1. Capital Budgeting: Estimating Cash Flows and Analyzing Risk
CHAPTER 13
Capital Budgeting: Estimating Cash Flows and Analyzing Risk

2. Chapter Topics Estimating cash flows: Risk Analysis: Decision Trees
Issues in Project Analysis
Depreciation & Tax Effects on Salvage Value
Inflation
Risk Analysis:
Sensitivity Analysis
Scenario Analysis
Simulation Analysis
Decision Trees
Real Options

3. Relevant Cash Flows: Incremental Cash Flow for a Project
Project’s incremental cash flow is:
Corporate cash flow with the project
Minus
Corporate cash flow without the project.

4. Free Cash Flow Capital Expenditures = FA + Deprec
ΔNOWC = Current Operating Assets
– Current Operating Liabilities
Current Operating Assets excludes Marketable Securities
Current Operating Liabilities excludes Notes Payable

5. Free Cash Flow “Investment outlay CF = CF0
“Operating CF” = Net Income + Non-cash items (deprec) each year
“NOWC CF” = Net working capital requirements each year
“Salvage CF” = After-tax salvage value of assets and NOWC recovery

6. Issues in Project Analysis
Purchase of Fixed Assets …………… Y
Non-cash charges …………………….. Y
Changes in Net Working Capital……Y
Interest/Dividends …………..……….. N
“Sunk” Costs …………………………….. N
Opportunity Costs …………………….. Y
Externalities/Cannibalism …………… Y
Tax Effects ………………………..…….. Y

7. Depreciation Basics MACRS  0 Recovery Period = Class Life
Straight Line  Salvage Value
MACRS  0
Recovery Period = Class Life
1/2 Year Convention

8. MACRS Depreciation Classes
TABLE 13.1

9. MACRS Depreciation
TABLE 13.2

10. Annual Depreciation Expense (000s)
SCC (Minicase): Equipment cost $200
Shipping
Installation
 Book
Depr Value %
0.33
0.45
0.15
0.07
x Basis =
Year 1 2 3 4
Depr
$ 79.2
108.0
36.0
16.8
$240

11. Tax Effect on Salvage Net Cash flow from sale = Sale proceeds
- taxes paid
Tax basis = difference between sales price
and book value, where:
Book value = Original basis
- Accumulated depreciation

12. Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where:
SP = Selling Price
BV = Book Value
T = Corporate tax rate

13. Example: If Asset Sold After 3 Years
BV (EOY 3) = $17
IF: Selling price = $20
TCF = $20 - (20-17)(.4) = $18.8
IF: Selling price = $10
TCF = $10 - (10-17)(.4) = $12.8

14. Adjusting for Inflation
Nominal r > real r
The cost of capital, r, includes a premium for inflation
Nominal CF > real CF
Nominal cash flows incorporate inflation
If you discount real CF with the higher nominal r, then your NPV estimate is biased downward.

15. Real vs. Nominal Cash flows
INFLATION
Real vs. Nominal Cash flows
Real
Nominal

16. Real vs. Nominal Cash flows
INFLATION
Real vs. Nominal Cash flows
2 Ways to adjust
Adjust WACC
Cash Flows = Real
Adjust WACC to remove inflation
Adjust Cash Flows for Inflation
Use Nominal WACC

17. Regency Integrated Chips

18. RIC – Depreciation & Salvage Value

19. RIC – Sales, Costs and NWC

20. RIC – Cash Flow Estimation

21. RIC: Cash Flow Analysis

22. Excel Functions

23. RIC Background Data Salvage Value Key Basic Calculations
Cash Flow Estimation
Cash Flow Analysis

24. “Risk” in Capital Budgeting
Uncertainty about a project’s future profitability
Measured by σNPV, σIRR, beta
Will taking on the project increase the firm’s and stockholders’ risk?

25. Three types of relevant risk
Stand-alone risk
Corporate risk
Market (or beta) risk

26. Stand-Alone Risk
The project’s risk if it were the firm’s only asset and there were no shareholders.
Ignores both firm and shareholder diversification.
Measured by the σ or CV of NPV, IRR, or MIRR.

27. Probability Density 0 E(NPV) NPV Flatter distribution,
larger , larger
stand-alone risk.
NPV

28. Corporate Risk
Reflects the project’s effect on corporate earnings stability.
Considers firm’s other assets (diversification within firm).
Depends on project’s σ, and its correlation, ρ, with returns on firm’s other assets.
Measured by the project’s corporate beta.

