10-1CHAPTER 11 Cash Flow EstimationAnd Chapter 12 Risk

Need to be in class for this ch. Relevant Cash Flows New Investment Replacement Investment Measuring Risk Market Risk (Beta) Project Risk Considerations

Capital Budgeting Processes

Capital budgeting process consists of the following steps: Determine (estimate) the expected cash flows

of available projects Apply decision criteria such as NPV and IRR

In this class you are given all the information to forecast cash flows but they are subject to error Estimating project cash flows is the most

difficult and error-prone part of capital budgeting

10-3

Example Proposed Project:

Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost: $240,000.

Inventories will rise by $25,000 and payables by $5,000.

Economic life = 4 years. Salvage value = $25,000. MACRS 3-year class.

10-4

Sales: 100,000 units/yr @ $2.

Var. cost = 60% of sales.

Tax rate = 40%.

WACC = 10%.

Data/Assumptions

10-5

Three “categories” of Cash Flow

1. Initial Cost, including installation and change in net Working Capital

2. Operating Cash Flows– Need: Returns/Savings

Tax Depreciation– Set up a modified income statement

for each year 3. Terminal Cash Flow

– Need to consider taxes and return of working capital

10-6

Set up, without numbers, a time line for the project’s cash flows:0 1 2 3 4

OCF1 OCF2 OCF3 OCF4InitialCost +

Terminal CF

CF0 CF1 CF2 CF3 CF4

10-7

Equipment -$200

Installation & Shipping -40

Increase in inv. -25

Increase in A/P 5

Net CF0 -$260

NWC = $25 - $5 = $20.

Investment at t = 0: (Initial cost)

10-8

10-9

What’s the annual depreciation?

Due to 1/2-yr conv., a 3-yr assetis depreciated over 4 years.

Depreciation Initial Basis: $240,000

year percentage Depreciation1 0.33 $ 79,200 2 0.45 $ 108,000 3 0.15 $ 36,000 4 0.07 $ 16,800

Total $ 240,000

10-10

Operating cash flows:

This is an income statement with no interest.

Operating Cash FlowItem Year 1 Year 2 Year 3 Year 4Sales $ 200,000 $ 200,000 $ 200,000 $ 200,000 Variable cost $ 120,000 $ 120,000 $ 120,000 $ 120,000 net returns $ 80,000 $ 80,000 $ 80,000 $ 80,000 less Depreciation $ (79,200) $ (108,000) $ (36,000) $ (16,800)

EBT $ 800 $ (28,000) $ 44,000 $ 63,200 Less 40% Tax $ (320) $ 11,200 $ (17,600) $ (25,280)

EAT $ 480 $ (16,800) $ 26,400 $ 37,920 Dep add back $ 79,200 $ 108,000 $ 36,000 $ 16,800 Operating CF $ 79,680 $ 91,200 $ 62,400 $ 54,720

10-11

Net Terminal CF at t = 4:

Salvage Value $25000 Tax on SV (40%) -10000 Recovery of NWC 20000 Terminal CF $35000

Q. Always a tax on SV? Q. Ever a positive tax number?Q. How is NWC recovered?

10-12Tax on SVDo a “side” calculation!

Selling Price- adjusted basis= Taxable gain (loss if negative)x tax rate= Tax (tax credit if negative)

• The tax basis when you sell an asset is the initial basis less accumulated depreciation (adjusted basis).

• The sign (negative or positive) can be confusing. You just have to think.

10-13

Calculator Workout

Draw the time line for this project and put the cash flows on the time line (on board).

Compute the NPV and IRR

Note we are skipping Profitability Index

10-14

IRR = 9.28%

10-15

What’s the Payback Period?

0

79.7

1

91.2

2

62.4

3

89.7

4

-260

Cumul:-26.7-260 -89.1-180.3 63.0

Payback = 3 + 26.7 / 89.7 = 3.3 years.

Numbers slightly rounded to fit onto slide better.

10-16

Should CFs include int. expense? Dividends?

No. The cost of capital is accounted for by discounting at the 10% WACC, so deducting interest and dividends would be “double counting” financing costs.

10-17

Suppose $50,000 had been spent last year to improve the building.

Should this cost be included in the analysis?

No. This is a sunk cost.Analyze incremental investment.

10-18

Suppose the plant could be leased out for $25,000 a year. Would this

affect the analysis?

