CHAPTER 13

Cash Flow Estimation and Risk

Analysis

 Relevant cash flows

 Types of risk
 Risk analysis

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Proposed Project 1
 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: 60% of sales
 Life of the project
 Economic life: 4 years
 Depreciable life: MACRS (33%, 45%, 15%, 7%)
 Salvage value: $25,000
 Tax rate: 40%, WACC: 10% 12-2
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 Determining Project Value  ∆NOWC = CA- (
 Most analysts v
a financing cost
 Estimate relevant cash flows
not part of the c
 Calculating annual operating cash flows.  Current liabilitie
treated as part
 Identifying changes in net operating working capital.
thus are include
 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
 Find 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:
Equipment cost -$200,000
Installation -40,000
CAPEX -240,000
NOWC -20,000
FCF0 -$260,000 12-5
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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 -120.0 -120.0 -120.0 -120.0
– Deprec. expense -79.2 -108.0 -36.0 -16.8
EBIT 0.8 -28.0 44.0 63.2
– Tax (40%) 0.3 -11.2 17.6 25.3
EBIT(1 – T) 0.5 -16.8 26.4 37.9
+ Depreciation 79.2 108.0 36.0 16.8
EBIT(1 – T) + DEP 79.7 91.2 62.4 54.7

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 Determining Annual Depreciation Expense
Year Rate x Basis Deprec.
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

Due to the MACRS ½-year convention, a 3-

year asset is depreciated over 4 years.

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Terminal Cash Flows

(Thousands of dollars)
Salvage value $25
 Tax on SV (40%) 10
AT salvage value $15
+ NOWC 20
Terminal CF $35

FCF4 = EBIT(1 – T) + DEP – CAPEX – NOWC

= $54.7 + $35
= $89.7
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 1) 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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2) Should a $50,000 improvement cost

from the previous year be included in
the analysis? – Sunk Cost

 No
 The building improvement cost is a sunk
cost (cost that has been incurred, cannot
be recovered) and should not be
considered.
 This analysis should only include
incremental investment.

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 3) If the facility could be leased out for
$25,000 per year, would this affect the
analysis? – Opportunity Cost
 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 12-11
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4) If the new product line decreases the

sales of the firm’s other lines, would this
affect the analysis? – Externality
 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).
The new product may actually add or take away to
sales of the existing product
Cannibalization
- the type of externality where the new project takes sales away from
the existing product.
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 Proposed Project’s Cash Flow
Time Line
(Thousands of dollars)
0 1 2 3 4

-260 79.7 91.2 62.4 89.7

 Enter CFs into calculator CFLO register, and enter I/YR = 10%.
NPV = -$4.03
Excel: =NPV(rate,C
IRR = 9.3% =IRR(CF0:C

MIRR = 9.6% =MIRR(CF0:

Payback = 3.3 years Assume both rat

Discounted Payback = more than 4 years

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What are the 3 types of project risk?

 A) Stand-alone risk
 B) Corporate risk
 C) Market risk

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 A) What is stand-alone risk?
 The project’s total risk, if it were
operated independently.
 Usually measured by standard
deviation (or coefficient of variation).
 However, it ignores the firm’s
diversification among projects and
investor’s diversification among firms.

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B) 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 projects in the firm.

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 C) 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?

 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.

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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.

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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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 I) What is sensitivity analysis?
 Sensitivity analysis is simply the method for
determining how sensitive our NPV analysis is to
changes in our variable assumptions.

 To perform a sensitivity analysis, all variables are

fixed at their expected values, except for the
variable in question which is allowed to fluctuate.

 Resulting changes in NPV are noted.

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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 magnitudes of the forecast errors.

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Evaluating Projects with

Unequal Lives
• Machines A and B are mutually exclusive, and will
be repurchased. If WACC = 10%, which is better?

