1. 12 - 1 Copyright © 2002 by Harcourt, Inc.All rights reserved. CHAPTER 12 Cash Flow Estimation and Risk Analysis Relevant cash flows

2. 12 - 2 Copyright © 2002 by Harcourt, Inc.All rights reserved. Proposed Project Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost: $240,000. Inventories will rise by $25,000 and payables by $5,000. Economic life = 4 years. Salvage value = $25,000. MACRS 3-year class.

3. 12 - 3 Copyright © 2002 by Harcourt, Inc.All rights reserved. Sales: 100,000 units/year @ $2. Variable cost = 60% of sales. Tax rate = 40%. WACC = 10%.

4. 12 - 4 Copyright © 2002 by Harcourt, Inc.All rights reserved. Set up, without numbers, a time line for the project’s cash flows. 01234 OCF 1 OCF 2 OCF 3 OCF 4 Initial Costs (CF 0 ) + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4

5. 12 - 5 Copyright © 2002 by Harcourt, Inc.All rights reserved. Equipment-$200 Installation & Shipping-40 Increase in inventories-25 Increase in A/P5 Net CF 0 -$260  NOWC = $25 – $5 = $20. Remember, depreciable basis = $240,000 Investment at t = 0:

6. 12 - 6 Copyright © 2002 by Harcourt, Inc.All rights reserved. What’s the annual depreciation? Due to 1/2-year convention, a 3-year asset is depreciated over 4 years. YearRatexBasisDepreciation 10.33$240$ 79 20.45240108 30.1524036 40.07240 17 1.00$240

7. 12 - 7 Copyright © 2002 by Harcourt, Inc.All rights reserved. Operating Cash Flows Operating Cash Flows have 2 components: 1. After tax increase revenues - increase in costs (or decreased costs) 2. Tax effect of Depreciation OCF = CFBT(1-T) + DT

8. 12 - 8 Copyright © 2002 by Harcourt, Inc.All rights reserved. Operating cash flows: 1234 Revenues 200 Op. Cost, 60%-120 Op. CF CFBT 80 80 80 80 CFBT(1-T)T=40% 48 48 48 48 Depreciation 79 108 36 17 DT 32 43 14 7 OCF 80 91 62 55

9. 12 - 9 Copyright © 2002 by Harcourt, Inc.All rights reserved. Terminal Values NOWC - once project has ended, no longer need that cash Need to compare Book value to Salvage value to determine if there’s again or loss on sale. Book value = Depreciable basis - depreciation taken (240 - 240 = 0 because fully depreciated)

10. 12 - 10 Copyright © 2002 by Harcourt, Inc.All rights reserved. Terminal Values Salvage Value - Book value = gain or loss on sale Gain - taxable, pay more taxes (Gain)(T) subtract from terminal value Loss - pay less taxes - add to terminal value (Loss)(T) In this case, 25 - 0 = 25(.4) = 10K, this is the additional tax you pay, so subtract from terminal value.

11. 12 - 11 Copyright © 2002 by Harcourt, Inc.All rights reserved. Net Terminal CF at t = 4: Salvage Value 25 Tax on SV (40%)-10 Recovery of NOWC$20 Net termination CF$35

12. 12 - 12 Copyright © 2002 by Harcourt, Inc.All rights reserved. What If the Machine Still Had Book Value (Not Fully Depreciated) If the project only had a 2 year life, so we start with the depreciable basis of $240,000 - $79,000 - $108,000 = $53,000 $25,000 - $53,000 = $28,000 loss on sale $28,000(.4) = $11,200 add to terminal value because this is the amount of tax that you do not pay because of the loss.

13. 12 - 13 Copyright © 2002 by Harcourt, Inc.All rights reserved. Should CFs include interest expense? Dividends? No. The cost of capital is accounted for by discounting at the 10% WACC, so deducting interest and dividends would be “double counting” financing costs.

14. 12 - 14 Copyright © 2002 by Harcourt, Inc.All rights reserved. Suppose $50,000 had been spent last year to improve the building. Should this cost be included in the analysis? No. This is a sunk cost. Analyze incremental investment.

15. 12 - 15 Copyright © 2002 by Harcourt, Inc.All rights reserved. Suppose the plant could be leased out for $25,000 a year. Would this affect the analysis? Yes. Accepting the project means foregoing the $25,000. This is an opportunity cost, and it should be charged to the project. A.T. opportunity cost = $25,000(1 – T) = $25,000(0.6) = $15,000 annual cost.

16. 12 - 16 Copyright © 2002 by Harcourt, Inc.All rights reserved. If the new product line would decrease sales of the firm’s other lines, would this affect the analysis? Yes. The effect on other projects’ CFs is an “externality.” Net CF loss per year on other lines would be a cost to this project. Externalities can be positive or negative, i.e., complements or substitutes.

17. 12 - 17 Copyright © 2002 by Harcourt, Inc.All rights reserved. Here are all the project’s net CFs (in thousands) on a time line: Enter CFs in CF register, and I = 10%. NPV = -$4.03. IRR = 9.3%. k = 10% 0 79.7 1 91.2 2 62.4 3 54.7 4 -260 Terminal CF35.0 89.7

18. 12 - 18 Copyright © 2002 by Harcourt, Inc.All rights reserved. If this were a replacement rather than a new project, would the analysis change? Yes. The old equipment would be sold, and the incremental CFs would be the changes from the old to the new situation.

19. 12 - 19 Copyright © 2002 by Harcourt, Inc.All rights reserved. The relevant depreciation would be the change with the new equipment. Also, if the firm sold the old machine now, it would not receive the SV at the end of the machine’s life. This is an opportunity cost for the replacement project.