1. All Rights Reserved Dr. David P. Echevarria 1 Cash Flow Estimation Risk Analysis CHAPTER 12 Conceptual Considerations Analytical Methodology Decision Metrics

2. Conceptual Considerations A.Free Cash Flow = EBIT*(1-Tax Rate) – (CapEx + Changes in WC) B.Accounting Income = Revenues – Expenses* Operating and Non-Operating Operating and Non-Operating C.Incremental Cash Flows: change in total cash flows as the result of an investment decision D.Sunk Costs: costs incurred in the past which cannot be recovered in the future regardless of the investment decision All Rights Reserved Dr. David P. Echevarria 2

3. All Rights Reserved Dr. David P. Echevarria 3 ANALYTICAL METHODOLOGY A. Tax Considerations When Replacing Old Plant and Equipment. 1. Replacement projects are undertaken to reduce costs. 2. May involve the disposition of the old asset being replaced. 3. Three possible situations when disposing (selling) old assets (continued on next slide)

4. All Rights Reserved Dr. David P. Echevarria 4 ANALYTICAL METHODOLOGY 3. Three possible situations when disposing (selling) old assets a. If salvage value is less than book = tax credit. The credit is a positive cash flow. The credit is a positive cash flow. a. If salvage value is equal to book = it's a wash. b. If salvage value is more than book = tax liability. The liability is a negative cash flow. The liability is a negative cash flow.

5. All Rights Reserved Dr. David P. Echevarria 5 ANALYTICAL METHODOLOGY B.Determining Initial Investment (Io) 1.The initial investment (or outlay) is the amount of new cash we must provide to launch the venture. 2.The initial outlay (Io) is assumed to occur on day zero. Io = CFo [-] in the BA II Plus C.Typical Investment Objectives 1.Support additional sales. 2.Lower operating costs. 3.All projects must produce additional ATCF.

6. All Rights Reserved Dr. David P. Echevarria 6 ANALYTICAL METHODOLOGY D. Learning Strategy 1. I will provide the change in operating income before depreciation and taxes. 2.Depreciation Schedule according to M-ACRS 3.The Net Present Value of a Project (NPV); NPV =  [ATCF n / (1+k a ) n ] - Io

7. Risk Analysis A.The riskiness of a potential investment can best be approximated by sensitivity analysis 1.Changes in the cost of equipment or construction 2.Changes on Production Costs: Fixed, Variable 3.Changes in Expected Sales 4.Changes in the Cost of Capital 5.Changes in Tax Rates All Rights Reserved Dr. David P. Echevarria 7

8. B.Sensitivity can best be gauged using an NPV profile 1.A steep curve is implies less sensitivity 2.A shallow curve suggest more sensitivity All Rights Reserved Dr. David P. Echevarria 8

9. All Rights Reserved Dr. David P. Echevarria 9 CAPITAL BUDGETING CLASS EXERCISE FIN 335

10. All Rights Reserved Dr. David P. Echevarria 10 CAPITAL BUDGETING EXERCISE A.Background Information: New Project Analysis 1.New machine [installed] cost = $ 250,000 2.Benefit: increases EBDT by $ 90,000 per year 3.Economic Expected Project Life = 5 years 4.Machine in 3 year ACRS category (ADC % rates = 33, 45, 15, 7 for years 1,2,3,4) 5.Expected Salvage Value at end of 5th year = $ 23,000 6.Startup Working Capital required = $ 25,000 (to be recouped at end of 5th year) 7.Tax rate = 40%, WACC = 10%

11. All Rights Reserved Dr. David P. Echevarria 11 Computing Depreciation Schedule DEPRECIATION SCHEDULE FOR NEW MACHINE YEARACRSCOSTADCACDEPBV 1 0.33250000 2 0.45250000 3 0.15250000 4 0.07250000

12. All Rights Reserved Dr. David P. Echevarria 12 Compute After Tax Cash Flows YEAR 12345 EBDT 9000090000900009000090000 DEPR EBT TAX EAT DEPR ATCF

13. All Rights Reserved Dr. David P. Echevarria 13 After Tax Cash Flows YEAR12345 ATCF8700099000690006100092800 Recoup WC 25000 Sale23000 Taxes Net ATCF

14. All Rights Reserved Dr. David P. Echevarria 14 Compute NPV Using BA II PLUS Press CF key: Use [ENTER] key to save values. Note CFo is a negative value. CFo = -275000 ($250,000 cost of new machine + $25,000 WC needs) ↓C01 = 87000↓F01 = 1 ↓C02 = 99000↓F02 = 1 ↓C03 = 69000↓F03 = 1 ↓C04 = 61000↓F04 = 1 ↓C05 = 92800↓F05 = 1 2ND QUIT Press NPV key I = 10[↓]Press [CPT]: NPV = 37,035.13 Press IRR key Press [CPT]IRR = 15.30 [%]

15. All Rights Reserved Dr. David P. Echevarria 15 MIRR: Compute FV of ATCF using the WACC (10%)FVIF = (1 + K a ) (5-n) Table 3 FVIF(1) = (1.10) (5-1) = 1.4641, FVIF(2) = (1.10) 3 = 1.3310, etc. Terminal Value =  FV n from Table 3 = $ 502,535.70 2 nd CLR TVM FV = 502535.7 PV = - 275000 N = 5 CPT I/Y = 12.81 [%]

16. All Rights Reserved Dr. David P. Echevarria 16 Compute Payback Period Number of years to recoup CFo ($ 275,000) 870000 + 99000 + 69000 = 255000 + 20000/61000 = 3.33 years Sensitivity Analysis A. NPV if annual savings are 20% greater (EBDT = $108,000 per year) NPV = $ 77,975.63 B. NPV if annual savings are 20% smaller (EBDT = 72,000 per year) NPV = $ -3,905.37

17. All Rights Reserved Dr. David P. Echevarria 17 HOMEWORK CHAPTER 12 A.Self-Test: ST-1, parts d, e, standalone risk B.Questions: 12-4, 12-6, 12-9 C.Problems: 12-1, 12-5, 12-9 D.Excel Simulation #2 1.The Excel simulation primarily focuses on sensitivity analysis. 2.Care should be taken when input the various options. Make certain you reset to base values before proceeding to the next option.