Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22 Chapter 10 Project Cash Flows and Risk

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 22 The cash flow estimation

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 22 Cash Flow from Assets Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 22 Basic Terminology Conventional Versus Nonconventional Cash Flows

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 22 The Relevant Cash Flows Incremental cash flows: –are cash flows specifically associated with the investment, and –their effect on the firms other investments (both positive and negative) must also be considered. For example, if a day-care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 22 Relevant Cash Flows Major Cash Flow Components

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 22 Categories of Cash Flows: –Initial Cash Flows are cash flows resulting initially from the project. These are typically net negative outflows. –Operating Cash Flows are the cash flows generated by the project during its operation. These cash flows typically net positive cash flows. –Terminal Cash Flows result from the disposition of the project. These are typically positive net cash flows. Relevant Cash Flows

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 22 Relevant Cash Flows Expansion Versus Replacement Cash Flows Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 22 Relevant Cash Flows Expansion Versus Replacement Cash Flows

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 22 Relevant Cash Flows Note that cash outlays already made (sunk costs) are irrelevant to the decision process. However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant. Sunk Costs Versus Opportunity Costs

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 22 Finding the Initial Investment

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 22 Expansion Project—Example Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34% Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500) Increase in gross profit$21,000 Marginal tax rate 34%* Depreciation methodMACRS Increase production by adding a machine Purchase price$(47,000) Installation$(3,000) Life 3 years Salvage$5,000 Increase in net WC$(1,500)* Increase in gross profit$21,000 Marginal tax rate 34%* Depreciation methodMACRS

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 22 MACRS Depreciation Life Class of Investment Year3-year5-year7-year 133%20%14% %100%100%

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 22 Expansion Project—Initial Investment Outlay Purchase Price$(47,000) Installation( 3,000) Δ Net WC( 1,500) Initial invest outlay$(51,500) Depreciable basis= $47,000 + $3,000 = $50,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 22 Expansion Project—Incremental Operating Cash Flows Depreciation 1 = $50,000(0.33) = $16,500 Depreciation 2 = $50,000(0.45) = $22,500 Depreciation 3 = $50,000(0.15) = $ 7,500 Year 1 Year 2 Year 3  gross profit$21,000$21,000$21,000 Depreciation(16,500) (22,500)( 7,500) Δ taxable income4,500( 1,500)13,500 Δ taxes (34%) (1,530) 510( 4,590) Δ net income2,970( 990)8,910 Depreciation16,50022,500 7,500 Δ operating CF19,47021,51016,410

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 22 Expansion Project—Terminal Cash Flow Salvage of asset$5,000 Taxes on sale (510) Δ net working capital 1,500 Terminal cash flow 5,990

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 22 Expansion Project—Cash Flow Time Line 19,47021,51016, (51,500.00) 12% 17, , , (1,024.55) 5,990 22,400 IRR = 10.9%

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 22 Capital Budgeting Project Evaluation Expansion projects—marginal cash flows include all cash flows associated with adding a new asset to grow the firm.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 22 Corporate (Within-Firm) Risk Determine how a capital budgeting project is related to the existing assets of the firm. If the firm wants to diversify its risk, it will try to invest in projects that are negatively related (or have little relationship) to the existing assets. If a firm can reduce its overall risk, then it generally becomes more stable and its required rate of return decreases.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 22 Beta (Market) Risk Theoretically any asset has a beta, , or some way to measure its systematic risk If we can determine the beta of an asset, then we can use the capital asset pricing model, CAPM, to compute its required rate of return as follows: k proj = k RF + (k M - k RF )  proj Measuring beta risk for a project—it is difficult to determine the beta for a project. –pure play method

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 22 Beta (Market) Risk—Example Capital Budgeting Project Characteristics: Cost= $100,000  project = 1.5 k RF = 3.0% k M = 9.0% k project = 3.0% + (9.0% - 3.0%)1.5 = 12.0% Firm’s Characteristics Before Purchasing the Project: Total assets = $400,000  firm = 1.0 Firm’s Beta Coefficient After Purchasing the Project: Total assets = $400,000 + $100,000 = $500,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 22 Capital Budgeting—Risk Analysis The firm generally uses its average required rate of return to evaluate projects with average risk. The average required rate of return is adjusted to evaluate projects with above-average or below- average risks. Project Required Risk Category Rate of Return Above-average16% Average12 Below-average10 If risk is not considered, high-risk projects might be accepted when they should be rejected and low- risk projects might be rejected when they should be accepted.