Finance Chapter 11 Cash flow estimation & risk analysis

Perspective  Procedures for estimating cash flow associated with capital budgeting  Techniques to measure and take account of project risk  Relevant cash flows – the specific cash flows that should be considered in a capital budgeting decision  Focus on cash flows not accounting income  Only incremental cash flows are relevant

Project cash flow  The most important and difficult step is estimating the incremental after-tax cash flows the project will produce  Only incremental cash flows are relevant  Recall that free cash flow is the cash flow available for distribution to investors, therefore, the relevant cash flow for a project is the additional free cash flow that the company expects if it implements the project, i.e., the cash flow above and beyond what the company would expect if it doesn’t implement the project.

Project cash flow  Project cash flow is different from accounting income. Project cash flow reflects:  Cash outlays for fixed assets  Tax shield from depreciation  Cash flows due to changes in net operating working capital (see pg. 426)  Difference between required increase in current assets minus the resulting increase in AP and accruals  Does not include interest payments (see pp )

Incremental cash flow problems  Problems associated with incremental cash flows – The net cash flow attributable to a investment project  Sunk cost – a cash outlay that already occurred and cannot be recovered regardless if the project is accepted or rejected (see pg. 427)  Not relevant since this is not an incremental cost  Opportunity cost – The return on the beat alternative use of an asset, or the highest return that will not be earned if funds are invested in a project

Incremental cash flow problems  Externalities – effects of a project on cash flows in other parts of the firm  E.g., some existing Starbuck’s customers patronize a newly opened store and stop patronizing the existing store  Cannibalization – occurs when the introduction of a new product causes sales of existing products to decline  IBM refused to fully support its PC division for fear sales of PCs would cannibalize its profitable mainframe business

NOWC  Required new investment in net operating working capital (NOWC)  Included in year 0 as a cash outflow and in the final year of the project as a cash inflow  Investment in operating working capital will be returned by the end of the project’s life

Incremental cash flows  Incremental cash flows from a typical project are classified as follows:  Initial investment outlay  Operating cash flows over the project’s life  Terminal year cash flows

Risk  Market risk (beta) – most relevant measure since stockholders are generally diversified. Market (beta) risk affects the cost of capital, which affects stock prices  Corporate risk – influences the firm’s ability to use low-cost debt  Sensitivity analysis – shows how much a project’s NPV will change in response to a given change in an input variable such as sales, ceteris paribus  Scenario analysis – best- & worst-case NPVs are compared to the project’s expected NPV

Risk  Monte Carlo simulation – computer simulation used to model future outcomes to estimate a project’s profitability and risk  Risk-adjusted discount rate – the rate used to evaluate a particular project based on the corporate WACC—increased for riskier projects, decreased for less risky projects