Gain or Loss from Sale of Asset
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How are Financing Costs Reflected?
Consider the NPV equation
Financing costs are reflected in the denominator
in the discount rate (WACC)
To also subtract them in the numerator would be
to double count them
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What is After-Tax Operating Cash Flow?
GAAP Income Statement vs. Capital Budgeting Analysis
Sales Sales
less: SG&A Expenses less: SG&A Expenses
less: Depreciation less: Depreciation
EBIT EBIT
less: Interest Expense less: Taxes
EBT After-tax operating income
less: Taxes plus: add back Depreciation
= Net income = After-tax operating cash flow
(note: interest expense is ignored)
A-T Operating CF = EBIT(1 – T) + Depreciation
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Capital Gains and Losses from Sale of Asset
formula from text:
definitions:
Salvage value = refers to market value (MV) of asset
Book value = undepreciated portion of asset on balance sheet
calculations:
Capital Gain = (Salvage value – Book value)
Tax on capital gain = Tax rate × (Salvage value – Book value)
or: T × (MV – BV)
Net proceeds from sale of asset = MV – Tax on capital gain
(also called “A-T salvage value”)
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Example: Capital Gain
If MV > BV, then the capital gain is positive
There is a positive tax liability
example:
MV = 100, BV = 60, and T=.25
Net proceeds from sale = MV – Tax on capital gain
= MV – [T × (MV – BV)]
= 100 – [.25 × (100 – 60)]
= 100 – [10]
= 90
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Example: Capital Loss
If MV < BV, then the capital gain is negative (i.e., a capital loss)
There is a negative tax liability (i.e., a tax savings)
example:
MV = 100, BV = 140, and T=.25
Net proceeds from sale = MV – Tax on capital gain
= MV – [T × (MV – BV)]
= 100 – [.25 × (100 – 140)]
= 100 – [– 10]
= 110
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Proposed Project
Equipment Cost
• Equipment purchase price: $280,000
• Equipment eligible for 100% bonus depreciation
• After-tax cost @ t = 0: $280,000 × (1 − T) = $210,000
Changes in net operating 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
• Equipment eligible for 100% bonus depreciation
We are interested in cash flows, so our focus is on
tax depreciation.
Equipment will be fully depreciated at time of
purchase.
• Salvage value: $25,000
Tax rate: 25%
WACC: 10%
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Determining Project Value
Estimate relevant cash flows
• Calculating annual operating cash flows.
• Identifying changes in net operating working
capital.
• Calculating terminal cash flows: after-tax salvage
value and recovery of NOWC.
0 1 2 3 4
Initial OCF1 OCF2 OCF3 OCF4
Costs +
Terminal
CFs
FCF0 FCF1 FCF2 FCF3 FCF4
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Initial Year Investment Outlays
A-T Capital Expenditure = 210,000
Compute NOWC.
• in inventories of $25,000
• Funded partly by an in A/P of $5,000
• NOWC = $25,000 – $5,000 = $20,000
Initial year outlays:
CAPEX (1 − T) -210,000
NOWC -20,000
FCF0 -$230,000
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Project Operating Cash Flows
(Thousands of dollars) 1 2 3 4
Revenues 200.0 200.0 200.0 200.0
– Op. costs (60% of sales) 120.0 120.0 120.0 120.0
– Depr. (100% at t = 0) 0.0 0.0 0.0 0.0
EBIT 80.0 80.0 80.0 80.0
– Tax (25%) 20.0 20.0 20.0 20.0
EBIT(1 – T) 60.0 60.0 60.0 60.0
+ Depreciation 0.0 0.0 0.0 0.0
EBIT(1 – T) + DEP 60.0 60.0 60.0 60.0
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Terminal Cash Flows
(Thousands of dollars)
Salvage value $25.00
Tax on Cap. Gain (25%) 6.25
AT salvage value $18.75
+ NOWC 20.00
Terminal CF $38.75
Note: Tax on Cap. Gain = T × (MV – BV)
= .25 × (25 – 0)
= 6.25
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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.
