1. Intro to Financial Management Cash Flow and Risk in Capital Budgeting

2. Review Homework Methods of evaluating a project –Payback Period –Discounted Payback Period –NPV –PI –IRR –MIRR Criteria for accepting a project

3. Free Cash Flows Interested in after-tax cash flows, not profits. Why? Interested in incremental cash flows. –Do not count if take cash from existing products/services –Can count synergistic effects of a new project –Include incremental expenses –“Sunk costs are sunk” Interested in free cash flows –Cash generated by operations –Cash available to pay creditors or owners Separate the investment decision from the financing –How is the cost of financing already incorporated?

4. Free Cash Flow Initial Outlay Initial outlay –Initial start-up costs –Increases in working capital –Sale prices of any replaced assets –Capital gains taxes due to sale above/below depreciated value initial outlay = cost of new assets + sale price of replaced assets +/- tax impact of sale of replaced assets

5. Free Cash Flow Annual and Terminal Flows Annually –Look at cash from operations –Adjust for Depreciation impact on taxes –Depreciation is not cash but is a cost and lowers taxes Interest expenses Changes in net working capital –E.g. if have greater accounts receivable or inventory or payables When project ends –Calculate terminal (final) value of assets

6. Projects in Practice Projects may end up being delayed –Due to economic reasons –Due to political reasons –Due to technological reasons Projects may be expanded Projects may be canceled –Due to economic reasons –Due to political reasons –Due to technological reasons

7. Project Risk Stand alone risk –All projects have risk, uncertainty Contribution-to-firm risk –Project add risk to firm –Project risk can be diversified with other projects Systematic risk –From viewpoint of shareholder –A project risk can be diversified by other shareholder investments Text says that theoretically only systematic risk is important –Not from the viewpoint of the firm! –Not from the viewpoint of a project manager!

8. Risk and Capital Budgeting Incorporate risk into discount rate –Increase hurdle rate to account for risk –Greater risk requires greater return Can try to calculate systematic risk –Calculate a beta for the project –But there are no historical returns –Two approaches: 1.Can try comparing past division results to benchmark (accounting method) 2.Pure play method – use the beta of a firm that looks like the project

9. Use Simulations to Evaluate Risk Have multiple factors that all have risk and a range of outcomes –Market size –Market share –Costs Evaluate a scenario –Select values for each factor and compute a result –Get an IRR or NPV Evaluate many (thousands) of scenarios –Get a distribution of outcomes for IRR or NPV –Can get a “probability” distribution for IRR or NPV