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10-1 CHAPTER 11 Cash Flow Estimation And Chapter 12 Risk Need to be in class for this ch. Relevant Cash Flows New Investment Replacement Investment Measuring Risk Market Risk (Beta) Project Risk Considerations

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Capital Budgeting Processes Capital budgeting process consists of the following steps: Determine (estimate) the expected cash flows of available projects Apply decision criteria such as NPV and IRR In this class you are given all the information to forecast cash flows but they are subject to error Estimating project cash flows is the most difficult and error-prone part of capital budgeting

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10-3 Example 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.

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10-4 Sales: 100,000 units/yr @ $2. Var. cost = 60% of sales. Tax rate = 40%. WACC = 10%. Data/Assumptions

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10-5 Three “categories” of Cash Flow 1. Initial Cost, including installation and change in net Working Capital 2. Operating Cash Flows –Need: Returns/Savings Tax Depreciation –Set up a modified income statement for each year 3. Terminal Cash Flow –Need to consider taxes and return of working capital

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10-6 Set up, without numbers, a time line for the project’s cash flows: 0123 4 OCF 1 OCF 2 OCF 3 OCF 4 Initial Cost + Terminal CF CF 0 CF 1 CF 2 CF 3 CF 4

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10-7 Investment at t = 0: (Initial cost)

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10-9 What’s the annual depreciation? Due to 1/2-yr conv., a 3-yr asset is depreciated over 4 years. DepreciationInitial Basis: $240,000 yearpercentageDepreciation 10.33 $ 79,200 20.45 $ 108,000 30.15 $ 36,000 40.07 $ 16,800 Total $ 240,000

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10-10 Operating cash flows: This is an income statement with no interest. Operating Cash Flow ItemYear 1Year 2Year 3Year 4 Sales $ 200,000 Variable cost $ 120,000 net returns $ 80,000 less Depreciation $ (79,200) $ (108,000) $ (36,000) $ (16,800) EBT $ 800 $ (28,000) $ 44,000 $ 63,200 Less 40% Tax $ (320) $ 11,200 $ (17,600) $ (25,280) EAT $ 480 $ (16,800) $ 26,400 $ 37,920 Dep add back $ 79,200 $ 108,000 $ 36,000 $ 16,800 Operating CF $ 79,680 $ 91,200 $ 62,400 $ 54,720

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10-11 Net Terminal CF at t = 4: Q. Always a tax on SV? Q. Ever a positive tax number? Q.How is NWC recovered?

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10-12 Tax on SV Do a “side” calculation! Selling Price - adjusted basis = Taxable gain (loss if negative) x tax rate = Tax (tax credit if negative) The tax basis when you sell an asset is the initial basis less accumulated depreciation (adjusted basis). The sign (negative or positive) can be confusing. You just have to think.

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10-13 Calculator Workout Draw the time line for this project and put the cash flows on the time line (on board). Compute the NPV and IRR Note we are skipping Profitability Index

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10-14 IRR = 9.28%

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10-15 What’s the Payback Period? 0 79.7 1 91.2 2 62.4 3 89.7 4 -260 Cumul: -26.7-260-89.1-180.363.0 Payback = 3 + 26.7 / 89.7 = 3.3 years. Numbers slightly rounded to fit onto slide better.

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10-16 Should CFs include int. 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.

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10-17 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.

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10-18 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. opp. cost = $25,000 (1 - T) = $25,000(0.6) = $15,000 annual cost.

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10-19 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 neg., i.e., complements or substitutes.

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10-20 Another Example Given the following information, calculate the NPV and IRR of a proposed project: Cost = $40,000; estimated life = 3 years; increase in accounts receivable = $10,000; estimated salvage value = $10,000; net income before taxes and depreciation = $20,000 per year; method of depreciation = 3-year MACRS; tax rate = 40 percent; required rate of return = 12 percent. (see spreadsheet key LectExample.xls)

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10-21 If this were a replacement rather than a new project, would the analysis change? Yes. The cash flows would be the incremental cash flow or changes in cash flow. 1. The old equipment would be sold now 2. You would calculate the change in revenue and expenses.

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10-22 3. The relevant depreciation would be the change with the new equipment. 4. Also, if the firm sold the old machine now, it would not receive the SV at the end of the machine’s life.

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10-23 Replacement Problem 9-3Atlantic Control Company purchased a machine two years ago at a cost of $70,000. At that time, the machine’s expected economic life was six years and its salvage value at the end of its life was estimated to be $10,000. It is being depreciated using the straight line method so that its book value at the end of six years is $10,000. In four years, however, the old machine will have a market value of $0. A new machine can be purchased for $80,000, including shipping and installation costs. The new machine has an economic life estimated to be four years. Three-year MACRS depreciation will be used. During its four-year life, the new machine will reduce cash operating expenses by $20,000 per year. Sales are not expected to change. But the new machine will require net working capital to be increased by $4,000. At the end of its useful life, the machine is estimated to have a market value of $2,500. The old machine can be sold today for $20,000. The firm’s marginal tax rate is 40 percent. The appropriate required rate of return is ten percent. a.If the new machine is purchased, what is the amount of the initial investment outlay at Year 0? b.What incremental operating cash flows will occur at the end of Years 1 through 4 as a result of replacing the old machine? c.What is the terminal cash flow at the end of Year 4 if the new machine is purchased? d.What is the NPV of this project? Should Atlantic replace the old machine?

