1. Chapter 9
Project Cash Flows and Risk
© 2005 Thomson/South-Western

2. Cash Flow Estimation
Most important and most difficult step in the analysis of a capital project
Financial staff’s role includes:
Coordinating other departments’ efforts
Ensuring that everyone uses the same set of economic assumptions
Making sure that no biases are inherent in forecasts

3. Relevant Cash Flows Cash Flow Versus Accounting Income
Incremental Cash Flows

4. Cash Flow Versus Accounting Income
2006 Situation Accounting Profits Cash Flows
Sales $50, $50,000
Costs except depreciation (25,000) (25,000)
Depreciation (15,000)
Net operating income or cash flow $10,000 $25,000
Taxes based on operating income (30%) (3,000) (3,000)
Net income or net cash flow $7,000 $22,000
Net cash flow = Net income plus depreciation = $7,000 + $15,000 = $22,000

5. Cash Flow Versus Accounting Income
2011 Situation Accounting Profits Cash Flows
Sales $50,000 $50,000
Costs except depreciation (25,000) (25,000)
Depreciation (5,000)
Net operating income or cash flow $20,000 $25,000
Taxes based on operating income (30%) (6,000) (6,000)
Net income or net cash flow $14,000 $19,000
Net cash flow = Net income plus depreciation = $14,000 + $5,000 = $19,000

6. Incremental Cash Flows
An Incremental Cash Flow is the change in a firm’s net cash flow attributable to an investment project.

7. Problems in Determining Incremental Cash Flows
Sunk Cost: A cash outlay that already has been incurred and cannot be recovered
Opportunity Cost: The return on the best alternative use of an asset
Externalities: The effect of accepting a project on the cash flows in other parts of the firm
Shipping and Installation Costs
Inflation

8. Identifying Incremental Cash Flows
Initial Investment Outlay: the incremental cash flows associated with a project that will occur only at the start of a project’s life
Incremental Operating Cash Flow: the changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset
Terminal Cash Flow: the net cash flows that occur only at the end of a project’s life

9. Incremental Operating Cash Flow
Incremental operating cash flowt
= D Cash revenuest- DCash expensest- DTaxest
= DNOIt x (1 - T) + DDeprt
= (DSt - DOCt - DDeprt) x (1 - T) + DDeprt
= (DSt - DOCt) x (1 - T) + T(DDeprt)

10. Capital Budgeting Project Evaluation
Expansion Project: A project that is intended to increase sales; provides growth to the firm
Replacement Analysis: An analysis involving the decision of whether to replace an existing, still productive asset with a new asset

11. Expansion Project Analysis of the Cash Flows
Initial Investment Outlay $(9,500) Shipping & installation ( 500) Increase in NWC (4,000) Initial Investment $(14,000) Incremental Operating Cash Flow Sales revenue $30,000 $30,000 $30,000 $30,000 Variable Costs (18,000) (18,000) (18,000) (18,000) Fixed Costs (5,000) (5,000) (5,000) (5,000) Depreciation on new equipment (2,000) (3,200) (1,900) (1,200) Earnings before taxes (EBT) $5,000 $3,800 $5,100 $5,800 Taxes (40%) (2,000) (1,520) (2,040) (2,320) Net Income $3,000 $2,280 $3,060 $3,480 Add back depreciation 2,000 3,200 1,900 1, Incremental operating cash flows $5,000 $5,480 $4,960 $4,680

12. Expansion Project Analysis of the Cash Flows
Incremental Operating Cash Flow Computation
2006
$5,000 =
($30,000 -
$18,000
$5,000) (1 –
0.40)
+ $2,000(0.40)
2007
$5,480 =
+ $3,200(0.40)
$4,960 =
+ $1,900(0.40)
2009
$4,680 =
+ $1,200(0.40)
Year

13. Expansion Project Analysis of the Cash Flows
Terminal Cash Flow Return of net working capital $4,000 Net salvage value , Terminal Cash Flow $5,880 Annual Net Cash Flow Total net cash flow/year $(14,000) $5,000 $5,480 $4,960 $10,560
NPV at k=15% $3,790

14. Expansion Project Cash Flow Time Line
k = 15%
5,000
4,960
5,480
(14,000)
4,384
4,143
3,261
6,038
$3,790
10,560 1 2 3 4
NPV =
2006
2008
2007
2009
2005
Net cash flows
IRR =
26.3%
Payback period = 2.7 years

