CASH FLOW ESTIMATION AND RISK

ANALYSIS
 PART 1: Cash Flow Estimation
Estimating Cash Flows
Most important, critical, and most difficult step in Capital Budgeting.
If not reasonably accurate, no matter how sophisticated the analytical
technique is, it can lead to poor decisions.
The key is to consider only incremental cash flows.
Financial staffs role in the forecasting process
Obtain information from various departments (engineering and marketing)
Ensure the use of a consistent set of economic assumptions
Make sure there are no biases inherent in the forecast
Conceptual Issues in Cash Flow Estimation
Cash Flow versus Accounting Income
The firms value is based on cash flows because cash is what firms use to
spend or reinvest.
Any changes to working capital of a project directly affects cash flows but
not net income.
How cash flows differ from accounting income:
Costs of fixed assets.
Non-cash charges.
Changes in net operating working capital.
Interest expenses are not included in project cash flows.
Timing of Cash Flows
Deal with cash flows exactly when they occur. But for simplicity purposes,
we assume year-end cash flows.
Incremental Cash Flows
A cash flow that will occur if and only if the firm takes on a project. They
should be included in estimating cash flows.
Replacement Projects
Projects where the firm replaces existing assets to: a) Reduce costs and/or
b) Increase operational efficiency.
Conceptual Issues in Cash Flow Estimation
Sunk Costs
A cash outlay that has already been incurred and that cant be recovered
regardless of whether the project is accepted or rejected. They should not be
included in estimating cash flows.
Opportunity Costs
The best returns that can be earned on assets the firm already own if those
assets are not used for the new project. They should be included in
estimating cash flows.
Externalities
They should be included in estimating cash flows.
Negative Within-Firm Externalities (Cannibalization) for substitutable
products
Positive Within-Firm Externalities for complementary products
Environment Externalities when a firms project can harm the environment
(firm can boost up goodwill when spending for the environment).

*Tax effects can have a major impact on cash flows. Hence, it is important that
taxes be dealt with properly when analyzing cash flows.
 Determining project value
Estimate relevant cash flows
Calculating annual operating cash flows.
Identifying changes in working capital.
Calculating terminal cash flows.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
 Terminal net cash flow

Recovery of NOWC
Salvage value
(Tax on SV)
Terminal CF
 Identifying Relevant Cash Flows
Based on Cash Flows, not Accounting Income
Only Include Incremental Cash Flows
Include costs of fixed assets and change in NOWC
Add back non-cash expenses
Financing effects are not included. Thus, do not include interest
expense. Do not include dividends.

Based on CFs
Free Cash Flow = EBIT(1-T) + Depreciation
CAPEX Change in NOWC
 Based on CFs
Free Cash Flow = EBIT(1-T) + Depreciation CAPEX Change in NOWC
EBIT(1-T) = Interest expense is not subtracted because you still have
to discount CF at the k or WACC wd(rd)(1-T) + wp(rp) + we(re). If
you subtract interest, you double-count the cost of debt.
Depreciation = Shields NI from tax but is not actually a cash expense,
so must add back to get FCF
CAPEX = Cost of fixed assets. You must use the full cost of the
equipment, including shipping and installation charges.
Depreciation basis = Cost + shipping + installation
Change in NOWC
Positive change additional funding is needed for inventories and
receivables, therefore you have to deduct from FCF
Negative change reduces cash needed to finance inventories
and receivables, so you add back to FCF.

Answer the following:

