1. Intro to Financial Management
Cash Flow and Risk in Capital Budgeting

2. Review Homework Methods of evaluating a project
Payback Period
Discounted Payback Period
NPV PI
IRR
MIRR
Criteria for accepting a project

3. Free Cash Flows Interested in after-tax cash flows, not profits. Why?
Interested in incremental cash flows.
Do not count if take cash from existing products/services
Can count synergistic effects of a new project
Include incremental expenses
“Sunk costs are sunk”
Interested in free cash flows
Cash generated by operations
Cash available to pay creditors or owners
Separate the investment decision from the financing
How is the cost of financing already incorporated?

4. Free Cash Flow Initial Outlay
Initial start-up costs
Increases in working capital
Sale prices of any replaced assets
Capital gains taxes due to sale above/below depreciated value
initial outlay = cost of new assets
- sale price of replaced assets
+/- tax impact of sale of replaced assets

5. Free Cash Flow Annual and Terminal Flows
Annually
Look at cash from operations
Adjust for
Depreciation impact on taxes
Depreciation is not cash but is a cost and lowers taxes
Interest expenses
Changes in net working capital
E.g. if have greater accounts receivable or inventory or payables
When project ends
Calculate terminal (final) value of assets

6. Projects in Practice Projects may end up being delayed
Due to economic reasons
Due to political reasons
Due to technological reasons
Projects may be expanded
Projects may be canceled

7. Project Risk Stand alone risk Contribution-to-firm risk
All projects have risk, uncertainty
Contribution-to-firm risk
Project add risk to firm
Project risk can be diversified with other projects
Systematic risk
From viewpoint of shareholder
A project risk can be diversified by other shareholder investments
Text says that theoretically only systematic risk is important
Not from the viewpoint of the firm!
Not from the viewpoint of a project manager!

8. Risk and Capital Budgeting
Incorporate risk into discount rate
Increase hurdle rate to account for risk
Greater risk requires greater return
Can try to calculate systematic risk
Calculate a beta for the project
But there are no historical returns
Two approaches:
Can try comparing past division results to benchmark (accounting method)
Pure play method – use the beta of a firm that looks like the project

9. Use Simulations to Evaluate Risk
Have multiple factors that all have risk and a range of outcomes
Market size
Market share
Costs
Evaluate a scenario
Select values for each factor and compute a result
Get an IRR or NPV
Evaluate many (thousands) of scenarios
Get a distribution of outcomes for IRR or NPV
Can get a “probability” distribution for IRR or NPV