ffm912-cash-flow-estimation-and-risk-analysis.ppt

fm912-cash-flow-estimation-and-risk-analysis

1. 12 - 1
Copyright © 2001 by Harcourt, Inc. All rights reserved.
CHAPTER 12
Cash Flow Estimation and
Risk Analysis
Relevant cash flows
Incorporating inflation
Types of risk

2. 12 - 2
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Proposed Project
Cost: $200,000 + $10,000 shipping
+ $30,000 installation. Depreciable
cost: $240,000.
Inventories will rise by $25,000 and
payables by $5,000.
Economic life = 4 years.
Salvage value = $25,000.
MACRS 3-year class.

3. 12 - 3
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Sales: 100,000 units/year @ $2.
Variable cost = 60% of sales.
Tax rate = 40%.
WACC = 10%.

4. 12 - 4
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Set up, without numbers, a time line
for the project’s cash flows.
0 1 2 3 4
OCF
1 OCF
2 OCF
3 OCF
4Initial
Costs
(CF
0
)
+
Terminal
CF
NCF
0
NCF
1
NCF
2
NCF
3
NCF
4

5. 12 - 5
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Equipment -$200
Installation & Shipping -40
Increase in inventories -25
Increase in A/P 5
Net CF
0 -$260
NOWC = $25 – $5 = $20.
Investment at t = 0:

6. 12 - 6
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What’s the annual depreciation?
Due to 1/2-year convention, a 3-year
asset is depreciated over 4 years.
YearRatexBasisDepreciation
1 0.33 $240 $ 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
1.00 $240

7. 12 - 7
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Operating cash flows:
1 2 3 4
Revenues $200$200$200$200
Op. Cost, 60%-120-120-120-120
Depreciation-79-108-36-17
Oper. inc. (BT)1-2844 63
Tax, 40% ---1118 25
1-1726 38
Add. Depr’n 79108 36 17
Op. CF 80 91 62 55
Oper. inc. (AT)

8. 12 - 8
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Net Terminal CF at t = 4:
Salvage Value 25
Tax on SV (40%) -10
Recovery of NOWC $20
Net termination CF$35
Q.Always a tax on SV? Ever a
positive tax number?
Q.How is NOWC recovered?

9. 12 - 9
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Should CFs include interest expense?
Dividends?
No. The cost of capital is
accounted for by discounting at
the 10% WACC, so deducting
interest and dividends would be
“double counting” financing
costs.

10. 12 - 10
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Suppose $50,000 had been spent last
year to improve the building. Should
this cost be included in the analysis?
No. This is a sunk cost.
Analyze incremental investment.

11. 12 - 11
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Suppose the plant could be leased out
for $25,000 a year. Would this affect
the analysis?
Yes. Accepting the project means
foregoing the $25,000. This is an
opportunity cost, and it should be
charged to the project.
A.T. opportunity cost = $25,000(1 – T)
= $25,000(0.6) = $15,000 annual cost.

12. 12 - 12
Copyright © 2001 by Harcourt, Inc. All rights reserved.
If the new product line would decrease
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 or negative,
i.e., complements or substitutes.

13. 12 - 13
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Here are all the project’s net CFs (in
thousands) on a time line:
Enter CFs in CF register, and I = 10%.
NPV = -$4.03
IRR = 9.3%
k = 10%
0
79.7
1
91.2
2
62.4
3
54.7
4
-260
Terminal CF 35.0
89.7

14. 12 - 14
Copyright © 2001 by Harcourt, Inc. All rights reserved.
MIRR = ?
10%
What’s the project’s MIRR?
Can we solve using a calculator?
0
79.7
1
91.2
2
62.4
3
89.7
4
-260
374.8-260
68.6
110.4
10%
10%
106.1

15. 12 - 15
Copyright © 2001 by Harcourt, Inc. All rights reserved.
4 10 -255.97 0
TV = FV = 374.8
Yes.CF
0
= 0
CF
1= 79.7
CF
2= 91.2
CF
3
= 62.4
CF
4
= 89.7
I= 10
NPV= 255.97
INPUTS
OUTPUT
N I/YRPVPMT FV

16. 12 - 16
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Use the FV = TV of inputs to find MIRR
4 -260 0 374.8
9.6
MIRR = 9.6%. Since MIRR < k = 10%,
reject the project.
INPUTS
OUTPUT
N I/YRPV PMT FV

17. 12 - 17
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What’s the payback period?
0
79.7
1
91.2
2
62.4
3
89.7
4
-260
Cumulative:
-26.7-260 -89.1-180.3 63.0
Payback = 3 + 26.7/89.7 = 3.3 years.

18. 12 - 18
Copyright © 2001 by Harcourt, Inc. All rights reserved.
If this were a replacement rather than a
new project, would the analysis change?
Yes. The old equipment would be
sold, and the incremental CFs would
be the changes from the old to the
new situation.

