1. Cash Flow Estimation and Risk Analysis
CHAPTER 11
Cash Flow Estimation and
Risk Analysis

2. CASH FLOW ESTIMATION Business Application Why?
Importance in Project Valuation
Effects on Firm Valuation
Relevance of CF over Acctg Income
Incremental CF Basis
Determine Value : Based on accurate CF Projections
New vs. Replacement Projects
Relevant CFs
Depreciation & Tax Effects
Inflation & Risk

3. CASH FLOW ESTIMATION Business Application Why?
Techniques to Manage CFs
Sensitivity Analysis
Scenario Analysis
Decision Tree Analysis
MonteCarlo Simulation

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

5. Project’s Cash Flows (CFt) Project’s risk-adjusted
The Big Picture:
Project Risk Analysis
Project’s Cash Flows (CFt)
NPV = ··· − Initial cost
CF1
CF2
CFN
(1 + r )1
(1 + r)N
(1 + r)2
Market
interest rates
Project’s
debt/equity capacity
For value box in Ch 4 time value FM13.
Project’s risk-adjusted
cost of capital
(r)
Market
risk aversion
Project’s
business risk

6. Capital Budgeting Analysis
What Long-Term projects (Capital Investments) should our company undertake in order to generate additional return (Value ($$)) to the owners (Stockholders)??
CFs are KEY, NOT Acctg Income!!

7. Consider Only Incremental CFs
Compare Outflows to acquire vs. inflows generated by operating project.
If PV of inflows > PV of outflows, then making $ and adding value.
Accept if project generates positive NPV

8. TYPES OF PROJECTS Replacement Expansion Add New Equipment
Increase in Op CFs
Swap out equipment
Decrease in Operating Costs

9. 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.
OR:
Project CFs on stand-alone basis

10. Type of Costs Sunk Costs Incremental Costs Externalities
Opportunity Costs
Shipping and installation
Financing Costs
Taxes

11. 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.

12. 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.

13. Externalities
If new product line decreases sales of 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:: PIRACY
Externalities be positive if new projects are complements to existing assets, negative if substitutes.

14. Treatment of Financing Costs
Should you subtract interest expense or dividends when calculating CF?
NO.
Project CFs discounted by cost of capital that is rate of return required by all investors so should discount total amount of cash flow available to all investors.
They are part of the costs of capital. If subtracted them from cash flows, would be double counting capital costs.

15. Relevant CFs: 3 categories
Initial Outlay time =0 (today))
Operating CFs
@ end of each year project is operated
Generated from day-to-day operations of using equipment or asset
Terminal Yr CF
@ end of FINAL year project is operated
Related to scrapping or Salvaging Asset

16. Relevant CFs: Initial Outlay
Initial Outlay time =0)
Typically negative
Cost to Acquire New Asset
Get it up & running
Shipping, install, NWC
Get rid of old

17. Relevant CFs: Op. CFs Income Statement adjusted for CF’s
@ end of each year project is operated
Typically positive

18. Relevant CFs: Op. CFs & I/S
Sales Revenues
- Costs & Expenses
- Depreciation
= EBIT
-Taxes
= Net Income or NOPAT
+ Depreciation Addback
= Operating CF

19. Relevant CFs: Terminal Year
Terminal Yr CF
@ end of FINAL year project is operated
Scrap or Salvaging end of life
Return to original state (NWC addback)
On after-tax basis

20. Relevant CFs: Terminal Year
Selling price or scrapping (salvage) value of used-up asset at end of life
- BV
= Taxable Gain/Loss
-/+ Tax Effect
+/- Adjustment for Return to normal (NWC recaptured)
= Total term yr CF
Then gets added to last Op CF to get net CF for final year.

21. MACRS Depreciation Modified Accelerated Cost Recovery System
Established by Congress, implemented by IRS
Required to be used by IRS on business taxes
Creates groups of asset classes for depreciation purpose
Six classes based on different asset types
Full depreciation to zero value, no residual or salvage value permitted

22. MACRS Depreciation Asset Classes
3-yr class
Certain special manufacturing tools
5- yr
Automobiles, light-duty trucks, computers, and certain special manufacturing equipment
7-yr
Most industrial equipment, office furniture, fixtures
10-yr
Certain longer-lived types of equipment
27.5-yr
Residential rental real property such as apartment buildings
39-yr
All nonresidential real property including commercial and industrial buildings

23. MACRS Depreciation Asset Classes Depreciation Rates
3-yr class
33%, 45% 15%, 7%
5- yr
20%, 32%, 19%, 12%, 11%, 6%
7-yr
14%, 25%, 17%, 13% 9%, 9%, 9%, 4%
Other classes: Consult tax professional or IRS !
NOTE: Land cannot be depreciated

24. What does “risk” mean in capital budgeting?
Uncertainty about a project’s future profitability or CFs.
Measured by σNPV, σIRR, beta.
Will taking on the project increase the firm’s and stockholders’ risk?

