1. 11-1 CHAPTER 11 Cash Flow Estimation and Risk Analysis Relevant cash flows Incorporating inflation Types of risk Risk Analysis

2. 11-2 Proposed Project Total depreciable cost Equipment: $200,000 Shipping: $10,000 Installation: $30,000 Changes in working capital Inventories will rise by $25,000 Accounts payable will rise by $5,000 Effect on operations New sales: 100,000 units/year @ $2/unit Variable cost: 60% of sales

3. 11-3 Proposed Project Life of the project Economic life: 4 years Depreciable life: MACRS 3-year class Salvage value: $25,000 Tax rate: 40% WACC: 10%

4. 11-4 Modified Accelerated Cost Recovery System (MACRS) The new accelerated cost recovery system, created after the release of the Tax Reform Act of 1986, which allows for greater accelerated depreciation over longer time periods. Faster acceleration allows individuals to deduct greater amounts during the first few years of an asset's life.

5. 11-5 Working Capital A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as: Positive working capital means that the company is able to pay off its short- term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory). Also known as "net working capital". If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

6. 11-6 Determining project value Estimate relevant cash flows Calculating annual operating cash flows. Identifying changes in working capital. Calculating terminal cash flows. 0 1 2 3 4 Initial OCF 1 OCF 2 OCF 3 OCF 4 Costs + Terminal CFs NCF 0 NCF 1 NCF 2 NCF 3 NCF 4

7. 11-7 Initial year net cash flow Find Δ NOWC. ⇧ in inventories of $25,000 Funded partly by an ⇧ in A/P of $5,000 Δ NOWC = $25,000 - $5,000 = $20,000 Combine Δ NOWC with initial costs. Equipment -$200,000 Installation -40,000 Δ NOWC -20,000 Net CF 0 -$260,000

8. 11-8 Determining annual depreciation expense YearRate x BasisDepr 10.33 x$240$ 79 20.45 x 240 108 30.15 x 240 36 40.07 x 240 17 1.00$240 Due to the MACRS ½-year convention, a 3-year asset is depreciated over 4 years.

9. 11-9 Annual operating cash flows 1 2 3 4 Revenues 200 200 200200 - Op. Costs (60%) -120-120-120 -120 - Deprn Expense -79-108 -36 -17 Oper. Income (BT) 1 -28 44 63 - Tax(40%) - -11 18 25 Oper. Income (AT) 1 -17 26 38 + Deprn Expense 79 108 36 17 Operating CF 80 91 62 55

10. 11-10 Terminal net cash flow Recovery of NOWC$20,000 Salvage value 25,000 Tax on SV (40%) -10,000 Terminal CF$35,000 Q. How is NOWC recovered? Q. Is there always a tax on SV? Q. Is the tax on SV ever a positive cash flow?

11. 11-11 Should financing effects be included in cash flows? No, dividends and interest expense should not be included in the analysis. Financing effects have already been taken into account by discounting cash flows at the WACC of 10%. Deducting interest expense and dividends would be “double counting” financing costs.

12. 11-12 Should a $50,000 improvement cost from the previous year be included in the analysis? No, the building improvement cost is a sunk cost and should not be considered. This analysis should only include incremental investment.

13. 11-13 If the facility could be leased out for $25,000 per year, would this affect the analysis? Yes, by accepting the project, the firm foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project. The relevant cash flow is the annual after- tax opportunity cost. A-T opportunity cost = $25,000 (1 – T) = $25,000(0.6) = $15,000

14. 11-14 If the new product line were to decrease the 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 (in the case of complements) or negative (substitutes).

15. 11-15 Proposed project’s cash flow time line Enter CFs into calculator CFLO register, and enter I/YR = 10%. NPV = -$4.03 million IRR = 9.3% 0 1 2 3 4 -260 79.7 91.2 62.4 54.7 Terminal CF → 35.0 89.7

16. 11-16 374.8 -260.0 79.7 91.2 62.4 89.7 68.6 110.4 106.1 What is the project’s MIRR? 0 1 2 3 4 10% PV outflows -260.0 $260 TV inflows MIRR = 9.6% < k = 10%, reject the project $374.8 (1 + MIRR) 4 =

17. 11-17 -260 79.7 91.2 62.4 89.7 0 1 2 3 4 Evaluating the project: Payback period Payback = 3 + 26.7 / 89.7 = 3.3 years. Cumulative: -260 -180.3 -89.1 -26.7 63.0

18. 11-18 If this were a replacement rather than a new project, would the analysis change? Yes, the old equipment would be sold, and new equipment purchased. The incremental CFs would be the changes from the old to the new situation. The relevant depreciation expense would be the change with the new equipment. If the old machine was sold, the firm would not receive the SV at the end of the machine’s life. This is the opportunity cost for the replacement project.

19. 11-19 What if there is expected annual inflation of 5%, is NPV biased? Yes, inflation causes the discount rate to be upwardly revised. Therefore, inflation creates a downward bias on PV. Inflation should be built into CF forecasts.

