ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WANG LAURENTIAN UNIVERSITY FINANCIAL MANAGEMENT

CHAPTER 11 CASH FLOW ESTIMATION AND RISK ANALYSIS

CHAPTER 11 OUTLINE Estimating Cash Flows Capital Cost Allowance Project Analysis: An Example An Alternative Approach for Calculating Project Cash Flows Issues in Project Analysis Project Risk Analysis: Techniques for Measuring Stand-Alone Risk Copyright © 2014 by Nelson Education Ltd. 11-3

CHAPTER 11 OUTLINE (cont’d) Project Risk Conclusions Incorporating Project Risk into Capital Budgeting Managing Risk through Phased Decisions: Decision Trees Introduction to Real Options Copyright © 2014 by Nelson Education Ltd. 11-4

Copyright © 2014 by Nelson Education Ltd. 11-5

Estimating Cash Flows The most important but also the most difficult step Many variables involved: – Unit sales, sales prices, capital outlays, operating costs, and so on Many individuals and departments participate: – Marketing, engineering, and product development – Staff, cost accountants, production experts Copyright © 2014 by Nelson Education Ltd. 11-6

A Proper Analysis Obtaining information Using a consistent set of realistic economic assumptions No biases inherent in the forecasts Copyright © 2014 by Nelson Education Ltd. 11-7

Cardinal Rules of Relevant Cash Flows 1.Capital budgeting decisions must be based on cash flows, not accounting income. 2.Only incremental cash flows are relevant. Copyright © 2014 by Nelson Education Ltd. 11-8

Relevant Cash Flow Also called the incremental cash flow It is the additional free cash flow (FCF) if the project is implemented. It can be broken down into the following components: Copyright © 2014 by Nelson Education Ltd. 11-9

Accounting Net Income vs. Cash Flow Project analysis focuses on expected cash flows, not accounting net income. Using the depreciation rates allowed by the Canada Revenue Agency (CRA) Not deducting interest expense Including the investment in working capital Copyright © 2014 by Nelson Education Ltd

Capital Cost Allowance (CCA) Depreciation is not a cash expense but shields some earnings from taxes and thus indirectly increases cash flows. CCA tax shield = CCA amount x tax rate CRA classifies capital assets into more than 40 asset groups or “classes” and specifies CCA rates. Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Elements of CCA Rules Most CCAs are calculated on a declining basis – undepreciated capital cost (UCC), that is, CCA = UCC begin of year x CCA rate UCC end of year = UCC begin of year – CCA Next year, UCC begin of year = UCC end of year A half-year rule: Only half the capital cost can be claimed for CCA in the year of acquiring. CCA is calculated not on individual assets but rather by asset class. Copyright © 2014 by Nelson Education Ltd

Asset Purchase and Disposition Net Acquisition = – Capital cost of new asset(s) minus – Lesser of original capital cost or net proceeds from disposed asset(s) The half-year rule applies if net acquisition > 0 Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

CCA Recapture and Terminal Loss Occur when the last asset in an asset class is disposed of CCA recapture generated if the disposition value > UCC remaining; that is, a negative UCC balance results from the sale and the extra CCA must be added back to pay tax Terminal loss is generated if a positive UCC balance results and the balance is allowed to be deducted against income. Copyright © 2014 by Nelson Education Ltd

Project Analysis: An Example $7.8 million cost + $0.2 million shipping & installation Economic life = 4 years Salvage value = $2 million CCA class 43 (30%) Building cost = $12 million CCA class 1 (4%) Building resale value = $10 million Copyright © 2014 by Nelson Education Ltd

Project Annual unit sales = 20,000 (0%) Unit sales price = $3,000 (+2% / year) Unit variable costs = $2,100 (+2% / year) Annual fixed costs = $8 million (+1% / year) Net operating working capital (NOWC) = 10% of the upcoming year’s sales Tax rate = 30% Project cost of capital = 12% Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Calculating Cash Flows Year 0: initial investment outlays = $7.8 million + $0.2 million = $8 million initial investment in NOWC = 10% x sales in Year 1 Year 1 – 4: operating cash flow = NOPAT + CCA NOPAT = (Sales revenue – variable costs – fixed operating costs – CCA) x (1 – tax rate) Copyright © 2014 by Nelson Education Ltd

Calculating Cash Flows (cont’d) Year 1-3: NOWC in Year t (t = 1, 2, 3) = 10% x Sales in Year t + 1 ∆NOWCt = NOWCt – NOWCt –1 Year 4: NOWC = Recovery of total investment in NOWC from Year 0 – 3 Net cash flow = Operating cash flow + NOWC inflow + Salvage cash flow Copyright © 2014 by Nelson Education Ltd

