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Chapter 9:
Project Cash Flows and Risk
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Cash Flow Estimation
Most important and most difficult step in the analysis of a capital project
Financial staff’s role includes:
Coordinating the efforts of other departments
Ensuring that everyone uses the same set of economic assumptions
Making sure that no biases are inherent in the forecasts
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Relevant Cash Flows
Cash Flow Versus Accounting Income
Incremental Cash Flows
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Cash Flow Versus Accounting Income
2001 Situation Accounting Profits Cash Flows
Sales $50, $50,000
Costs except depreciation (25,000) (25,000)
Depreciation (15,000) --
Net operating income or cash flow $10,000 $25,000
Taxes based on operating income (30%) (3,000) (3,000)
Net income or net cash flow $7,000 $22,000
Net cash flow = Net income plus depreciation = $7,000 + $15,000 = $22,000
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Cash Flow Versus Accounting Income
2006 Situation Accounting Profits Cash Flows
Sales $50,000 $50,000
Costs except depreciation (25,000) (25,000)
Depreciation (5,000) --
Net operating income or cash flow $20,000 $25,000
Taxes based on operating income (30%) (6,000) (6,000)
Net income or net cash flow $14,000 $19,000
Net cash flow = Net income plus depreciation = $14,000 + $5,000 = $19,000
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Incremental Cash Flows
An Incremental Cash Flow is the change in a firm’s net cash flow attributable to an investment project
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Problems in Determining Incremental Cash Flows
Sunk Cost: A cash outlay that already has been incurred and cannot be recovered
Opportunity Cost: The return on the best alternative use of an asset
Externalities: The effect accepting a project will have on the cash flows in other parts of the firm
Shipping and Installation Costs
Inflation
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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 life CF0
Incremental 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 asset
Terminal Cash Flow: The net cash flow that occurs at the end of a project’s life
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Incremental Operating Cash Flow
Incremental operating cash flowt
= DNIt + DDeprt
= DEBTt X (1 - T) + DDeprt
= (DSt - DOCt - DDeprt) X (1 - T) + DDeprt
= (DSt - DOCt) X (1 - T) + T(DDeprt)
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Capital Budgeting Project Evaluation
Expansion Project: A project that is intended to increase sales
Replacement Analysis: An analysis involving the decision of whether to replace an existing asset that is still productive with a new asset
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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
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Expansion Project Analysis of the Cash Flows
Year
Incremental Operating Cash Flow Computation
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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 $10,560
Net Present Value $3,790
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Expansion Project Cash Flow Time Line
2000
2001
2002
2003
2004 1 2 3 4
k = 15%
Net cash flows
(14,000)
4,384
4,143
3,261
6,038
$3,790
5,000
5,480
4,960
10,560
NPV =
IRR =
26.3%
Payback period = 2.7 years
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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 D Operating costs $3,500 $3,500 $3,500 $3,500 $3,500 D Depreciation (3,460) (4,900) (1,300) (340) 500 D Earnings before taxes (EBT) 40 (1,400) 2,200 3,160 4,000 D Taxes (40%) (16) 560 (880) (1,264) (1,600) D Net Income 24 (840) 1,320 1,896 2,400 Add back D depreciation 3,460 4,900 1, (500) Incremental operating cash flows $3,484 $4,060 $2,620 $2,236 $1,900
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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 $4,100
Net Present Value (15%) $(261)
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Replacement Project Cash Flow Time Line
2000
2001
2002
2003
2004
2005 1 2 3 4 5
k = 15%
Net cash flows
(11,400)
3,030
3,070
1,723
1,278
2,038
$(261)
3,484
4,060
2,620
2,236
4,100
NPV =
IRR =
14.0%
Payback period = 3.6 years
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Introduction to Project Risk Analysis
Stand-Alone Risk: The risk an asset would have if it were a firm’s only risk
Measured by the variability of the asset’s expected returns
Corporate (Within-Firm) Risk: Risk not considering the effects of stockholder’s diversification
Measured by a project’s effect on the firm’s earnings variability
Beta (Market) Risk: Part of a project’s risk that cannot be eliminated by diversification
Measured by the project’s beta coefficient
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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
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Sensitivity Analysis Graph
-60
-40
-20 20 40 60 80
-30
-10 10 30
Base
NPV (000s)
Unit sales SV k
% change
from base
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Scenario Analysis
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
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Scenario Analysis
Standard Deviation:
NPV = $30.3
Coefficient of Variation:
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Advantages / Disadvantages of Simulation Analysis?
Advantages
Reflects probability of each input.
Shows range of NPVs, expected NPV, NPV, and CVNPV.
Disadvantages
Difficult to specify probability distributions and correlation.
If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!
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Beta (or Market) Risk Beta Risk and Required Rate of Return for a Project
Security Market Line equation:
kS = kRF + (kM - kRF)bs
Erie Steel is all equity financed, so cost of equity is also its averaged required rate of return, or cost of capital.
Erie’s b = 1.1; kRF = 8%; and kM = 12%
kS = 8% + (12% - 8%) = 12.4% = Erie’s cost of equity
Investors should be willing to give Erie money to invest in average-risk projects.
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Project Required Rate of Return, kproj
kproj = The risk adjusted required rate of return for an individual project
kproj = kRF + (kM - kRF)bproj
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Measuring Beta Risk for a Project
Pure Play Method:
Identify companies whose only business is the project in question
Determine the beta for each company
Average the betas to find an approximation of proposed project’s beta
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How Project Risk Is Considered in Capital Budgeting Decisions
Most firms use: Risk Adjusted Discount Rate
Discount rate that applies to particularly risky stream of income
It is equal to the risk-free rate of interest plus a risk premium
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Capital Rationing
A situation in which a constraint is placed on the total size of the firm’s capital investment.
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Multinational Capital Budgeting
Repatriation of Earnings: The process of sending cash flows from a foreign subsidiary back to the parent company.
Exchange Risk Rate: The uncertainty associated with the price at which the currency from one country can be converted into the currency of another country.
Political 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.
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End of Chapter 9 Project Cash Flows and Risk
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