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Capital Budgeting: Estimating Cash Flows and Analyzing Risk

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1 Capital Budgeting: Estimating Cash Flows and Analyzing Risk
CHAPTER 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk

2 Chapter Topics Estimating cash flows: Risk Analysis: Decision Trees
Issues in Project Analysis Depreciation & Tax Effects on Salvage Value Inflation Risk Analysis: Sensitivity Analysis Scenario Analysis Simulation Analysis Decision Trees Real Options

3 Relevant Cash Flows: Incremental Cash Flow for a Project
Project’s incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project.

4 Free Cash Flow Capital Expenditures = FA + Deprec
ΔNOWC = Current Operating Assets – Current Operating Liabilities Current Operating Assets excludes Marketable Securities Current 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 …………… Y Non-cash charges …………………….. Y Changes in Net Working Capital……Y Interest/Dividends …………..……….. N “Sunk” Costs …………………………….. N Opportunity Costs …………………….. Y Externalities/Cannibalism …………… Y Tax Effects ………………………..…….. Y

7 Depreciation Basics MACRS  0 Recovery Period = Class Life
Straight Line  Salvage Value MACRS  0 Recovery Period = Class Life 1/2 Year Convention

8 MACRS Depreciation Classes
TABLE 13.1

9 MACRS Depreciation TABLE 13.2

10 Annual Depreciation Expense (000s)
SCC (Minicase): Equipment cost $200 Shipping Installation  Book Depr Value % 0.33 0.45 0.15 0.07 x Basis = Year 1 2 3 4 Depr $ 79.2 108.0 36.0 16.8 $240

11 Tax Effect on Salvage Net Cash flow from sale = Sale proceeds
- taxes paid Tax basis = difference between sales price and 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 Price BV = Book Value T = Corporate tax rate

13 Example: If Asset Sold After 3 Years
BV (EOY 3) = $17 IF: Selling price = $20 TCF = $20 - (20-17)(.4) = $18.8 IF: Selling price = $10 TCF = $10 - (10-17)(.4) = $12.8

14 Adjusting for Inflation
Nominal r > real r The cost of capital, r, includes a premium for inflation Nominal CF > real CF Nominal cash flows incorporate inflation If you discount real CF with the higher nominal r, then your NPV estimate is biased downward.

15 Real vs. Nominal Cash flows
INFLATION Real vs. Nominal Cash flows Real Nominal

16 Real vs. Nominal Cash flows
INFLATION Real vs. Nominal Cash flows 2 Ways to adjust Adjust WACC Cash Flows = Real Adjust WACC to remove inflation Adjust Cash Flows for Inflation Use Nominal WACC

17 Regency Integrated Chips

18 RIC – Depreciation & Salvage Value

19 RIC – Sales, Costs and NWC

20 RIC – Cash Flow Estimation

21 RIC: Cash Flow Analysis

22 Excel Functions

23 RIC Background Data Salvage Value Key Basic Calculations
Cash Flow Estimation Cash Flow Analysis

24 “Risk” in Capital Budgeting
Uncertainty about a project’s future profitability Measured by σNPV, σIRR, beta Will taking on the project increase the firm’s and stockholders’ risk?

25 Three types of relevant risk
Stand-alone risk Corporate risk Market (or beta) risk

26 Stand-Alone Risk The 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 , larger stand-alone risk. NPV

28 Corporate Risk Reflects 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 benefits Profitability Project X Total Firm Rest of Firm Years

30 Market Risk Reflects 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 Risk Stand-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 Analysis Shows how changes in an input variable affect NPV or IRR Each variable is fixed except one Change one variable to measure the effect on NPV or IRR Answers “what if” questions

33 RIC: Sensitivity Analysis

34 RIC: Sensitivity Graph

35 Results of Sensitivity Analysis
Steeper sensitivity lines = greater risk Small changes → large declines in NPV Unit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast

36 RIC: Sensitivity Analysis

37 Sensitivity Ratio If SR>0  Direct relationship
14-37 Sensitivity Ratio %NPV = (New NPV - Base NPV)/Base NPV %VAR = (New VAR - Base VAR)/Base VAR If SR>0  Direct relationship If SR<0  Inverse relationship

38 RIC: Sensitivity Ratios

39 RIC: Sensitivity Ratios & Graph

40 Sensitivity Analysis: Weaknesses
Does not reflect diversification Says nothing about the likelihood of change in a variable i.e. a steep sales line is not a problem if sales won’t fall Ignores relationships among variables

41 Sensitivity Analysis: Strengths
Provides indication of stand-alone risk Identifies dangerous variables Gives some breakeven information

42 Scenario Analysis Examines several possible situations, usually:
Worst case Base case or most likely case, and Best case Provides a range of possible outcomes

43 RIC: Scenario Analysis

44 RIC: Scenario Analysis

45 Problems with Scenario Analysis
Only considers a few possible out-comes Assumes that inputs are perfectly correlated All “bad” values occur together and all “good” values occur together Focuses on stand-alone risk

46 Monte Carlo Simulation Analysis
A computerized version of scenario analysis which uses continuous probability distributions Computer selects values for each variable based on given probability distributions

47 Monte Carlo Simulation Analysis
NPV and IRR are calculated Process is repeated many times (1,000 or more) End result: Probability distribution of NPV and IRR based on sample of simulated values Generally shown graphically

48 Histogram of Results

49 Advantages of Simulation Analysis
Reflects the probability distributions of each input Shows range of NPVs, the expected NPV, σNPV, and CVNPV Gives an intuitive graph of the risk situation

50 Disadvantages of Simulation Analysis
Difficult to specify probability distributions and correlations If 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 rule They do not indicate whether a project’s expected return is sufficient to compensate for its risk Sensitivity, scenario, and simulation analyses all ignore diversification They 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 project For 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 information Assign probabilities to each leg

54 United Robotics Stage 1: (t=0) Invest $500,000 in market potential study Stage 2: (t=1) If study results positive, invest $1 million in prototype Stage 3: (t=2) Build plant at cost of $10 million Stage 4: (t=3) Product acceptance?

55 United Robotics Decision Tree
Figure 13-5

56 United Robotics Decision Tree

57 Real Options Real 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 conditions Alert managers always look for real options in projects Smarter managers try to create real options

58 Types of Real Options Investment timing options Growth options
Expansion of existing product line New products New geographic markets Abandonment options Contraction Temporary suspension Flexibility options

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