Projected Net Cash Flows Copyright © 2014 by Nelson Education Ltd

Making the Decision NPV, IRR, MIRR, PI, payback, and discounted payback can be calculated based on the cash flows shown in Row 77. Though these measures indicate that the project should be accepted, the final decision can not be made until the project’s risk is evaluated. Copyright © 2014 by Nelson Education Ltd

Project Evaluation Criteria Copyright © 2014 by Nelson Education Ltd

An Alternative Approach for Calculating Project Cash Flows Operating cash flows = (Sales – Operating costs – CCA) x (1 – Tax rate) + CCA = (Sales – Operating costs) x (1 – Tax rate) – CCA x (1 – Tax rate) + CCA = (Sales – Operating costs) x (1 – Tax rate) + Tax rate x CCA = Cash flows from operating the project + Tax savings from CCA Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Present Value of CCA Tax Shield n n+1 ∞ | | | | | | TxCCA 1 TxCCA 2 TxCCA n TxCCA n+1 TxCCA∞ PV of CCA tax shield (from Year 1 to n) = PV of CCA tax shield (from Year 1 to ∞) – PV of CCA tax shield lost due to salvage at Year n (from Year n+1 to ∞) = Copyright © 2014 by Nelson Education Ltd

Formula: PV of CCA Tax Shield Copyright © 2014 by Nelson Education Ltd

Issues in Project Analysis Changes in NOWC Interest expenses Sunk costs Opportunity costs Externalities Replacement projects Timing of cash flows Adjusting for inflation Copyright © 2014 by Nelson Education Ltd

Changes in NOWC Refers to the difference between the required increase in operating current assets (A/R and inventories) and the increase in operating current liabilities (A/P and accruals) due to a project Additional financing required to launch the project The investment to be returned (a cash inflow) by the end of the project’s life Copyright © 2014 by Nelson Education Ltd

Interest Expenses Not Subtracted When Estimating Project Cash Flows The discount rate used in discounting project cash flows is the weighted average cost of capital (WACC), representing the rate of return for all investors, both shareholders and debtholders. The matching principle dictates that the project cash flows to be discounted should also be those available to all investors. Therefore, interest expenses – cash flows to debtholders – should NOT be subtracted. Copyright © 2014 by Nelson Education Ltd

Sunk Costs Not Included 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. No bearing on the decision. Focus on incremental investment and operating cash flows. Other example: Marketing or feasibility reports before a decision is made Copyright © 2014 by Nelson Education Ltd

Opportunity Costs to Be Included 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. Copyright © 2014 by Nelson Education Ltd

Externalities If the new product line would decrease sales of the 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, a cannibalization effect. Externalities will be positive if new projects are complements to existing assets, negative if substitutes. It is critical to identify and account for all externalities, including environmental ones. Copyright © 2014 by Nelson Education Ltd

Replacement Project Occurs when the firm replaces an existing asset Generally reduces costs Relevant cash flows take the form of differences in cash flows between the existing project and the replacement project. Copyright © 2014 by Nelson Education Ltd

Replacement Analysis: An Example New machine cost = $12,000 Old machine current market value = $1,000 Salvage value at the end of Year 5 = $2,000 (new machine) and $0 (old machine) CCA rate = 20% Tax rate = 30% Project life = 5 years Investment in NOWC = $1,000 Annual operating costs = $9,000 cut to $4,000 WACC = 11.5% Copyright © 2014 by Nelson Education Ltd

Calculation Incremental investment outlay – Cost of new machine $12,000 Minus: Proceeds from old one (1,000) Add: Investment in NOWC 1,000 Total incremental investment $12,000 Copyright © 2014 by Nelson Education Ltd

Calculation (cont’d) Incremental annual cash inflow: Current annual operating costs $9,000 Minus: New annual costs (4,000) Savings in operating costs $5,000 After-tax operating savings $3,500 Copyright © 2014 by Nelson Education Ltd

Calculation (cont’d) Incremental terminal cash inflow Salvage value of new machine $2,000 Minus: Salvage value of old one 0 Add: Recovery of NOWC 1,000 Incremental cash inflow $3,000 Copyright © 2014 by Nelson Education Ltd

PV of CCA Tax Shield Copyright © 2014 by Nelson Education Ltd

NPV = –$12,000 + $1,766 + $3,000/ $3,500 x (1 – 1/ )/0.115 = $4, (12,000) 1,766 3,500 NPV Calculation 5 3,500 3,000 Copyright © 2014 by Nelson Education Ltd

Timing of Cash Flows A compromise between accuracy and feasibility Cash flows in most cases are assumed to occur at the end of every year. For some projects, cash flows may be assumed to occur at mid-year, or even quarterly or monthly. Copyright © 2014 by Nelson Education Ltd

Adjusting for Inflation The cost of capital used as the discount rate already includes the effect of expected inflation. Correspondingly, the project cash flows should also be adjusted for inflation. The sales price and both variable and fixed costs should be made to increase at the expected inflation rate. Copyright © 2014 by Nelson Education Ltd