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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.
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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(0.75)
= $18,750
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If the new product line decreases the sales of the firm’s other
lines, would this affect the analysis?
Yes. The effect on other projects’ CFs is an
“externality” or “project interaction”
Net CF loss per year on other lines would be a
cost to this project.
• This is called “cannibalization”
Externalities can be positive (in the case of
complements) or negative (substitutes).
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Proposed Project’s Cash Flow Time Line
(Thousands of dollars)
0 1 2 3 4
-230 60 60 60 98.75
Enter CFs into calculator CFLO register,
and enter I/YR = 10%.
NPV = -$13.34
IRR = 7.5%
MIRR = 8.4%
Payback = 3.5 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.
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Other Topics
Risk Analysis in Capital Budgeting
• Stand-Alone Risk
• Corporate Risk
• Market Risk
Measuring the Impact of Risk
• Sensitivity Analysis
• Scenario Analysis
• Simulation
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What are the 3 types of project risk?
Stand-alone risk
Corporate risk
Market 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) of NPV.
However, it ignores the firm’s diversification
among projects and investors’ diversification
among firms.
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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 firm projects.
Recall the correlation coefficient ranges from -1
to +1.
Typically a project has 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 overall risk.
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What is market risk?
The project’s risk to a well-diversified investor.
Theoretically, it is measured by the project’s
beta and it considers both corporate and
stockholder diversification.
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Which type of risk is most relevant?
For publicly traded firms, market risk is the most
relevant risk for capital projects, because
management’s primary goal is shareholder
wealth maximization and shareholders are
assumed to be well diversified.
However, since corporate risk affects creditors,
customers, suppliers, and employees, it should
not be completely ignored.
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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 (see next slide).
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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.
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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 other
variables are fixed at their expected values,
except for the variable in question which is
allowed to fluctuate.
Resulting changes in NPV are noted.
NPV Profiles are an example of sensitivity
analysis with respect to the variable WACC
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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 magnitude of the forecast errors.
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What is Scenario Analysis?
Construct a probability distribution based on
best-case, worst-case and base-case scenarios.
For example:
Case Probability NPV
Worst 0.25 ($43.1)
Base 0.50 10.4
Best 0.25 63.9
Base case often corresponds to all variables
being at their expected value or mean
Worst case assumes the worst outcome for all
input variables; best case assumes the best
outcome for all input variables
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Determining Expected NPV, NPV, and CVNPV from the Scenario
Analysis
E(NPV) = 0.25(-$43.1) + 0.5($10.4) + 0.25($63.9)
= $10.4
σNPV = [0.25(-$43.1 − $10.4)2 + 0.5($10.4 − $10.4)2
+ 0.25($63.9 − $10.4)2]1/2
= $37.8
CVNPV = $37.8/$10.4 = 3.6
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If firm’s average projects’ CVNPV range is 1.25 - 1.75, would this
project have high, average, or low risk?
With a CVNPV of 3.6, this project would be
classified as a high-risk project.
Perhaps, some sort of risk correction is required
for proper analysis.
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If the firm uses a +/-4% risk adjustment for the cost of
capital, should the project be accepted?
Reevaluating this project at a 14% cost of
capital (due to high stand-alone risk), the NPV of
the project is -$10.83.
If, however, it were a low-risk project, we would
use a 6% cost of capital and the project NPV is
$35.09.
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What is simulation analysis?
Most common type is Monte Carlo simulation
A computer randomly picks values for input
variables like sales, costs, etc., and uses them to
compute a hypothetical NPV
This process is repeated many times (usually
thousands of iterations)
This generates thousands of NPV values that form
a hypothetical probability distribution which is
used to make probability estimates
A complex and costly process, requires data from
multiple departments to estimate input variables,
as well as correlations and probabilities
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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 than otherwise
thought.
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End of Chapter 12
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5
