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

Topics Estimating cash flows: Risk analysis: Real options Relevant cash flows Working capital treatment Risk analysis: Sensitivity analysis Scenario analysis Real options

Rules Incremental cash flows Noncash charges such as depreciation Changes in NOWC (changes in inventory, A/R, A/P, accruals, and minimum cash balance) Interest payment Sunk cost Opportunity cost Externality (e.g., cannibalization)

Proposed Project Data Machine: $200,000 cost + $10,000 shipping + $30,000 installation. Economic life = 4 years. Salvage value = $25,000. MACRS 3-year class (modified accelerated cost recovery system). Continued…

Project Data (Continued) Annual unit sales = 1,250. Unit sales price = $200. Unit costs = $100. Net working capital: NWCt = 12%(Salest+1) Tax rate = 40%. Project cost of capital = 10%.

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.

Treatment of Financing Costs Should you subtract interest expense when calculating CF? NO. We discount project cash flows with a cost of capital that is the rate of return required by all investors (including debtholders). Interest expense are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

Sunk Costs Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

Incremental Costs Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. A.T. opportunity cost = $25,000 (1 – T) = $15,000 annual cost.

Externalities If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis? Yes. The effects on the other projects’ CFs are “externalities.” Net CF loss per year on other lines would be a cost to this project. Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

What is an asset’s depreciable basis? Basis = Cost + Shipping + Installation $240,000

Annual Depreciation Expense Year % X (Initial Basis) = Deprec. 1 0.3333 $240,000 $79,992 2 0.4445 106,680 3 0.1481 35,544 4 0.0741 17,784

Include inflation 3% when estimating cash flows Nominal r > real r. The cost of capital, r, includes a premium for inflation. Continued…

Annual Sales and Costs Year 1 Year 2 Year 3 Year 4 Units Unit Price 1,250 Unit Price $200 $206 $212.18 $218.55 Unit Cost $100 $103 $106.09 $109.27 Sales $250,000 $257,500 $265,225 $273,188 Costs $125,000 $128,750 $132,613 $136,588

Operating Cash Flows Year 1 Year 2 Year 3 Year 4 Sales 250,000 257,500 265,225 273,188 Costs 125,000 128,750 132,613 136,591 Deprec. 79,992 106,680 35,544 17,784 EBIT 45,008 22,070 97,069 118,807 Taxes (40%) 18,003 8,828 38,827 47,523 EBIT(1 – T) 27,005 13,242 58,241 71,284 + Deprec. Net Op. CF 106,997 119,922 93,785 89,068

Cash Flows Due to Investments in Net Working Capital (NWC) Sales NWC (12% of sales) CF Due to New Investment in NWC Year 0 $30,000 -$30,000 Year 1 $250,000 30,900 -900 Year 2 257,500 31,827 -927 Year 3 265,225 32,783 -956 Year 4 273,188

Salvage Cash Flow at t = 4 Salvage Value $25,000 Book Value Gain or loss Tax on SV (40%) 10,000 Net Terminal CF $15,000

Net Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Init. Cost ($240,000) Op. CF $106,997 $119,922 $93,785 $89,068 NWC CF ($30,000) ($900) ($927) ($955) $32,782 Salvage CF $15,000 Net CF ($270,000) $106,097 $118,995 $92,830 $136,850

Project Net CFs Time Line I/YR = 10 NPV = $88,010. IRR = 23.9%. 1 2 3 4 (270,000) 106,097 118,995 92,830 136,850

What if you terminate a project before the asset is fully depreciated? Basis = Original basis – Accum. deprec. Taxes are based on difference between sales price and tax basis. Taxes paid – Sale proceeds Cash flow from sale =

Example: If Sold After 3 Years for $25 ($ thousands) Original basis = $240. After 3 years, basis = $17.8 remaining. Sales price = $25. Gain or loss = $25 – $17.8 = $7.2. Tax on sale = 0.4($7.2) = $2.88. Cash flow = $25 – $2.88 = $22.12.

Example: If Sold After 3 Years for $10 ($ thousands) Original basis = $240. After 3 years, basis = $17.8 remaining. Sales price = $10. Gain or loss = $10 – $17.8 = -$7.8. Tax on sale = 0.4(-$7.8) = -$3.12. Cash flow = $10 – (-$3.12) = $13.12. Sale at a loss provides a tax credit, so cash flow is larger than sales price!

Example in textbook (Fig 13-1, 13-2)

What is sensitivity analysis? Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. Answers “what if” questions, e.g. “What if sales decline by 30%?”

Example: sensitivity analysis

What are the weaknesses of sensitivity analysis? Says nothing about the likelihood of change in a variable. Ignores relationships among variables.

What is scenario analysis? Examines several possible situations, usually worst case, most likely case, and best case. Provides a range of possible outcomes.

Figure 13-5 Repeated Here for convenience.   Inputs and Key Results for Each Scenario (Dollars in Thousands) Scenarios: Scenario Name Base Worst Best Probability of Scenario 50% 25% Inputs: Equipment cost $7,750 $8,250 $7,250 Salvage value, equipment, Year 4 $639 Opportunity cost $0 Externalities (cannibalization) Units sold, Year 1 10,000 8,500 11,500 Annual change in units sold, after Year 1 15% 5% Sales price per unit, Year 1 $1.50 $1.25 $1.75 Annual change in sales price, after Year 1 4% Variable cost per unit (VC), Year 1 $1.07 $1.17 $0.97 Annual change in VC, after Year 1 3% Nonvariable cost (Non-VC), Year 1 $2,120 $2,330 $1,910 Annual change in Non-VC, after Year 1 Project WACC 10% Tax rate 40% 30% Working capital as % of next year's sales Key Results: NPV $1,048 −$7,543 $19,468 IRR 13.79% −29.40% 62.41% MIRR 12.78% −22.23% 43.49% Profitability index 1.10 0.23 2.90 Payback 3.39 Not found 1.83 Discounted payback 3.80 2.07

Example: scenario analysis 1

Are there any 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.

What is a real option? 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.

What are some types of real options? Investment timing options—delay the decision. Growth options Increase the capacity of an existing product line Add new products Expand into new geographic markets Abandonment options Contraction Temporary suspension Flexibility options

Simple decision tree

Staged decision tree Read page 525-526.

Example: staged decision tree

Assignment Review Chapter 12 slides from FINC3131 Chapter 13 problems:1,2,3,4,6,7,8 (a),9,17.