Project Risk Analysis: Techniques for Measuring Stand-Alone Risk Reasons for measuring stand-alone risk Sensitivity analysis Scenario analysis Monte Carlo simulation Copyright © 2014 by Nelson Education Ltd

Reasons for Measuring Stand-Alone Risk Of the three distinct types of risk, a project’s stand-alone risk is the easiest to estimate. Stand-alone risk is generally a good proxy for hard-to-measure corporate and market risk. A project’s stand-alone risk refers to the uncertainty inherent in its cash flows. Copyright © 2014 by Nelson Education Ltd

Sensitivity Analysis Shows how changes in an input variable such as unit sales affect NPV or IRR. Answers “what if” questions, e.g., “What if sales decline by 30%?” In order to find out to which input variable the project’s NPV or IRR is the most sensitive Copyright © 2014 by Nelson Education Ltd

Sensitivity Tables Sensitivity analysis starts with a base-case situation. The base-case NPV is calculated using the expected or most likely values for each input. Then each variable is changed by several percentage points above and below the expected value with all other variables held constant and a new NPV is calculated. Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Sensitivity Graphs The set of NPVs in the sensitivity table is plotted against each input variable. The slope of each NPV line measures the sensitivity of the project’s NPV to this particular input variable. The steeper the slope, the more sensitive the NPV is to a change in the variable. Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

NPV Breakeven Analysis A special application of sensitivity analysis Used to find the level of an input producing an NPV of exactly zero. Helpful in determining how bad things can get before the project has a negative NPV. Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Weaknesses of Sensitivity Analysis Does not reflect diversification Says nothing about the likelihood of change in a variable; that is, a steep sales line is not a problem if sales won’t fall. Ignores relationships among variables Copyright © 2014 by Nelson Education Ltd

Scenario Analysis Extends sensitivity analysis to deal with its weaknesses Allows more than one variable to change at a time to see the combined effects of changes in the variables Examines several possible situations, usually worst case, most likely case, and best case Provides a range of possible outcomes Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

Calculations Copyright © 2014 by Nelson Education Ltd

Scenario Analysis Graph Copyright © 2014 by Nelson Education Ltd

Problems With Scenario Analysis Only considers a few possible outcomes 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 Copyright © 2014 by Nelson Education Ltd

Monte Carlo Simulation A computerized version of scenario analysis that uses continuous probability distributions Computer selects values for each variable based on given probability distributions NPV is repeatedly calculated and the set of NPVs constitute a continuous probability distribution. Copyright © 2014 by Nelson Education Ltd

NPV Probability Distribution 0E(NPV) Flatter distribution, larger , larger stand-alone risk NPV Copyright © 2014 by Nelson Education Ltd

Project Risk Conclusions Given the possibility that CAPM may not operate exactly as theory says it should and the fact that CAPM ignores bankruptcy costs, even well-diversified investors should want a firm’s management to consider a project’s corporate risk. The project’s stand-alone risk will be a good measure of its corporate risk. Copyright © 2014 by Nelson Education Ltd

Incorporating Project Risk into Capital Budgeting Certainty equivalent approach: Every cash inflow not known with certainty is scaled down to be a certainty equivalent value. Risk-adjusted discount rate approach: Changing the discount rate to deal with differential project risk; the higher the project risk, the higher the discount rate. Copyright © 2014 by Nelson Education Ltd

Managing Risk Through Phased Decisions: Decision Trees Managers are more interested in reducing risk than in measuring it. Decision trees reduce risk by giving managers the opportunity to re-evaluate decisions using new information and then either invest additional funds or terminate the project. Copyright © 2014 by Nelson Education Ltd

Copyright © 2014 by Nelson Education Ltd

United Robotics: Decision Tree Analysis Two types of nodes: Decision nodes and outcome nodes Three decision nodes at which managers can respond to new information: – The first (Decision Point 1) at t = 1, after marketing study completed – The second (Decision Point 2) at t = 2, after prototype study completed – The third (Decision Point 4) between t = 3 and t = 4, where the decision to stop is made Copyright © 2014 by Nelson Education Ltd

United Robotics: Decision Tree Analysis (cont’d) One outcome node (Decision Point 3): at t = 3, and its branches show the possible results (cash flows) if a particular decision is taken The joint probability and the associated NPV can be calculated for each branch (every possible result). The project’s expected NPV can also be calculated. Copyright © 2014 by Nelson Education Ltd

Introduction to Real Options Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the 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. Copyright © 2014 by Nelson Education Ltd

Types of Real Options Investment timing options Growth options – Expansion of existing product line – New products – New geographic markets Copyright © 2014 by Nelson Education Ltd

Types of Real Options (cont’d) Abandonment options – Contraction – Temporary suspension Flexibility options Copyright © 2014 by Nelson Education Ltd