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10-24 Problem 9-3 Key

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10-25 Operating Cash flow Item1234 Cost Savings$20,000 -Depreciation change -16,400-26,000-2000--4400 EBT3,600-600018,00024,400 -Taxes (40%)-1440--2400-7200-9760 EAT2160-360010,80014640 Depreciation add back 16,40026,0002000-4400 Operating Cash Flow 18560224001280010240

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10-26 Cash Flows and NPV K=10

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10-27 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.

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10-28 What does “risk” mean in capital budgeting? Risk relates to uncertainty about a project’s future profitability. Is NPV, IRR, large? Will taking on project increase firm’s and stockholders’ risk?

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10-29 Chapter 12 Read chapter 12 for background on the remaining slides in this set. There will not be a usual chapter homework for chapter 12 There will be questions on the chapter handed out in lab.

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10-30 Is risk analysis based on historical data or subjective inputs? Can sometimes use historical data, but generally can’t. So, risk analysis is usually based primarily on subjective judgment.

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10-31 What three types of risk are relevant in capital budgeting? 1.Stand-alone risk 2.Within-firm risk 3.Market risk

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10-32 How is each type of risk measured, and how do they relate to one another? 1.Stand-Alone Risk: Risk of the project if it were investor’s only asset. Ignores diversification. Measured by the std. dev. or CV of NPV.

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10-33 2. Within-Firm (Corporate) Risk: Reflects the project’s effect on corporate earnings stability. Considers firm’s other assets (diversification within the firm). Depends on (1) project’s std. dev. and (2) its correlation with returns on other projects. Measured by the project’s beta versus total corp. earnings.

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10-34 3. Market Risk: Project’s risk to a well-diversified investor. Takes account of firms’ and stockholders’ other assets. Total diversification. Depends on project’s correlation with the stock market. Stock market beta.

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10-35 How is each type of risk used? Market risk is theoretically best. However, creditors, customers, suppliers, and employees are affected by within-firm risk. Therefore, within-firm risk is also relevant.

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10-36 Stand-alone risk is easiest to measure, intuitive. Core projects correlated with other assets, so stand-alone risk reflects within-firm risk; Maybe?? If project is correlated with the economy, stand-alone risk also may reflect market risk; Not likely??

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10-37 What is sensitivity analysis? Shows how changes in a variable such as sales affect NPV or IRR. Each variable is fixed except for one. Change this one variable to see effect on NPV or IRR.

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10-38 Illustration *Salvage Value

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10-39 Sensitivity Graph Base NPV (000s) Unit sales SV k % change from base

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10-40 Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV. Unit sales line is steeper than salvage value or k, so NPV is more sensitive to changes in unit sales than in salvage value or k.

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10-41 Weaknesses of sensitivity analysis: 1. Does not reflect diversification. 2. Does not incorporate info. about the likelihood of changing variables, i.e., steep sales line not a problem if sales won’t fall. Why useful? 1.Gives idea of project risk. 2.Identifies dangerous variables.

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10-42 What is scenario analysis? Examines several possible situations, usually worst case, most likely case, and best case. Indicates range of possible outcomes.

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10-43 Assume we know all variables except unit sales, which could range from 75,000 to 125,000 (or 75 to 125). Here are the scenario NPVs: E(NPV) =$15.0 (NPV) =$30.3 Problem 6 in lab

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10-44 Standard Deviation: NPV = $30.3 Coefficient of Variation:

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10-45 With a 3% risk adjustment, should project be accepted? Project k = 10% + 3% = 13%. That’s 30% above base k. NPV = -$2,200, so reject.

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10-46 Define Monte Carlo simulation. A type of scenario analysis which brings in probabilities of input variables. Computer selects values for variables based on probability distributions.

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10-47 NPV and IRR are calculated. Process is repeated 1,000’s of times. End result: Prob. distr. of NPV and IRR.

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10-48 Prob. Density E(NPV)0 NPV xxxxxxxxx xxxxxxxxxxxxxx xxxxxxxxxxxxxxxxxx xxxxxx xxxxxxxxxxxxxx xxxxx

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10-49 Advantages of simulation analysis? Reflects probability ofeach input. Shows range of NPVs,expected NPV, NPV, and CV NPV. Simulation fairly easy to do with a spreadsheet (@risk)

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10-50 Disadvantages of simulation: Difficult to specify probability distributions and correlations. (If you have historical data there is software to help) If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!

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10-51 Sensitivity, scenario, and simulation analysis all ignore diversification. Thus, they measure only stand-alone risk.

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10-52 Find the project’s market risk and cost of capital based on the CAPM, given these inputs: Target debt ratio = 50%. k d = 12%Tax rate = 40% k RF = 10%Beta Project = 1.2 Market risk premium = 6%.

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10-53 Beta = 1.2, so project has more market risk than average. Project’s required return on equity:

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10-54 Project’s market risk vs. the firm’s overall risk: Project’s WACC = 12.2% vs. company WACC = 10%. Risk adjusted discount rate So project’s market risk must be greater than average. Problem 15, Hudson Furniture in lab

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10-55 Estimating project beta: 1.Pure-play. Find several publicly traded companies exclusively in project’s business. Use average of their betas as proxy for project’s beta. Hard to find such companies.

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10-56 2. Accounting beta. Run regression between “project’s” rate of return and S&P index rate of return. Accounting betas are correlated with market betas. But hard to get data on projects’ rate of return before the cap. bud. decision has been made. Usually accounting data for a division of the company is used for the “project”

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