Yes. Accepting the project means foregoing the $25,000. This is an opportunity cost, and it should be charged to the project.

A.T. opp. cost = $25,000 (1 - T) = $25,000(0.6) = $15,000 annual cost.

10-19

If the new product line would decrease 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 or neg., i.e., complements or substitutes.

10-20Another Example Given the following information, calculate

the NPV and IRR of a proposed project: Cost = $40,000; estimated life = 3 years; increase in accounts receivable = $10,000; estimated salvage value = $10,000; net income before taxes and depreciation = $20,000 per year; method of depreciation = 3-year MACRS; tax rate = 40 percent; required rate of return = 12 percent.

(see spreadsheet key LectExample.xls)

10-21

If this were a replacement rather than a new project, would the

analysis change?

Yes. The cash flows would be the incrementalcash flow or changes in cash flow.

1. The old equipment would be sold now

2. You would calculate the change in revenue and expenses.

10-22

3. The relevant depreciation would be the change with the new equipment.

4. Also, if the firm sold the old machine now, it would not receive the SV at the end of the machine’s life.

10-23Replacement Problem 9-3 Atlantic Control Company purchased a machine two years ago at a cost of

$70,000. At that time, the machine’s expected economic life was six years and its salvage value at the end of its life was estimated to be $10,000. It is being depreciated using the straight line method so that its book value at the end of six years is $10,000. In four years, however, the old machine will have a market value of $0.

  A new machine can be purchased for $80,000, including shipping and installation costs. The new machine has an economic life estimated to be four years. Three-year MACRS depreciation will be used. During its four-year life, the new machine will reduce cash operating expenses by $20,000 per year. Sales are not expected to change. But the new machine will require net working capital to be increased by $4,000. At the end of its useful life, the machine is estimated to have a market value of $2,500.

  The old machine can be sold today for $20,000. The firm’s marginal tax rate is 40 percent. The appropriate required rate of return is ten percent.

  a. If the new machine is purchased, what is the amount of the initial investment outlay at Year 0?

  b. What incremental operating cash flows will occur at the end of Years 1 through 4 as a result of replacing the old machine?

  c. What is the terminal cash flow at the end of Year 4 if the new machine is purchased?

  d. What is the NPV of this project? Should Atlantic replace the old machine?

 

10-24Problem 9-3 Key

10-25Operating Cash flow

Item 1 2 3 4

Cost Savings $20,000 $20,000 $20,000 $20,000

-Depreciation change

-16,400 -26,000 -2000 --4400

EBT 3,600 -6000 18,000 24,400

-Taxes (40%) -1440 --2400 -7200 -9760

EAT 2160 -3600 10,800 14640

Depreciation add back

16,400 26,000 2000 -4400

Operating Cash Flow

18560 22400 12800 10240

10-26

Cash Flows and NPV

K=10

10-27

NPV CF

kv Cost

kt

nt

tt t

t

0 1 1

Re .

Q. If E(INFL) = 5%, is NPV biased?

A. YES.

k = k* + IP + DRP + LP + MRP.

Inflation is in denominator but not innumerator, so downward bias to NPV.

Should build inflation into CF forecasts.

10-28

What does “risk” mean in capital budgeting?

Risk relates to uncertainty about a project’s future profitability.

Is NPV, IRR, large? Will taking on project increase firm’s and stockholders’ risk?

10-29

Chapter 12

Read chapter 12 for background on the remaining slides in this set.

There will not be a usual chapter homework for chapter 12

There will be questions on the chapter handed out in lab.

10-30

Is risk analysis based on historical data or subjective

inputs? Can sometimes use historical

data, but generally can’t. So, risk analysis is usually based

primarily on subjective judgment.

10-31

What three types of risk are relevant in capital budgeting?

1. Stand-alone risk

2. Within-firm risk

3. Market risk

10-32

How is each type of risk measured, and how do they relate

to one another?

1. Stand-Alone Risk:Risk of the project if it wereinvestor’s only asset. Ignoresdiversification. Measured bythe std. dev. or CV of NPV.

10-33

2. Within-Firm (Corporate) Risk: Reflects the project’s effect on

corporate earnings stability. Considers firm’s other assets (diversification within the firm).

Depends on (1) project’s std. dev. and (2) its correlation with returns on other projects.

Measured by the project’s beta versus total corp. earnings.

