Presentation on theme: "Capital Budgeting: Estimating Cash Flows and Analyzing Risk"— Presentation transcript:
1 Capital Budgeting: Estimating Cash Flows and Analyzing Risk CHAPTER 13Capital Budgeting: Estimating Cash Flows and Analyzing Risk
2 Chapter Topics Estimating cash flows: Risk Analysis: Decision Trees Issues in Project AnalysisDepreciation & Tax Effects on Salvage ValueInflationRisk Analysis:Sensitivity AnalysisScenario AnalysisSimulation AnalysisDecision TreesReal Options
3 Relevant Cash Flows: Incremental Cash Flow for a Project Project’s incremental cash flow is:Corporate cash flow with the projectMinusCorporate cash flow without the project.
4 Free Cash Flow Capital Expenditures = FA + Deprec ΔNOWC = Current Operating Assets– Current Operating LiabilitiesCurrent Operating Assets excludes Marketable SecuritiesCurrent Operating Liabilities excludes Notes Payable
5 Free Cash Flow “Investment outlay CF = CF0 “Operating CF” = Net Income + Non-cash items (deprec) each year“NOWC CF” = Net working capital requirements each year“Salvage CF” = After-tax salvage value of assets and NOWC recovery
6 Issues in Project Analysis Purchase of Fixed Assets …………… YNon-cash charges …………………….. YChanges in Net Working Capital……YInterest/Dividends …………..……….. N“Sunk” Costs …………………………….. NOpportunity Costs …………………….. YExternalities/Cannibalism …………… YTax Effects ………………………..…….. Y
7 Depreciation Basics MACRS 0 Recovery Period = Class Life Straight Line Salvage ValueMACRS 0Recovery Period = Class Life1/2 Year Convention
11 Tax Effect on Salvage Net Cash flow from sale = Sale proceeds - taxes paidTax basis = difference between sales priceand book value, where:Book value = Original basis- Accumulated depreciation
12 Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling PriceBV = Book ValueT = Corporate tax rate
13 Example: If Asset Sold After 3 Years BV (EOY 3) = $17IF: Selling price = $20TCF = $20 - (20-17)(.4) = $18.8IF: Selling price = $10TCF = $10 - (10-17)(.4) = $12.8
14 Adjusting for Inflation Nominal r > real rThe cost of capital, r, includes a premium for inflationNominal CF > real CFNominal cash flows incorporate inflationIf you discount real CF with the higher nominal r, then your NPV estimate is biased downward.
15 Real vs. Nominal Cash flows INFLATIONReal vs. Nominal Cash flowsRealNominal
16 Real vs. Nominal Cash flows INFLATIONReal vs. Nominal Cash flows2 Ways to adjustAdjust WACCCash Flows = RealAdjust WACC to remove inflationAdjust Cash Flows for InflationUse Nominal WACC
23 RIC Background Data Salvage Value Key Basic Calculations Cash Flow EstimationCash Flow Analysis
24 “Risk” in Capital Budgeting Uncertainty about a project’s future profitabilityMeasured by σNPV, σIRR, betaWill taking on the project increase the firm’s and stockholders’ risk?
25 Three types of relevant risk Stand-alone riskCorporate riskMarket (or beta) risk
26 Stand-Alone RiskThe project’s risk if it were the firm’s only asset and there were no shareholders.Ignores both firm and shareholder diversification.Measured by the σ or CV of NPV, IRR, or MIRR.
27 Probability Density 0 E(NPV) NPV Flatter distribution, larger , largerstand-alone risk.NPV
28 Corporate RiskReflects the project’s effect on corporate earnings stability.Considers firm’s other assets (diversification within firm).Depends on project’s σ, and its correlation, ρ, with returns on firm’s other assets.Measured by the project’s corporate beta.
29 Project X is negatively correlated to firm’s other assets → big diversification benefits If r = 1.0, no diversification benefits. If r < 1.0, some diversification benefitsProfitabilityProject XTotal FirmRest of FirmYears
30 Market RiskReflects the project’s effect on a well-diversified stock portfolio.Takes account of stockholders’ other assets.Depends on project’s σ and correlation with the stock market.Measured by the project’s market beta.
31 Conclusions on RiskStand-alone risk is easiest to measure, more intuitive.Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk.If the project is highly correlated with the economy, stand-alone risk also reflects market risk.
32 Sensitivity AnalysisShows how changes in an input variable affect NPV or IRREach variable is fixed except oneChange one variable to measure the effect on NPV or IRRAnswers “what if” questions
35 Results of Sensitivity Analysis Steeper sensitivity lines = greater riskSmall changes → large declines in NPVUnit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast
37 Sensitivity Ratio If SR>0 Direct relationship 14-37Sensitivity Ratio%NPV = (New NPV - Base NPV)/Base NPV%VAR = (New VAR - Base VAR)/Base VARIf SR>0 Direct relationshipIf SR<0 Inverse relationship
40 Sensitivity Analysis: Weaknesses Does not reflect diversificationSays nothing about the likelihood of change in a variablei.e. a steep sales line is not a problem if sales won’t fallIgnores relationships among variables
41 Sensitivity Analysis: Strengths Provides indication of stand-alone riskIdentifies dangerous variablesGives some breakeven information
42 Scenario Analysis Examines several possible situations, usually: Worst caseBase case or most likely case, andBest caseProvides a range of possible outcomes
45 Problems with Scenario Analysis Only considers a few possible out-comesAssumes that inputs are perfectly correlatedAll “bad” values occur together and all “good” values occur togetherFocuses on stand-alone risk
46 Monte Carlo Simulation Analysis A computerized version of scenario analysis which uses continuous probability distributionsComputer selects values for each variable based on given probability distributions
47 Monte Carlo Simulation Analysis NPV and IRR are calculatedProcess is repeated many times (1,000 or more)End result: Probability distribution of NPV and IRR based on sample of simulated valuesGenerally shown graphically
49 Advantages of Simulation Analysis Reflects the probability distributions of each inputShows range of NPVs, the expected NPV, σNPV, and CVNPVGives an intuitive graph of the risk situation
50 Disadvantages of Simulation Analysis Difficult to specify probability distributions and correlationsIf inputs are bad, output will be bad: “Garbage in, garbage out”
51 Disadvantages of Sensitivity, Scenario and Simulation Analysis Sensitivity, scenario, and simulation analyses do not provide a decision ruleThey do not indicate whether a project’s expected return is sufficient to compensate for its riskSensitivity, scenario, and simulation analyses all ignore diversificationThey measure only stand-alone risk, which may not be the most relevant risk in capital budgeting
52 Subjective risk factors Numerical analysis may not capture all of the risk factors inherent in the projectFor example, if the project has the potential for bringing on harmful lawsuits, then it might be riskier than a standard analysis would indicate
53 Decision Trees A technique for reducing risk Analyze multi-stage projects“Decision Nodes”Points where managers can take action based on new informationAssign probabilities to each leg
54 United RoboticsStage 1: (t=0) Invest $500,000 in market potential studyStage 2: (t=1) If study results positive, invest $1 million in prototypeStage 3: (t=2) Build plant at cost of $10 millionStage 4: (t=3) Product acceptance?
57 Real OptionsReal options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditionsAlert managers always look for real options in projectsSmarter managers try to create real options
58 Types of Real Options Investment timing options Growth options Expansion of existing product lineNew productsNew geographic marketsAbandonment optionsContractionTemporary suspensionFlexibility options