19. 12 - 19
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The relevant depreciation would be
the change with the new equipment.
Also, if the firm sold the old machine
now, it would not receive the SV at
the end of the machine’s life. This is
an opportunity cost for the
replacement project.

20. 12 - 20
Copyright © 2001 by Harcourt, Inc. All rights reserved.
 
.
k1
CostvRe
k1
CF
NPV
t
tt
t
t
n
0t 





Q. If E(INFL) = 5%, is NPV biased?
A. YES.
k = k* + IP + DRP + LP + MRP.
Inflation is in denominator but not in
numerator, so downward bias to NPV.
Should build inflation into CF forecasts.

21. 12 - 21
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Consider project with 5% inflation.
Investment remains same, $260.
Terminal CF remains same, $35.
Operating cash flows:
1 2 3 4
Revenues $210$220$232$243
Op. cost 60%-126-132-139-146
Depr’n -79 -108 -36 -17
Oper. inc. (BT)5 -20 57 80
Tax, 40% 2 -8 23 32
Oper. inc. (AT)3 -12 34 48
Add Depr’n 79 108 36 17
Op. CF 82 96 70 65

22. 12 - 22
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Here are all the project’s net CFs (in
thousands) when inflation is considered.
Enter CFs in CF register, and I = 10%.
NPV = $15.0
IRR = 12.6%
k = 10%
0
82.1
1
96.1
2
70.0
3
65.0
4
-260
Terminal CF 35.0
100.0
Project should be accepted.

23. 12 - 23
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What are the three types of project risk
that are normally considered?
Stand-alone risk
Corporate risk
Market risk

24. 12 - 24
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What is stand-alone risk?
The project’s total risk if it were
operated independently. Usually
measured by standard deviation (or
coefficient of variation). Though it
ignores the firm’s diversification
among projects and investor’s
diversification among firms.

25. 12 - 25
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What is corporate risk?
The project’s risk giving consideration
to 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.

26. 12 - 26
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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.

27. 12 - 27
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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.

28. 12 - 28
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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,
which in turn is likely to be highly
correlated with its market risk.

29. 12 - 29
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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. The
resulting changes in NPV are noted.

30. 12 - 30
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What are the primary advantages and
disadvantages of sensitivity analysis?
ADVANTAGE:
Sensitivity analysis identifies variables
that may have the greatest potential
impact on profitability. This allows
management to focus on those
variables that are most important.

31. 12 - 31
Copyright © 2001 by Harcourt, Inc. All rights reserved.
DISADVANTAGES:
Sensitivity analysis does not reflect
the effects of diversification.
Sensitivity analysis does not
incorporate any information about
the possible magnitudes of the
forecast errors.

32. 12 - 32
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Best 0.25 125,000
Perform a scenario analysis of the
project, based on changes in the
sales forecast.
Assume that we are confident of all the
variables that affect the cash flows,
except unit sales. We expect unit sales
to adhere to the following profile:
Case ProbabilityUnit sales
Base 0.50 100,000
Worst 0.25 75,000

33. 12 - 33
Copyright © 2001 by Harcourt, Inc. All rights reserved.
If cash costs are to remain 60% of
revenues, and all other factors are
constant, we can solve for project
NPV under each scenario.
Best 0.25 $57.8
Case Probability NPV
Base 0.50 $15.0
Worst 0.25 ($27.8)

34. 12 - 34
Copyright © 2001 by Harcourt, Inc. All rights reserved.
E(NPV)=.25(-$27.8)+.5($15.0)+.25($57.8)
E(NPV)= $15.0.
Use these scenarios, with their given
probabilities, to find the project’s
expected NPV, 
NPV, and CV
NPV.

NPV = [.25(-$27.8-$15.0)
2
+ .5($15.0-$15.0)
2
+ .25($57.8-$15.0)
2
]
1/2

NPV = $30.3.
CV
NPV = $30.3 /$15.0 = 2.0.

35. 12 - 35
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The firm’s average projects have
coefficients of variation ranging from
1.25 to 1.75. Would this project be of
high, average, or low risk?
The project’s CV of 2.0 would
suggest that it would be
classified as high risk.

36. 12 - 36
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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 this correlation is not perfectly
positive (i.e., r  1), we would
expect it to contribute to the
lowering of the firm’s total risk.

37. 12 - 37
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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.
If the project had a high correlation
with the economy, how would
corporate and market risk be affected?

38. 12 - 38
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Reevaluating this project at a 13%
cost of capital (due to high stand-
alone risk), the NPV of the project
is -$2.2 .
If the firm uses a +/-3% risk adjustment
for the cost of capital, should the
project be accepted?

39. 12 - 39
Copyright © 2001 by Harcourt, Inc. All rights reserved.
A risk analysis technique in
which probable future events
are simulated on a computer,
generating estimated rates of
return and risk indexes.
What is Monte Carlo simulation?