Expected Net CFs

Year Machine A Machine B
0 ($50,000) ($50,000)
1 17,500 34,000
2 17,500 27,500
3 17,500 –
4 17,500 –
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 Solving for NPV with No
Repetition

 Enter CFs into calculator CFLO register for

both projects, and enter I/YR = 10%.
 NPVA = $5,472.65
 NPVB = $3,636.36
 Is Machine A better?
 Need replacement chain and/or equivalent
annual annuity analysis.

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Replacement Chain
 Use the replacement chain to calculate an
extended NPVB to a common life.
 Since Machine B has a 2-year life and Machine A
has a 4-year life, the common life is 4 years.
0 1 2 3 4
10%

-50,000 34,000
27,500
-50,000 34,000 27,500
-22,500
NPVB = $6,641.62 (on extended basis)
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 Equivalent Annual Annuity
 Using the previously solved project NPVs, the
EAA is the annual payment that the project
would provide if it were an annuity.
 Machine A
 Enter N = 4, I/YR = 10, PV = -5472.65, FV = 0;
solve for PMT = EAAA = $1,726.46.
 Machine B
 Enter N = 2, I/YR = 10, PV = -3636.36, FV = 0;
solve for PMT = EAAB = $2,095.24.
 Machine B is better!
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If expected inflation equals

5% is NPV biased?

 Yes, inflation causes the discount rate

to be upwardly revised.
 Therefore, inflation creates a
downward bias on NPV.
 Inflation should be built into CF
forecasts.

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 Project Operating Cash Flows, If
Expected Inflation = 5% 200*1.05
210*1.05

(Thousands of dollars) 1 2 3 4
Revenues 210 220 232 243
Op. costs (60%) -126 - 132 - 139 -146
– Depreciation -79 - 108 - 36 -17
EBIT 5 - 20 57 80
– Tax (40%) 2 -8 23 32
EBIT(1 – T) 3 - 12 34 48
+ Depreciation 79 108 36 17
EBIT(1 – T) + DEP 82 96 70 65

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Considering Inflation:
Project CFs, NPV, and IRR
(Thousands of dollars)
0 1 2 3 4

-260 82.1 96.1 70.0 65.1

35.0
FCFs -260 82.1 96.1 70.0 100.1

 Enter CFs into calculator CFLO register, and

enter I/YR = 10%.
NPV = $15.0. MIRR = 11.6%.
IRR = 12.6%. Payback = 3.1 years.
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 II) Scenario analysis (Kepekaan)
 Scenario analysis takes sensitivity analysis a step further.
 Rather than just looking at the sensitivity of our NPV
analysis to changes in our variable assumptions, scenario
analysis also looks at the probability distribution of the
variables.
 Scenario analysis includes the construction of a base case
scenario, the "best-case scenario" and the "worst-case
scenario".
Case Probability NPV
Worst 0.25 ($27.8)
Base 0.50 $15.0
Best 0.25 $57.8
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Perform a Scenario Analysis of the

Project, Based on Changes in the
Sales Forecast

 Suppose we are confident of all the variable

estimates, except unit sales. The actual unit
sales are expected to follow the following
probability distribution:

Case Probability Unit Sales

Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000
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Determining expected NPV, NPV, and

CVNPV from the scenario analysis

 E(NPV) = 0.25(-$27.8)+0.5($15.0)+0.25($57.8)
= $15.0

 NPV = [0.25(-$27.8-$15.0)2 + 0.5($15.0-

$15.0)2 + 0.25($57.8-$15.0)2]1/2
= $30.3.

 CVNPV = $30.3 /$15.0 = 2.0.

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 If the firm’s average projects have CVNPV
ranging from 1.25 to 1.75, would this
project be of high, average, or low risk?

 With a CVNPV of 2.0, 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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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 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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 If the project had a high correlation with
the economy, how would corporate and
market risk be affected?

 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.

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If the firm uses a +/-3% risk

adjustment for the cost of capital,
should the project be accepted?

 Reevaluating this project at a 13% cost

of capital (due to high stand-alone
risk), the NPV of the project is -$2.2.
 If, however, it were a low-risk project,
we would use a 7% cost of capital and
the project NPV is $34.1.

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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.
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