chapter 9 project cash flows and risk © 2005 thomson/south-western
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Chapter 9
Project Cash Flows and Risk
© 2005 Thomson/South-Western
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Cash Flow Estimation
Most important and most difficult step in the analysis of a capital project
Financial staff’s role includes:Coordinating other departments’ effortsEnsuring that everyone uses the same set
of economic assumptionsMaking sure that no biases are inherent in
forecasts
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Relevant Cash Flows
Cash Flow Versus Accounting Income
Incremental Cash Flows
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Cash Flow Versus Accounting Income
2006 Situation Accounting Profits Cash Flows
Sales $50,000 $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
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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 = $19,000
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Incremental Cash Flows
An Incremental Cash FlowAn Incremental Cash Flow is the change in a firm’s net cash flow attributable to an investment project.
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Problems in Determining Incremental Cash Flows Sunk Cost:Sunk Cost: A cash outlay that already has
been incurred and cannot be recovered
Opportunity Cost:Opportunity Cost: The return on the best alternative use of an asset
Externalities:Externalities: The effect of accepting a project on the cash flows in other parts of the firm
Shipping and Installation CostsShipping and Installation Costs
InflationInflation
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Identifying Incremental Cash Flows
Initial Investment Outlay:Initial Investment Outlay: the incremental cash flows associated with a project that will occur only at the start of a project’s life
Incremental Operating Cash Flow:Incremental Operating Cash Flow: the changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset
Terminal Cash Flow:Terminal Cash Flow: the net cash flows that occur only at the end of a project’s life
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Incremental Operating Cash Flow
Incrementaloperatingcash flowt
= NOIt x (1 - T) + Deprt
= (St - OCt - Deprt) x (1 - T) + Deprt
= (St - OCt) x (1 - T) + T(Deprt)
= Cash revenuest- Cash expensest- Taxest
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Capital Budgeting Project Evaluation
Expansion Project:Expansion Project: A project that is intended to increase sales; provides growth to the firm
Replacement Analysis:Replacement Analysis: An analysis involving the decision of whether to replace an existing, still productive asset with a new asset
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Expansion Project Analysis of the Cash Flows
2005 2006 2007 2008 2009Initial Investment Outlay$(9,500)Shipping & installation ( 500)Increase in NWC (4,000)Initial Investment $(14,000)
Incremental Operating Cash FlowSales revenue $30,000$30,000 $30,000$30,000Variable 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 $5,800Taxes (40%) (2,000) (1,520) (2,040) (2,320) Net Income $3,000 $2,280 $3,060 $3,480Add back depreciation 2,000 3,200 1,900 1,200 Incremental operating cash flows $5,000 $5,480 $4,960
$4,680
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Expansion Project Analysis of the Cash Flows
2006 $5,000 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $2,000(0.40)
2007 $5,480 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $3,200(0.40)
2007 $4,960 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $1,900(0.40)
2009 $4,680 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $1,200(0.40)
Year
Incremental Operating Cash Flow Computation
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Expansion Project Analysis of the Cash Flows
2005 2006 2007 2008 2009Terminal Cash FlowReturn of net working capital $4,000Net salvage value 1,800 Terminal Cash Flow $5,880
Annual Net Cash FlowTotal net cash flow/year$(14,000) $5,000 $5,480 $4,960$10,560
NPV at k=15% $3,790
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k = 15%
5,000 4,9605,480(14,000)4,3844,1433,2616,038
$3,790
10,560
0 1 2 3 4
NPV =
2006 20082007 20092005
Net cashflows
IRR = 26.3% Payback period = 2.7 years
Expansion Project Cash Flow Time Line
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Replacement Project Analysis of the Cash Flows
2005 2006 2007 2008 2009 2010Initial Investment OutlayCost 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%) ( 16) 560 ( 880) (1,264) (1,600) Δ Net Income 24 ( 840) 1,320 1,896 2,400Add back Δ depreciation 3,460 4,900 1,300 340 ( 500) Incremental operating cash flows $3,484 $4,060 $2,620 $2,236 $1,900
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Replacement Project Analysis of the Cash Flows
2005 2006 2007 2008 2009 2010Terminal Cash FlowReturn of net working capital $1,000Net salvage value of new asset 1,200 Terminal Cash Flow $2,200
Annual Net Cash FlowTotal net cash flow each year$(11,400) $3,484 $4,060 $2,620 $2,236$4,100
Net Present Value (15%) $(261)
17IRR = 14.0% Payback period = 3.6 years
Replacement Project Cash Flow Time Line
k = 15%
3,484 2,6204,060(11,400)3,0303,0701,7231,2782,038
$(261)
2,236
0 1 2 3 4
NPV =
2001 20032002 20042000
Net cashflows
52005
4,100
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Introduction to Project Risk Analysis
Stand-Alone Risk:Stand-Alone Risk: the risk an asset would have if it were a firm’s only riskMeasured by the variability of the asset’s
expected returns Corporate (Within-Firm) Risk:Corporate (Within-Firm) Risk: risk not
considering the effects of stockholder’s diversificationMeasured by a project’s effect on the firm’s
earnings variability Beta (Market) Risk:Beta (Market) Risk: part of a project’s risk that
cannot be eliminated by diversificationMeasured by the project’s beta coefficient
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Techniques for Measuring Stand-Alone Risk
Sensitivity Analysis:Sensitivity Analysis: Key variables are changed and the resulting changes in the NPV and the IRR are observed.
Scenario Analysis:Scenario Analysis: “Bad” and “good” sets of financial circumstances are compared with the most likely situation.
Monte Carlo Simulation:Monte Carlo Simulation: Probable future events are simulated on a computer.
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Sensitivity Analysis Graph
NPV (000s)
-60
-40
-20
0
20
40
60
80
-30 -20 -10 0 10 20 30
Base
Unit sales
SV
k
% changefrom base
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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:Scenario Probability NPV (000)
Worst 0.25 -$27.8
Base 0.50 15.0
Best 0.25 57.8
E(NPV) = $15.0(NPV) =$30.3
Scenario Analysis
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Standard Deviation:Standard Deviation:
σNPV = $30.3
Coefficient of Variation:Coefficient of Variation:
.0 2$15
$30.3NPVENPV
σ
NPVCV
Scenario Analysis
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Advantages / Disadvantages of Simulation Analysis
Reflects probability of each input Shows range of NPVs, expected
NPV, σNPV, and CVNPV
Difficult to specify probability distributions and correlation
If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!
AdvantagesAdvantages
DisadvantagesDisadvantages
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Beta Beta (or Market) Risk and Risk and Required Rate of Return for a Required Rate of Return for a ProjectProject
Security Market Line equation: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.
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Required Rate of Return for a Project
kproj = the risk-adjusted required rate of return for an individual project
kproj = kRF + (kM - kRF)proj
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Measuring Beta Risk for a Project
Pure Play Method: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.
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How Project Risk Is Considered in Capital Budgeting Decisions
Most firms use: Risk-Adjusted Discount RateRisk-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.
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Capital Rationing
A situation in which a constraint is placed on the total size of the firm’s capital investment.
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Multinational Capital Budgeting
Repatriation of Earnings:Repatriation of Earnings: The process of sending cash flows from a foreign subsidiary back to the parent company
Exchange Risk Rate: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: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
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End of Chapter 7
Project Cash Flows and Risk