Chapter 7 Project Cash Flows and Risk © 2005 Thomson/South-Western

Cash Flow Estimation  Most important and most difficult step in the analysis of a capital project  Financial staff’s role includes:  Coordinating other departments’ efforts  Ensuring that everyone uses the same set of economic assumptions  Making sure that no biases are inherent in forecasts

Relevant Cash Flows  Cash Flow Versus Accounting Income  Incremental Cash Flows

Cash Flow Versus Accounting Income 2010 Situation Accounting ProfitsCash Flows Sales$50,000 $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

Cash Flow Versus Accounting Income 2011 Situation Accounting ProfitsCash 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

Incremental Cash Flows An Incremental Cash Flow An Incremental Cash Flow is the change in a firm’s net cash flow attributable to an investment project.

Problems in Determining Incremental Cash Flows  Sunk Cost:  Sunk Cost: A cash outlay that already has been incurred and cannot be recovered  Opportunity Cost:  Opportunity Cost: The return on the best alternative use of an asset  Externalities:  Externalities: The effect of accepting a project on the cash flows in other parts of the firm  Shipping and Installation Costs  Inflation

Identifying Incremental Cash Flows  Initial Investment Outlay:  Initial Investment Outlay: the incremental cash flows associated with a project that will occur only at the start of a project’s life  Incremental Operating Cash Flow:  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:  Terminal Cash Flow: the net cash flows that occur only at the end of a project’s life

Incremental Operating Cash Flow Incremental operating cash flow t =  NOI t x (1 - T) +  Depr t = (  S t -  OC t -  Depr t ) x (1 - T) +  Depr t = (  S t -  OC t) x (1 - T) + T(  Depr t ) =  Cash revenues t -  Cash expenses t -  Taxes t

Capital Budgeting Project Evaluation  Expansion Project:  Expansion Project: A project that is intended to increase sales; provides growth to the firm  Replacement Analysis:  Replacement Analysis: An analysis involving the decision of whether to replace an existing, still productive asset with a new asset

11 Classwork 3 and 4

Expansion Project Analysis of the Cash Flows 2010 $5,000 = ($30,000- $18,000- $5,000) (1– 0.40) + $2,000(0.40) 2011 $5,480 = ($30,000- $18,000- $5,000) (1– 0.40) + $3,200(0.40) 2012 $4,960 = ($30,000- $18,000- $5,000) (1– 0.40) + $1,900(0.40) 2013 $4,680 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $1,200(0.40) Year Incremental Operating Cash Flow Computation

k = 15% 5,000 4,9605,480(14,000) 4,384 4,143 3,261 6,038 $3,790 10, NPV = Net cash flows IRR = 26.3%Payback period = 2.7 years Expansion Project Cash Flow Time Line

IRR = 14.0% Payback period = 3.6 years Replacement Project Cash Flow Time Line k = 15% 3,484 2,6204,060(11,400) 3,030 3,070 1,723 1,278 2,038 $(261) 2, NPV = Net cash flows ,100

Introduction to Project Risk Analysis  Stand-Alone Risk:  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:  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:  Beta (Market) Risk: part of a project’s risk that cannot be eliminated by diversification  Measured by the project’s beta coefficient

Techniques for Measuring Stand-Alone Risk  Sensitivity Analysis:  Sensitivity Analysis: Key variables are changed and the resulting changes in the NPV and the IRR are observed.  Scenario Analysis:  Scenario Analysis: “Bad” and “good” sets of financial circumstances are compared with the most likely situation.  Monte Carlo Simulation:  Monte Carlo Simulation: Probable future events are simulated on a computer.

Sensitivity Analysis Graph NPV (000s) Base Unit sales SV k % change from base

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 Scenario Analysis

Standard Deviation: σ NPV = $30.3 Coefficient of Variation: Scenario Analysis

Advantages / Disadvantages of Simulation Analysis  Reflects probability of each input  Shows range of NPVs, expected NPV, σ NPV, and CV NPV  Difficult to specify probability distributions and correlation  If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out! Advantages Disadvantages

Beta Risk and Required Rate of Return for a Project Beta (or Market) Risk and Required Rate of Return for a Project Security Market Line equation: k S = k RF + (k M - k RF )β s Erie Steel is all equity financed, so cost of equity is also its averaged required rate of return, or cost of capital. Erie’s β = 1.1; k RF = 8%; and k M = 12% k S = 8% + (12% - 8%)1.1 = 12.4% = Erie’s cost of equity Investors should be willing to give Erie money to invest in average-risk projects.

Required Rate of Return for a Project k proj = the risk-adjusted required rate of return for an individual project k proj = k RF + (k M - k RF )  proj

Measuring Beta Risk for a Project Pure Play Method: 1. Identify companies whose only business is the project in question. 2. Determine the beta for each company. 3. Average the betas to find an approximation of proposed project’s beta.

How Project Risk Is Considered in Capital Budgeting Decisions Risk-Adjusted Discount Rate 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.

Capital Rationing A situation in which a constraint is placed on the total size of the firm’s capital investment.