Chapter 12

Cash Flow Estimation and Risk Analysis

Allied Food Products
Capital Budgeting and Cash Flow Estimation

Allied Food Products is considering expanding into the fruit juice

business with a new fresh lemon juice product. Assume that you were
recently hired as assistant to the director of capital budgeting and you
must evaluate the new project.
The lemon juice would be produced in an unused building
adjacent to Allied’s Fort Myers plant; Allied owns the building, which
is fully depreciated. The required equipment would cost $200,000,
plus an additional $40,000 for shipping and installation. In addition,
inventories would rise by $25,000, while accounts payable would
increase by $5,000. All of these costs would be incurred at t = 0. By a
special ruling, the machinery could be depreciated under the MACRS
system as 3-year property. The applicable depreciation rates are
33%, 45%, 15%, and 7%.
The project is expected to operate for 4 years, at which time it will
be terminated. The cash inflows are assumed to begin 1 year after the
project is undertaken, or at t = 1, and to continue out to t = 4. At the
end of the project’s life (t = 4), the equipment is expected to have a
salvage value of $25,000.
Unit sales are expected to total 100,000 units per year, and the
expected sales price is $2.00 per unit. Cash operating costs for the
project (total operating costs less depreciation) are expected to total
60% of dollar sales. Allied’s tax rate is 40%, and its WACC is 10%.
Tentatively, the lemon juice project is assumed to be of equal risk to
Allied’s other assets.

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 1
 You have been asked to evaluate the project and to make a
recommendation as to whether it should be accepted or rejected. To
guide you in your analysis, your boss gave you the following set of
tasks/questions:

Table IC 12-1. Allied’s Lemon Juice Project

(Total Cost in Thousands)

End of Year: 0 1 2 3 4

I. Investment Outlay
Equipment cost
Installation
Increase in inventory
Increase in accounts payable
Total net investment
II. Project Operating Cash Flows
Unit sales (thousands) 100
Price/unit $ $
2.00 2.00
Total revenues $200.
0
Operating costs, excluding $120.
depreciation 0
Depreciation
36.0 16.8
Total costs $199. $228.
2 0
Operating income before taxes $
(EBIT) 44.0
Taxes on operating income
0.3 25.3
After-tax operating income $
26.4
Depreciation
79.2 36.0
Project operating cash flows $ $ $
0.0 79.7 54.7
III. Project Termination Cash Flows
Return of net working capital
Salvage value
Tax on salvage value

Total project termination cash flows

IV. Project Net Cash Flows

Project net cash flows ($260.0 $

2 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 ) 89.7
V. Results
NPV =
IRR =
MIRR =
Payback =

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 3
A. Allied has a standard form that is used in the capital
budgeting process. (See Table IC 12-1.) Part of the table
has been completed, but you must replace the blanks with
the missing numbers. Complete the table using the
following steps:

(1) Fill in the blanks under Year 0 for the initial investment
outlay.

A. (2) Complete the table for unit sales, sales price, total
revenues, and operating costs excluding depreciation.

A. (3) Complete the depreciation data.

A. (4) Complete the table down to after-tax operating income and

then down to the project’s operating cash flows.

A. (5) Fill in the blanks under Year 4 for the terminal cash flows,
and complete the project cash flow line. Discuss working
capital. What would have happened if the machinery had
been sold for less than its book value?

B. (1) Allied uses debt in its capital structure, so some of the

money used to finance the project will be debt. Given this
fact, should the projected cash flows be revised to show
projected interest charges? Explain.

B. (2) Suppose you learned that Allied had spent $50,000 to

renovate the building last year, expensing these costs.
Should this cost be reflected in the analysis? Explain.

4 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
B. (3) Suppose you learned that Allied could lease its building to
another party and earn $25,000 per year. Should that fact
be reflected in the analysis? If so, how?

B. (4) Assume that the lemon juice project would take profitable
sales away from Allied’s fresh orange juice business.
Should that fact be reflected in your analysis? If so, how?

C. Disregard all the assumptions from Part B, and assume

there is no alternative use for the building over the next 4
years. Now calculate the project’s NPV, IRR, MIRR, and
payback. Do these indicators suggest that the project
should be accepted? Explain.

D. If this project had been a replacement rather than an

expansion project, how would the analysis have changed?
Think about the changes that would have to occur in the
cash flow table.

E. (1) What three levels, or types, of project risk are normally

considered?

E. (2) Which type is most relevant?

E. (3) Which type is easiest to measure?

E. (4) Are the three types of risk generally highly correlated?

F. (1) What is sensitivity analysis?

F. (2) How would you perform a sensitivity analysis on the unit

sales, salvage value, and WACC for the project? Assume
that each of these variables deviates from its base-case, or

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 5
 expected, value by plus or minus 10%, 20%, and 30%.
Explain how you would calculate the NPV, IRR, MIRR, and
payback for each case; but don’t do the analysis unless
your instructor asks you to.

F. (3) What is the primary weakness of sensitivity analysis? What

are its primary advantages?

6 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
G. Unrelated to the lemon juice project, Allied is upgrading its
plant and must choose between two machines that are
mutually exclusive. The plant is highly successful, so
whichever machine is chosen will be repurchased after its
useful life is over. Both machines cost $50,000; however,
Machine A provides after-tax savings of $17,500 per year
for 4 years, while Machine B provides after-tax savings of
$34,000 in Year 1 and $27,500 in Year 2.

(1) Using the replacement chain method, what is the NPV of

the better machine?

G. (2) Using the EAA method, what is the EAA of the better
machine?

H. Assume that inflation is expected to average 5% over the

next 4 years and that this expectation is reflected in the
WACC. Moreover, inflation is expected to increase revenues
and variable costs by this same 5%. Does it appear that
inflation has been dealt with properly in the lemon juice
project’s initial analysis to this point? If not, what should
be done and how would the required adjustment affect the
decision?

I. The lemon juice project’s expected cash flows, considering

inflation (in thousands of dollars), are given in Table IC 12-2.
Allied’s WACC is 10%. Assume that you are confident about
the estimates of all the variables that affect the cash flows
except unit sales. If product acceptance is poor, sales will be
only 75,000 units a year, while a strong consumer response
would produce sales of 125,000 units. In either case, cash

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 7
 costs would still amount to 60% of revenues. You believe
that there is a 25% chance of poor acceptance, a 25% chance
of excellent acceptance, and a 50% chance of average
acceptance (the base case). Provide numbers only if you are
using a computer model.

(1) What is the worst-case NPV? The best-case NPV?

I. (2) Use the worst-case, most likely case (or base-case), and
best-case NPVs with their probabilities of occurrence to find
the lemon juice project's expected NPV, standard deviation,
and coefficient of variation.

J. Assume that Allied's average project has a coefficient of

variation (CV) in the range of 1.25 to 1.75. Would the
lemon juice project be classified as a high risk, an average
risk, or a low risk? What type of risk is being measured
here?

K. Based on common sense, how highly correlated do you

think the project would be with the firm's other assets?
(Give a correlation coefficient or range of coefficients based
on your judgment.)

L. How would the correlation coefficient and the previously

calculated  combine to affect the lemon juice project's
contribution to corporate, or within-firm, risk? Explain.

M. Based on your judgment, what do you think the lemon juice

project's correlation coefficient will be with respect to the
general economy and thus with returns on "the market"?

8 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 How will correlation with the economy affect the project’s
market risk?

N. Allied typically adds or subtracts 3% to its WACC to adjust

for risk. After adjusting for risk, should the lemon juice
project be accepted? Should any subjective risk factors be
considered before the final decision is made? Explain.

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 9