13-1 : 12 million
13-2 : 2.6 million
 Only include Incremental CFs
Incremental Cash Flows
Change in CFs as a direct result of accepting the
project
Net Cash Flow attributable to an Investment Project
Projects Incremental Cash Flow
Corporate CF with the Project Corporate CF
without the Project
3 problematic costs that may affect incremental CFs
Sunk Costs
Costs already incurred and are not recoverable.
Suppose P100,000 had been spent last year to improve the production line site. Should
the cost be included in the analysis?
Must not be reflected/included in the analysis
Opportunity Costs
Return on the best alternative use of an asset.
Suppose the plant space could be leased out for P250,000 a year, and tax is 30%
Would this affect the analysis? (P250,000 x (1-T)) = P175,000 (after tax OC)
Must be reflected/included in the analysis
Externalities (e.g. Cannibalization)
Effects of a project on cash flows in other parts of the firm.
May be positive or negative. Positive, if undertaking the project or introducing the new
product causes the sales of existing products to increase. Negative, if undertaking the
project or introducing the new product causes the sales of existing products to decline.
Positive, if new projects are complements to existing assets, negative if substitutes.
If the new product line would decrease sales of the firms other products by P50,000 per
year, would this affect the analysis?
Must be reflected/included in the analysis. Net CF loss per year on other lines would be
a cost to this project.
Why is it important to include inflation
when estimating cash flows?
Nominal r > real r. The cost of capital, r, includes a
premium for inflation.
Nominal CF > real CF. This is because nominal cash
flows incorporate inflation.
If you discount real CF with the higher nominal r, then
your NPV estimate is too low.
Nominal CF should be discounted with nominal r, and real
CF should be discounted with real r.
It is more realistic to find the nominal CF (i.e., increase
cash flow estimates with inflation) than it is to reduce the
nominal r to a real r.
Sample Problem (Expansion Project v1):
Summit Inc. is planning an expansion project and has the following estimates
relating to that particular project for the next four years:
Year 1 Year 2 Year 3 Year 4
Units 1,250 1,250 1,250 1,250
Unit price 200 206 212.18 218.55
Unit cost 100 103 106.09 109.27

Summit decides to buy an equipment costing $200,000. Shipping costs and

installations are $20,000 and $20,000 respectively. Summit uses a 3-year
MACRS class life method to compute for depreciation. The equipment can be
sold after 4 years for $25,000. Taxes are 40%. Summit estimates that it needs
net operating working capital of $30,000 at the start of the project and 12.36%
of sales for subsequent years.
Requirement 1: Calculate Summits: a) Operating Cash Flows for Years 1 to 4,
and b) Free Cash Flows for Years 1 to 4.
Requirement 2: Compute the Payback Period, Discounted Payback Period,
NPV, IRR, and MIRR, if WACC is 10%. Should this project be undertaken?
Sample Problem (Expansion Project v2):
Summit Inc. has the following estimates for the next four years:
Year 1 Year 2 Year 3 Year 4
Units 1,250 1,250 1,250 1,250
Unit price 200 206 212.18 218.55
Unit cost 100 103 106.09 109.27

Summit decides to buy an equipment costing $200,000. Shipping costs and

installations are $20,000 and $20,000 respectively. Summit uses a 3-year
MACRS class life method to compute for depreciation. The equipment can be
sold after 3 years for $25,000. Taxes are 40%. Summit estimates that it needs
net operating working capital of P30,000 at the start of the project and 12.36%
of sales subsequently. Summit intends to sell the equipment after 3 years.
Requirement 1: Calculate Summits: a) Operating Cash Flows for Years 0 to 3,
and b) Free Cash Flows for Years 0 to 3.
Requirement 2: Compute the Payback Period, Discounted Payback Period,
NPV, IRR, and MIRR, if WACC is 10%. Should this project be undertaken?
Sample Problem (Replacement Project):
Austen Inc. is considering whether it should replace its old machinery. The firm has
gathered data below:
Data applicable to both machines:
Sales revenues, which would remain constant $2,500
Expected life of the new and old machines 4 years
WACC 10%
Tax rate 40%
Data for old machine:
AT Market (salvage) value of the old machine today $400
Old labor, materials, and other costs per year $1,000
Old machines annual depreciation $100
Data for new machine:
Cost of new machine $2,000
New labor, materials, and other costs per year $400
(Use MACRS method)

Should Austen replace its old machinery?

 PART 2: Risk Analysis
Risk in capital budgeting:
Uncertainty about a projects future probability
Must address the question: Will taking on the project increase the firms
and stockholders risk?
Risk analysis is usually based on subjective judgment rather than historical
data.
Issues surrounding the analysis of project risk:
The risk of the project independent of both the firms other projects and
investors diversification (stand-alone risk)
The effect of a project on the probability of bankruptcy (corporate risk)
The effect of a project on the firms BETA (market risk)
Thus the 3 relevant risks in Capital Budgeting are:
Stand-alone risk
Corporate risk
Market risk
 Stand-alone Risk:
The projects risk if it were the firms only asset.
Ignores both firm and shareholder diversification.
It is measured by the variability of the assets
expected returns, e.g.: measured by the or CV of
NPV, IRR, or MIRR.
 Advantages of Stand-alone Risk:
Easier to estimate than corporate risk and far
easier to measure than market risk
In general, all 3 types of risk are highly correlated,
so if the general economy does well, so will the
firm, and if the firm does well, so will most of its
projects.
It is a good proxy for hard to measure corporate
and market risk.
Probability Density

Flatter distribution,
larger , larger
stand-alone risk.