10-34

3. Market Risk: Project’s risk to a well-diversified

investor. Takes account of firms’ and stockholders’ other assets. Total diversification.

Depends on project’s correlation with the stock market. Stock market beta.

10-35

How is each type of risk used?

Market risk is theoretically best. However, creditors, customers,

suppliers, and employees are affected by within-firm risk.

Therefore, within-firm risk is also relevant.

10-36

Stand-alone risk is easiest to measure, intuitive.

Core projects correlated with other assets, so stand-alone risk reflects within-firm risk; Maybe??

If project is correlated with the economy, stand-alone risk also may reflect market risk; Not likely??

10-37

What is sensitivity analysis?

Shows how changes in a variable such as sales affect NPV or IRR.

Each variable is fixed except for one.

Change this one variable to see effect on NPV or IRR.

10-38

IllustrationResulting NPV (000):

Change fromBase Level Unit Sales SV* k

-30% -$36 $12 $34-20 -19 13 28-10 -2 14 21

0(base) 15 15 15+10 32 16 9+20 49 17 3+30 66 18 -2

*Salvage Value

10-39

Sensitivity Graph

-60

-40

-20

0

20

40

60

80

-30 -20 -10 0 10 20 30

Base

NPV (000s)Unit sales

SV

k

% changefrom base

10-40

Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV.

Unit sales line is steeper than salvage value or k, so NPV is more sensitive to changes in unit sales than in salvage value or k.

10-41

Weaknesses of sensitivity analysis:

1. Does not reflect diversification.2. Does not incorporate info. about

the likelihood of changing variables, i.e., steep sales line not a problem if sales won’t fall.

Why useful?

1. Gives idea of project risk.2. Identifies dangerous variables.

10-42

What is scenario analysis?

Examines several possible situations, usually worst case, most likely case, and best case.

Indicates range of possible outcomes.

10-43

Scenario Probability NPV (000)

Worst 0.25 -$27.8

Base 0.50 15.0

Best 0.25 57.8

Assume we know all variables exceptunit sales, which could range from 75,000 to 125,000 (or 75 to 125). Hereare the scenario NPVs:

E(NPV) = $15.0(NPV) = $30.3

Problem 6 in lab

10-44

Standard Deviation:

NPV = $30.3

Coefficient of Variation:

CV

E NPVNPVNPV

$30.$15

.3 2 0

10-46

Define Monte Carlo simulation.

A type of scenario analysis which brings in probabilities of input variables.

Computer selects values for variables based on probability distributions.

10-47

NPV and IRR are calculated.

Process is repeated 1,000’s of times.

End result: Prob. distr. of NPV and

IRR.

10-48

Prob. Density

E(NPV)0 NPV

xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx

xxxxx

10-49

Advantages of simulation analysis?

• Reflects probability of each input.

• Shows range of NPVs, expected NPV, NPV, and CVNPV.

• Simulation fairly easy to do with a spreadsheet (@risk)

10-50

Disadvantages of simulation:

Difficult to specify probability distributions and correlations. (If you have historical data there is software to help)

If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!

10-51

Sensitivity, scenario, and simulation analysis all ignore diversification.

Thus, they measure only stand-alone risk.

10-52

Find the project’s market risk and cost of capital based on the CAPM, given these inputs:

Target debt ratio = 50%.

kd = 12% Tax rate = 40%

kRF = 10% BetaProject = 1.2

Market risk premium = 6%.

10-53

Beta = 1.2, so project has more market risk than average.

Project’s required return on equity:

WACC w k T w kP d d ce s 1

0 5 12% 0 6 0 5 17 2%

12 2%.

. . . .

.

k k k k bs RF M RF p

10% 6% 12 17 2%.. .

10-54

Project’s market risk vs. the firm’s overall risk:

Project’s WACC = 12.2% vs. company WACC = 10%.

Risk adjusted discount rate So project’s market risk must be

greater than average.

Problem 15, Hudson Furniture in lab

10-55

Estimating project beta:

1. Pure-play. Find several publiclytraded companies exclusively inproject’s business.

Use average of their betas as proxy for project’s beta.

Hard to find such companies.

10-56

2. Accounting beta. • Run regression between “project’s” rate of

return and S&P index rate of return.

• Accounting betas are correlated with market betas. But hard to get data on projects’ rate of return before the cap. bud. decision has been made.

• Usually accounting data for a division of the company is used for the “project”