15. Replacement Project Analysis of the Cash Flows
Initial Investment Outlay Cost of new asset $(12,000) Change in net working capital ( 1,000) Net cash flow/sale of old asset 1,600 Initial Investment $(11,400) Incremental Operating Cash Flow Δ Operating costs $3,500 $3,500 $3,500 $3,500 $3,500 Δ Depreciation (3,460) (4,900) (1,300) ( 340) 500 Δ Earnings before taxes (EBT) 40 (1,400) 2,200 3,160 4,000 Δ Taxes (40%) ( ) ( 880) (1,264) (1,600) Δ Net Income 24 ( 840) 1,320 1,896 2,400 Add back Δ depreciation 3, , , ( 500) Incremental operating cash flows $3,484 $4,060 $2,620 $2,236 $1,900

16. Replacement Project Analysis of the Cash Flows
Terminal Cash Flow Return of net working capital $1,000 Net salvage value of new asset , Terminal Cash Flow $2,200 Annual Net Cash Flow Total net cash flow each year $(11,400) $3,484 $4,060 $2,620 $2,236 $4,100
Net Present Value (15%) $(261)

17. Replacement Project Cash Flow Time Line
k = 15%
3,484
2,620
4,060
(11,400)
3,030
3,070
1,723
1,278
2,038
$(261)
2,236 1 2 3 4
NPV =
2001
2003
2002
2004
2000
Net cash flows 5
2005
4,100
IRR =
14.0%
Payback period = 3.6 years

18. Introduction to Project Risk Analysis
Stand-Alone Risk: the risk an asset would have if it were a firm’s only risk
Measured by the variability of the asset’s expected returns
Corporate (Within-Firm) Risk: risk not considering the effects of stockholder’s diversification
Measured by a project’s effect on the firm’s earnings variability
Beta (Market) Risk: part of a project’s risk that cannot be eliminated by diversification
Measured by the project’s beta coefficient

19. Techniques for Measuring Stand-Alone Risk
Sensitivity Analysis: Key variables are changed and the resulting changes in the NPV and the IRR are observed.
Scenario Analysis: “Bad” and “good” sets of financial circumstances are compared with the most likely situation.
Monte Carlo Simulation: Probable future events are simulated on a computer.

20. Sensitivity Analysis Graph
NPV (000s)
-60
-40
-20 20 40 60 80
-30
-10 10 30
Base
Unit sales SV k
% change
from base

21. Scenario Analysis (NPV) = $30.3
Assume we know all variables except unit sales, which could range from 75,000 to 125,000 (or 75 to 125). Here are the scenario NPVs:
E(NPV) = $15.0
(NPV) = $30.3

22. Scenario Analysis Standard Deviation: σNPV = $30.3
Coefficient of Variation:

23. Advantages / Disadvantages of Simulation Analysis
Reflects probability of each input
Shows range of NPVs, expected NPV, σNPV, and CVNPV
Disadvantages
Difficult to specify probability distributions and correlation
If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!

24. Beta (or Market) Risk and Required Rate of Return for a Project
Security Market Line equation:
kS = kRF + (kM - kRF)βs
Erie Steel is all equity financed, so cost of equity is also its averaged required rate of return, or cost of capital. Erie’s β = 1.1; kRF = 8%; and kM = 12%
kS = 8% + (12% - 8%)1.1 = 12.4%
= Erie’s cost of equity
Investors should be willing to give Erie money to invest in average-risk projects.

25. Required Rate of Return for a Project
kproj = the risk-adjusted required rate of return for an individual project
kproj = kRF + (kM - kRF)bproj

26. Measuring Beta Risk for a Project
Pure Play Method:
1. Identify companies whose only business is the project in question.
2. Determine the beta for each company.
3. Average the betas to find an approximation of proposed project’s beta.

27. How Project Risk Is Considered in Capital Budgeting Decisions
Most firms use: Risk-Adjusted Discount Rate
Discount rate that applies to particularly risky stream of income
It is equal to the risk-free rate of interest plus a risk premium.

28. Capital Rationing
A situation in which a constraint is placed on the total size of the firm’s capital investment.

29. Multinational Capital Budgeting
Repatriation of Earnings: The process of sending cash flows from a foreign subsidiary back to the parent company
Exchange Risk Rate: The uncertainty associated with the price at which the currency from one country can be converted into the currency of another country
Political Risk: The risk of seizure of a foreign subsidiary’s assets by the host country or unanticipated restrictions on cash flows to the parent company

30. Project Cash Flows and Risk
End of Chapter 7
Project Cash Flows and Risk