0 E(NPV) NPV

Such graphics are increasingly used

by corporations.
 Corporate Risk:
Reflects the projects effect on corporate earnings
stability. Considers firms other assets (diversification
within firm).
In other words, it is the projects risk to the company,
considering the fact that the project represents only
one of the firms portfolio of assets.
Usually is of concern to small business and
undiversified shareholders.
Depends on a projects standard deviation and its
correlation with returns on firms other assets.
Measured by the projects corporate beta.
 What is a corporate beta?
A quantitative measure of corporate risk.
Measures the volatility of returns on the project
relative to the firm as a whole.
Why is corporate risk important?
Undiversified stockholders are more
concerned about corporate risk than about
market risk.
Empirical studies generally find that both
market and corporate risk affect stock prices.
The firms stability is important to its
managers, workers, customers, suppliers, and
creditors, as well as to the community in which
it operates.
Profitability
Project X

Total Firm
Rest of Firm

0 Years
1. Project X is negatively correlated to
firms other assets.
2. If r < 1.0, some diversification benefits.
3. If r = 1.0, no diversification effects.
 Market Risk:
Reflects the projects effect on a well-diversified stock
portfolio.
Market risk is the riskiness of the project as seen by a
well-diversified stockholder who recognizes that the
project is only one of the firms assets and that the
firms stock is but one small part of the investors total
portfolio.
Takes account of stockholders other assets.
Depends on projects standard deviation and
correlation with the stock market.
Measured by the projects market beta.
How does a corporate beta differ
from a market beta?

A projects market beta is a similar quantitative

measure of a projects market risk, but it
measures the volatility of project returns
relative to market returns.
 How is each type of risk used?
Market risk is theoretically best in most situations. It is also the
most relevant risk for capital projects.
However, creditors, customers, suppliers, and employees are
more affected by corporate risk.
Therefore, corporate risk is also relevant.
Stand-alone risk is easiest to measure, more intuitive. But we
shouldnt always just focus on stand-alone risk.
Core projects are highly correlated with other assets, so stand-
alone risk generally reflects corporate risk. In addition, corporate
risk is likely to be highly correlated with its market risk.
If the project is highly correlated with the economy, stand-alone
risk also reflects market risk.
Techniques in measuring stand-
alone risk:
Sensitivity Analysis
Scenario Analysis
Monte-Carlo Simulation
 Sensitivity analysis:
Percentage change in NPV resulting from a given percentage
change in an input variable, other things held constant.
Shows how changes in a variable such as unit sales affect NPV
or IRR.
Each variable is fixed except one. Change this one variable to
see the effect on NPV or IRR.
Answers what if questions, e.g. What if sales decline by 30%?
Sensitivity analysis can provide useful insights into the riskiness
of a project.
Spreadsheet computer models are ideally suited for performing
sensitivity analysis.
Base-Case NPV the NPV when sales and other input variables
are set equal to the most likely (or base-case) values.
 Sensitivity Analysis
NPV with Variables at different deviations from base
Deviation from Base Sales Price VC/Unit Units Sold Fixed Costs Equipment WACC
25% 2,256.86 -1,245.67 1202.37 -872.14 -71.26 33.62
0% 78.82 78.82 78.82 78.82 78.82 78.82
-25% -2,369.22 1,403.31 -1,044.73 1,029.78 228.90 127.62
Range 4,626.08 2,648.98 2,247.10 1,901.92 300.16 94.00
 NPV
(000s)
Unit Sales