25. Is risk analysis based on historical data or subjective judgment?
Can sometimes use historical data, but generally cannot.
So risk analysis in capital budgeting is usually based on subjective judgments.

26. Risk Issues
Inflation
Forecast Bias
Real Options

27. Importance of including inflation when estimating CFs?
Nominal r > real r.
Cost of capital, r, includes a premium for inflation.
Nominal CF > real CF.
Because nominal cash flows incorporate inflation.
If discount real CF with higher nominal r, then NPV estimate is too low.
Continued…

28. Inflation (Continued)
Discount Nominal CF by nominal r%, and real CF by real r%.
More realistic to find nominal CF (which captures inflation) than to reduce nominal r to a real r.

29. Inflation & Forecast Bias
‘Glass half full’ or ‘Rose-colored glasses’ effect
Tendency to overstate Revs & understate Costs
= overstatement of Op CFs & overstatement (upward bias) of NPV
Ask ‘What is underlying Cause?’
Inherent advantage to long-run competition
or erosion of above normal profits

30. Forecast Bias & Additional Options
Failure to recognize project’s addt’l options can cause projects profitability to be understated
Positive v. Negative Options
& ability to capture effects in NPV analysis
i.e. Abandon / Discontinue

31. What is a real option?
Real (additional) options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during 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.

32. What are some types of real options?
Investment timing options
Growth options
Expansion of existing product line
New products
New geographic markets

33. Types of real options (Continued)
Abandonment options
Contraction
Temporary suspension
Flexibility options

34. Real options
Real options often improve size of expected cash flow, which is relatively easy to handle in DCF methods
But real options
Usually decrease project risk, meaning lower cost of capital should be used.
But problems arises in quantifying new WACC.
So, many firms either make a qualitative adjustment to WACC or use non-DCF valuation techniques similar to option pricing

35. 3 types of risk relevant in capital budgeting?
Stand-alone risk
Corporate risk
Market (or beta) risk

36. 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.

37. Probability Density 0 E(NPV) NPV Flatter distribution,
larger , larger
stand-alone risk.
NPV

38. 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.

39. Project X is negatively correlated to firm’s other assets, so has big diversification benefits
Profitability
If r = 1.0, no diversification benefits. If r < 1.0, some diversification benefits.
Project X
Total Firm
Rest of Firm
Years

40. 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.

41. How is each type of risk used?
Market risk is theoretically best in most situations.
However, creditors, customers, suppliers, and employees are more affected by corporate risk.
Therefore, corporate risk is also relevant.
Continued…

42. 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.

43. Another Problem: Proposed Project Data
$200,000 cost + $10,000 shipping + $30,000 installation.
Economic life = 4 years.
Salvage value = $25,000.
MACRS 3-year class.
Continued…

44. 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%.

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

46. Annual Depreciation Expense (000s)
Year
% X
(Initial Basis)
= Deprec. 1
0.33
$240
$79.2 2
0.45
108.0 3
0.15
36.0 4
0.07
16.8

47. 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

48. Operating Cash Flows (Years 1 and 2)
Sales
$250,000
$257,500
Costs
125,000
128,750
Deprec.
79,200
108,000
EBIT
$ 45,800
$ 20,750
Taxes (40%)
18,320
8,300
EBIT(1 – T)
$ 27,480
$ 12,450
+ Deprec.
Net Op. CF
$106,680
$120,450

49. Operating Cash Flows (Years 3 and 4)
Sales
$265,225
$273,188
Costs
132,613
136,588
Deprec.
36,000
16,800
EBIT
$ 96,612
$119,800
Taxes (40%)
38,645
47,920
EBIT(1 – T)
$ 57,967
$ 71,880
+ Deprec.
Net Op. CF
$ 93,967
$ 88,680

50. Cash Flows Due to Investments in Net Working Capital (NWC)
Sales
NWC
(% of sales)
CF Due to
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

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

52. 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 =

53. Example: If Sold After 3 Years for $25 ($ thousands)
Original basis = $240.
After 3 years, basis = $16.8 remaining.
Sales price = $25.
Gain or loss = $25 – $16.8 = $8.2.
Tax on sale = 0.4($8.2) = $3.28.
Cash flow = $25 – $3.28 = $21.72.

54. Example: If Sold After 3 Years for $10 ($ thousands)
Original basis = $240.
After 3 years, basis = $16.8 remaining.
Sales price = $10.
Gain or loss = $10 – $16.8 = -$6.8.
Tax on sale = 0.4(-$6.8) = -$2.72.
Cash flow = $10 – (-$2.72) = $12.72.
Sale at a loss provides a tax credit, so cash flow is larger than sales price!