20. 11-20 Annual operating cash flows, if expected annual inflation = 5% 1 2 3 4 Revenues 210 220 232243 Op. Costs (60%) -126-132-139 -146 - Deprn Expense -79-108 -36-17 - Oper. Income (BT) 5 -20 57 80 - Tax (40%) 2 -8 23 32 Oper. Income (AT) 3 -12 34 48 + Deprn Expense 79108 36 17 Operating CF 82 96 70 65

21. 11-21 Considering inflation: Project net CFs, NPV, and IRR 0 1 2 3 4 -260 82.1 96.1 70.0 65.1 Terminal CF → 35.0 100.1 Enter CFs into calculator CFLO register, and enter I/YR = 10%. NPV = $15.0 million. IRR = 12.6%.

22. 11-22 What are the 3 types of project risk? Stand-alone risk Corporate risk Market risk

23. 11-23 What is stand-alone risk? The project’s total risk, if it were operated independently. Usually measured by standard deviation (or coefficient of variation). However, it ignores the firm’s diversification among projects and investor’s diversification among firms.

24. 11-24 What is corporate risk? The project’s risk when considering the firm’s other projects, i.e., diversification within the firm. Corporate risk is a function of the project’s NPV and standard deviation and its correlation with the returns on other projects in the firm.

25. 11-25 What is market risk? The project’s risk to a well-diversified investor. Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder diversification.

26. 11-26 Which type of risk is most relevant? Market risk is the most relevant risk for capital projects, because management’s primary goal is shareholder wealth maximization. However, since total risk affects creditors, customers, suppliers, and employees, it should not be completely ignored.

27. 11-27 Which risk is the easiest to measure? Stand-alone risk is the easiest to measure. Firms often focus on stand- alone risk when making capital budgeting decisions. Focusing on stand-alone risk is not theoretically correct, but it does not necessarily lead to poor decisions.

28. 11-28 Are the three types of risk generally highly correlated? Yes, since most projects the firm undertakes are in its core business, stand-alone risk is likely to be highly correlated with its corporate risk. In addition, corporate risk is likely to be highly correlated with its market risk.

29. 11-29 What is sensitivity analysis? Sensitivity analysis measures the effect of changes in a variable on the project’s NPV. To perform a sensitivity analysis, all variables are fixed at their expected values, except for the variable in question which is allowed to fluctuate. Resulting changes in NPV are noted.

30. 11-30 What are the advantages and disadvantages of sensitivity analysis? Advantage Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables. Disadvantages Does not reflect the effects of diversification. Does not incorporate any information about the possible magnitudes of the forecast errors.

31. 11-31 Perform a scenario analysis of the project, based on changes in the sales forecast Suppose we are confident of all the variable estimates, except unit sales. The actual unit sales are expected to follow the following probability distribution: CaseProbabilityUnit Sales Worst 0.25 75,000 Base 0.50 100,000 Best 0.25 125,000

32. 11-32 Scenario analysis All other factors shall remain constant and the NPV under each scenario can be determined. CaseProbability NPV Worst 0.25 ($27.8) Base 0.50 $15.0 Best 0.25 $57.8

33. 11-33 Determining expected NPV,  NPV, and CV NPV from the scenario analysis E(NPV)= 0.25(-$27.8)+0.5($15.0)+0.25($57.8) = $15.0  NPV = [0.25(-$27.8-$15.0) 2 + 0.5($15.0- $15.0) 2 + 0.25($57.8-$15.0) 2 ] 1/2 = $30.3. CV NPV = $30.3 /$15.0 = 2.0.

34. 11-34 If the firm’s average projects have CV NPV ranging from 1.25 to 1.75, would this project be of high, average, or low risk? With a CV NPV of 2.0, this project would be classified as a high-risk project. Perhaps, some sort of risk correction is required for proper analysis.

35. 11-35 Is this project likely to be correlated with the firm’s business? How would it contribute to the firm’s overall risk? We would expect a positive correlation with the firm’s aggregate cash flows. As long as correlation is not perfectly positive (i.e., ρ  1), we would expect it to contribute to the lowering of the firm’s total risk.

36. 11-36 If the project had a high correlation with the economy, how would corporate and market risk be affected? The project’s corporate risk would not be directly affected. However, when combined with the project’s high stand-alone risk, correlation with the economy would suggest that market risk (beta) is high.

37. 11-37 If the firm uses a +/- 3% risk adjustment for the cost of capital, should the project be accepted? Reevaluating this project at a 13% cost of capital (due to high stand-alone risk), the NPV of the project is -$2.2. If, however, it were a low-risk project, we would use a 7% cost of capital and the project NPV is $34.1.

38. 11-38 What subjective risk factors should be considered before a decision is made? Numerical analysis sometimes fails to capture all sources of risk for a project. If the project has the potential for a lawsuit, it is more risky than previously thought. If assets can be redeployed or sold easily, the project may be less risky.

39. 11-39 What is Monte Carlo simulation? A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes. Simulation software packages are often add-ons to spreadsheet programs.