29. Project X is negatively correlated to firm’s other assets → big diversification benefits
If r = 1.0, no diversification benefits. If r < 1.0, some diversification benefits
Profitability
Project X
Total Firm
Rest of Firm
Years

30. Market Risk
Reflects the project’s effect on a well-diversified stock portfolio.
Takes account of stockholders’ other assets.
Depends on project’s σ and correlation with the stock market.
Measured by the project’s market beta.

31. Conclusions on Risk
Stand-alone risk is easiest to measure, more intuitive.
Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk.
If the project is highly correlated with the economy, stand-alone risk also reflects market risk.

32. Sensitivity Analysis
Shows how changes in an input variable affect NPV or IRR
Each variable is fixed except one
Change one variable to measure the effect on NPV or IRR
Answers “what if” questions

33. RIC: Sensitivity Analysis

34. RIC: Sensitivity Graph

35. Results of Sensitivity Analysis
Steeper sensitivity lines = greater risk
Small changes → large declines in NPV
Unit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast

36. RIC: Sensitivity Analysis

37. Sensitivity Ratio If SR>0  Direct relationship
14-37
Sensitivity Ratio
%NPV = (New NPV - Base NPV)/Base NPV
%VAR = (New VAR - Base VAR)/Base VAR
If SR>0  Direct relationship
If SR<0  Inverse relationship

38. RIC: Sensitivity Ratios

39. RIC: Sensitivity Ratios & Graph

40. Sensitivity Analysis: Weaknesses
Does not reflect diversification
Says nothing about the likelihood of change in a variable
i.e. a steep sales line is not a problem if sales won’t fall
Ignores relationships among variables

41. Sensitivity Analysis: Strengths
Provides indication of stand-alone risk
Identifies dangerous variables
Gives some breakeven information

42. Scenario Analysis Examines several possible situations, usually:
Worst case
Base case or most likely case, and
Best case
Provides a range of possible outcomes

43. RIC: Scenario Analysis

44. RIC: Scenario Analysis

45. Problems with Scenario Analysis
Only considers a few possible out-comes
Assumes that inputs are perfectly correlated
All “bad” values occur together and all “good” values occur together
Focuses on stand-alone risk

46. Monte Carlo Simulation Analysis
A computerized version of scenario analysis which uses continuous probability distributions
Computer selects values for each variable based on given probability distributions

47. Monte Carlo Simulation Analysis
NPV and IRR are calculated
Process is repeated many times (1,000 or more)
End result: Probability distribution of NPV and IRR based on sample of simulated values
Generally shown graphically

48. Histogram of Results

49. Advantages of Simulation Analysis
Reflects the probability distributions of each input
Shows range of NPVs, the expected NPV, σNPV, and CVNPV
Gives an intuitive graph of the risk situation

50. Disadvantages of Simulation Analysis
Difficult to specify probability distributions and correlations
If inputs are bad, output will be bad: “Garbage in, garbage out”

51. Disadvantages of Sensitivity, Scenario and Simulation Analysis
Sensitivity, scenario, and simulation analyses do not provide a decision rule
They do not indicate whether a project’s expected return is sufficient to compensate for its risk
Sensitivity, scenario, and simulation analyses all ignore diversification
They measure only stand-alone risk, which may not be the most relevant risk in capital budgeting

52. Subjective risk factors
Numerical analysis may not capture all of the risk factors inherent in the project
For example, if the project has the potential for bringing on harmful lawsuits, then it might be riskier than a standard analysis would indicate

53. Decision Trees A technique for reducing risk
Analyze multi-stage projects
“Decision Nodes”
Points where managers can take action based on new information
Assign probabilities to each leg

54. United Robotics
Stage 1: (t=0) Invest $500,000 in market potential study
Stage 2: (t=1) If study results positive, invest $1 million in prototype
Stage 3: (t=2) Build plant at cost of $10 million
Stage 4: (t=3) Product acceptance?

55. United Robotics Decision Tree
Figure 13-5

56. United Robotics Decision Tree

57. 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

58. Types of Real Options Investment timing options Growth options
Expansion of existing product line
New products
New geographic markets
Abandonment options
Contraction
Temporary suspension
Flexibility options