2 Cash Flow EstimationMost important and most difficult step in the analysis of a capital projectFinancial staff’s role includes:Coordinating other departments’ effortsEnsuring that everyone uses the same set of economic assumptionsMaking sure that no biases are inherent in forecasts
3 Relevant Cash Flows Cash Flow Versus Accounting Income Incremental Cash Flows
4 Cash Flow Versus Accounting Income 2006 Situation Accounting Profits Cash FlowsSales $50, $50,000Costs except depreciation (25,000) (25,000)Depreciation (15,000)Net operating income or cash flow $10,000 $25,000Taxes based on operating income (30%) (3,000) (3,000)Net income or net cash flow $7,000 $22,000Net cash flow = Net income plus depreciation = $7,000 + $15,000 = $22,000
5 Cash Flow Versus Accounting Income 2011 Situation Accounting Profits Cash FlowsSales $50,000 $50,000Costs except depreciation (25,000) (25,000)Depreciation (5,000)Net operating income or cash flow $20,000 $25,000Taxes based on operating income (30%) (6,000) (6,000)Net income or net cash flow $14,000 $19,000Net cash flow = Net income plus depreciation = $14,000 + $5,000 = $19,000
6 Incremental Cash Flows An Incremental Cash Flow is the change in a firm’s net cash flow attributable to an investment project.
7 Problems in Determining Incremental Cash Flows Sunk Cost: A cash outlay that already has been incurred and cannot be recoveredOpportunity Cost: The return on the best alternative use of an assetExternalities: The effect of accepting a project on the cash flows in other parts of the firmShipping and Installation CostsInflation
8 Identifying Incremental Cash Flows Initial Investment Outlay: the incremental cash flows associated with a project that will occur only at the start of a project’s lifeIncremental Operating Cash Flow: the changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the assetTerminal Cash Flow: the net cash flows that occur only at the end of a project’s life
10 Capital Budgeting Project Evaluation Expansion Project: A project that is intended to increase sales; provides growth to the firmReplacement Analysis: An analysis involving the decision of whether to replace an existing, still productive asset with a new asset
11 Expansion Project Analysis of the Cash Flows Initial Investment Outlay $(9,500) Shipping & installation ( 500) Increase in NWC (4,000) Initial Investment $(14,000) Incremental Operating Cash Flow Sales revenue $30,000 $30,000 $30,000 $30,000 Variable Costs (18,000) (18,000) (18,000) (18,000) Fixed Costs (5,000) (5,000) (5,000) (5,000) Depreciation on new equipment (2,000) (3,200) (1,900) (1,200) Earnings before taxes (EBT) $5,000 $3,800 $5,100 $5,800 Taxes (40%) (2,000) (1,520) (2,040) (2,320) Net Income $3,000 $2,280 $3,060 $3,480 Add back depreciation 2,000 3,200 1,900 1, Incremental operating cash flows $5,000 $5,480 $4,960 $4,680
13 Expansion Project Analysis of the Cash Flows Terminal Cash Flow Return of net working capital $4,000 Net salvage value , Terminal Cash Flow $5,880 Annual Net Cash Flow Total net cash flow/year $(14,000) $5,000 $5,480 $4,960 $10,560NPV at k=15% $3,790
14 Expansion Project Cash Flow Time Line k = 15%5,0004,9605,480(14,000)4,3844,1433,2616,038$3,79010,5601234NPV =20062008200720092005Net cash flowsIRR =26.3%Payback period = 2.7 years
15 Replacement Project Analysis of the Cash Flows Initial Investment Outlay Cost of new asset $(12,000) Change in net working capital ( 1,000) Net cash flow/sale of old asset 1,600 Initial Investment $(11,400) Incremental Operating Cash Flow Δ Operating costs $3,500 $3,500 $3,500 $3,500 $3,500 Δ Depreciation (3,460) (4,900) (1,300) ( 340) 500 Δ Earnings before taxes (EBT) 40 (1,400) 2,200 3,160 4,000 Δ Taxes (40%) ( ) ( 880) (1,264) (1,600) Δ Net Income 24 ( 840) 1,320 1,896 2,400 Add back Δ depreciation 3, , , ( 500) Incremental operating cash flows $3,484 $4,060 $2,620 $2,236 $1,900
16 Replacement Project Analysis of the Cash Flows Terminal Cash Flow Return of net working capital $1,000 Net salvage value of new asset , Terminal Cash Flow $2,200 Annual Net Cash Flow Total net cash flow each year $(11,400) $3,484 $4,060 $2,620 $2,236 $4,100Net Present Value (15%) $(261)
17 Replacement Project Cash Flow Time Line k = 15%3,4842,6204,060(11,400)3,0303,0701,7231,2782,038$(261)2,2361234NPV =20012003200220042000Net cash flows520054,100IRR =14.0%Payback period = 3.6 years
18 Introduction to Project Risk Analysis Stand-Alone Risk: the risk an asset would have if it were a firm’s only riskMeasured by the variability of the asset’s expected returnsCorporate (Within-Firm) Risk: risk not considering the effects of stockholder’s diversificationMeasured by a project’s effect on the firm’s earnings variabilityBeta (Market) Risk: part of a project’s risk that cannot be eliminated by diversificationMeasured by the project’s beta coefficient
19 Techniques for Measuring Stand-Alone Risk Sensitivity Analysis: Key variables are changed and the resulting changes in the NPV and the IRR are observed.Scenario Analysis: “Bad” and “good” sets of financial circumstances are compared with the most likely situation.Monte Carlo Simulation: Probable future events are simulated on a computer.
20 Sensitivity Analysis Graph NPV (000s)-60-40-2020406080-30-101030BaseUnit salesSVk% changefrom base
21 Scenario Analysis (NPV) = $30.3 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
22 Scenario Analysis Standard Deviation: σNPV = $30.3 Coefficient of Variation:
23 Advantages / Disadvantages of Simulation Analysis Reflects probability of each inputShows range of NPVs, expected NPV, σNPV, and CVNPVDisadvantagesDifficult to specify probability distributions and correlationIf inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!
24 Beta (or Market) Risk and Required Rate of Return for a Project Security Market Line equation:kS = kRF + (kM - kRF)βsErie Steel is all equity financed, so cost of equity is also its averaged required rate of return, or cost of capital. Erie’s β = 1.1; kRF = 8%; and kM = 12%kS = 8% + (12% - 8%)1.1 = 12.4%= Erie’s cost of equityInvestors should be willing to give Erie money to invest in average-risk projects.
25 Required Rate of Return for a Project kproj = the risk-adjusted required rate of return for an individual projectkproj = kRF + (kM - kRF)bproj
26 Measuring Beta Risk for a Project Pure Play Method:1. Identify companies whose only business is the project in question.2. Determine the beta for each company.3. Average the betas to find an approximation of proposed project’s beta.
27 How Project Risk Is Considered in Capital Budgeting Decisions Most firms use: Risk-Adjusted Discount RateDiscount rate that applies to particularly risky stream of incomeIt is equal to the risk-free rate of interest plus a risk premium.
28 Capital RationingA situation in which a constraint is placed on the total size of the firm’s capital investment.
29 Multinational Capital Budgeting Repatriation of Earnings: The process of sending cash flows from a foreign subsidiary back to the parent companyExchange Risk Rate: The uncertainty associated with the price at which the currency from one country can be converted into the currency of another countryPolitical Risk: The risk of seizure of a foreign subsidiary’s assets by the host country or unanticipated restrictions on cash flows to the parent company
30 Project Cash Flows and Risk End of Chapter 7Project Cash Flows and Risk