55. Net Cash Flows for Years 1-2
Init. Cost
-$240,000
Op. CF
$106,680
$120,450
NWC CF
-$30,000
-$900
-$927
Salvage CF
Net CF
-$270,000
$105,780
$119,523

56. Net Cash Flows for Years 3-4
Init. Cost
Op. CF
$93,967
$88,680
NWC CF
-$956
$32,783
Salvage CF
$15,000
Net CF
$93,011
$136,463

57. Project Net CFs Time Line
Enter CFs in CFLO register and I/YR = 10.
NPV = $88,030.
IRR = 23.9%. 1 2 3 4
(270,000)
105,780
119,523
93,011
136,463

58. What is the project’s MIRR?
(270,000)
MIRR = ? 1 2 3 4
105,780
119,523
93,011
136,463
102,312
144,623
140,793
524,191
10%

59. Calculator Solution
Enter positive CFs in CFLO. Enter I/YR = 10. Solve for NPV = $358,
Now use TVM keys: PV = -358, , N = 4, I/YR = 10; PMT = 0; Solve for FV = 524,191. (This is TV of inflows)
Use TVM keys: N = 4; FV = 524,191; PV = -270,000; PMT= 0; Solve for I/YR = 18.0%.
MIRR = 18.0%.

60. What is the project’s payback? ($ thousands)
Cumulative:
Payback = 2 + $44/$93 = 2.5 years. 1 2 3 4
(270)
106
(164)
120
(44) 93 49
136
185

61. 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%?”

62. Sensitivity Analysis Change From Resulting NPV (000s) Base level r
Unit sales
Salvage
-30%
$113
$17
$85
-15%
$100
$52
$86 0%
$88
15%
$76
$124
$90
30%
$65
$159
$91

63. Sensitivity Graph NPV ($ 000s) Unit Sales Salvage 88 r
Base (%) 88
NPV
($ 000s)
Unit Sales
Salvage r

64. Results of Sensitivity Analysis
Steeper sensitivity lines show greater risk. Small changes result in 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.

65. What are the weaknesses of sensitivity analysis?
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.

66. Why is sensitivity analysis useful?
Gives some idea of stand-alone risk.
Identifies dangerous variables.
Gives some breakeven information.

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

68. Best scenario: 1,600 units @ $240 Worst scenario: 900 units @ $160
Probability
NPV(000)
Best
0.25
$279
Base
0.50 88
Worst
-49
E(NPV) = $101.6
σ(NPV) =
CV(NPV) = σ(NPV)/E(NPV) =

69. 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.
Focuses on stand-alone risk, although subjective adjustments can be made.

70. What is a simulation analysis?
A computerized version of scenario analysis that uses continuous probability distributions.
Computer selects values for each variable based on given probability distributions.
(More...)

71. 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.

72. Simulation Example Assumptions
Normal distribution for unit sales:
Mean = 1,250
Standard deviation = 200
Normal distribution for unit price:
Mean = $200
Standard deviation = $30

73. Simulation Process
Pick a random variable for unit sales and sale price.
Substitute these values in the spreadsheet and calculate NPV.
Repeat the process many times, saving the input variables (units and price) and the output (NPV).

74. Simulation Results (2,000 trials)
Units
Price
NPV
Mean
1,252
$200
$88,808
Std deviation
199 30
$82,519
Maximum
1,927
294
$475,145
Minimum
454 94
-$166,208
Median
685
$163
$84,551
Prob NPV > 0
86.9% CV
0.93

75. Interpreting the Results
Inputs are consistent with specified distributions.
Units: Mean = 1,252; St. Dev. = 199.
Price: Mean = $200; St. Dev. = $30.
Mean NPV = $ $88,808. Low probability of negative NPV (100% – 87% = 13%).

76. Histogram of Results

77. What are the 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.

78. What are the disadvantages of simulation?
Difficult to specify probability distributions and correlations.
If inputs are bad, output will be bad: “Garbage in, garbage out.”
(More...)

79. 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. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting.

80. If the firm’s average project has a CV of 0. 2 to 0
If the firm’s average project has a CV of 0.2 to 0.4, is this a high-risk project? What type of risk is being measured?
CV from scenarios = 1.15, CV from simulation = Both are > 0.4, this project has high risk.
CV measures a project’s stand-alone risk.
High stand-alone risk usually indicates high corporate and market risks.

81. With a 3% risk adjustment, should our project be accepted?
Project r = 10% + 3% = 13%.
That’s 30% above base r.
NPV = $65,371.
Project remains acceptable after accounting for differential (higher) risk.

82. Should subjective risk factors be considered?
Yes. A 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.