88 Salvage

-30 -20 -10 Base 10 20 30

Value (%)
 Results of Sensitivity Analysis
Steeper sensitivity lines show greater risk.
Small changes result in 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.
Advantages of Sensitivity Analysis:
Identifies variables that may have the greatest potential
impact on profitability and allows management to focus
on these variables.
Gives some idea of stand-alone risk.
Identifies dangerous variables.
Gives some breakeven information.
Disadvantages of sensitivity analysis:
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
wont fall.
Ignores relationships among variables.
Does not incorporate any information about the
possible magnitudes of the forecast errors.
 Scenario Analysis:
It is a risk analysis technique in which bad and good sets of
financial circumstances are compared with a most likely, or base-
case, situation.
The projects CV can be compared to the CV of the firms average
project to determine the relative stand-alone riskiness of the project.
Examines several possible situations, usually worst case, most
likely case, and best case.
Provides a range of possible outcomes.
Base-Case Scenario - an analysis in which all of the input
variables are set at their most likely values.
Worst-Case Scenario - an analysis in which all of the input
variables are set at their worst reasonably forecasted values.
Best-Case Scenario - an analysis in which all of the input
variables are set at their best reasonably forecasted values.
 Scenario Analysis Example:
Scenario Probability NPV(000)
Best 0.25 279
Base 0.50 88
Worst 0.25 -49
E(NPV) = 101.5
Determine the expected NPV, NPV(NPV) = 116.75
, and CVNPV from the scenario
analysis.CV(NPV)
Assume that = (NPV)/E(NPV)
WACC = 10% = 1.15
If the firms average project has a CV of 1.2 to 1.4, is this a high-risk
project? What type of risk is being measured?
Problems with scenario analysis:
Only considers a few possible outcomes even though
there are infinite number of possibilities.
Assumes that inputs are perfectly correlated--all bad
values occur together and all good values occur
together.
Focuses on stand-alone risk, although subjective
adjustments can be made.
 Simulation Analysis:
A computerized version of scenario analysis which
uses continuous probability distributions.
Computer selects values for each variable based on
given probability distributions.
Monte Carlo Simulation
A risk analysis technique in which probable future events are
simulated on a computer, generating estimated rates of return
and risk indexes.
In spite of its appeal, the Monte Carlo simulation has not been
as widely used in the industry as one might expect. The major
problem is specifying each uncertain variables probability
distribution and the correlations among the distributions.
Simulation Process
Pick a random variable for unit sales and sale price.
Substitute these values in the spreadsheet and calculate
NPV.
Repeat the process many times, saving the input
variables (units and price) and the output (NPV).
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.
 Take note
Sensitivity, scenario, and simulation analyses
do not provide a decision rule. They do not
indicate whether a projects expected return is
sufficient to compensate for its risk.
Sensitivity, scenario, and simulation analyses
all ignore diversification. Thus they
measure only stand-alone risk, which may not
be the most relevant risk in capital budgeting.
 Histogram of Results
Probability

-$60,000 $45,000 $150,000 $255,000 $360,000

NPV ($)
Advantages of simulation analysis:

Reflects the probability distributions of each input.

Shows range of NPVs, the expected NPV, NPV, and
CVNPV.
Gives an intuitive graph of the risk situation.
 Disadvantages of simulation
analysis:
Difficult to specify probability distributions and
correlations.
If inputs are bad, output will be bad:
Garbage in, garbage out.
Should subjective risk factors be
considered?
Yes. A 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.
 Conclusions on risk analysis:
Very difficult, if not impossible, to quantitatively measure projects within-firm and
beta risks.
Not much is lost by focusing just on stand-alone risk because most projects
returns are positively correlated w/ returns on the firms other assets and with
returns on the stock market.
Introductory students like neat, precise answers and want to make decision son
the basis of calculated NPVs.
Managers, not computers, make the final decision on whether to accept of reject
projects. Unlike computers, managers bring qualitative judgment into the decision
process, and the stand-alone risk profile of a project can provide some extremely
valuable insights.
Experienced managers make many judgmental assessments, including those
related to risk, and hence consider quantitative NPVs, but also bring subjective
judgment into the decision process.
Problems may arise if the firm doesnt use quantitative analyses in the chapter.
On the other hand, problems may also arise if a firm tries to quantify everything
and let a computer makes its decisions.
Thus, good managers understand and use the theory of finance, but they apply it
with judgment.
 UNEQUAL PROJECT LIVES
Analysis needed when a company is choosing between
two projects that are:
Have significantly different lives
Are mutually exclusive
Can be repeated
 UNEQUAL PROJECT LIVES
Two methods to evaluate these kinds of projects:
Replacement Chain (Common Life) Approach
A method of comparing projects with unequal lives that
assumes that each project can be repeated as many times
as necessary to reach a common life. The NPVs over this
life are then compared, and the project with the higher
common-life NPV is chosen.
Equivalent Annual Annuity Approach
A method that calculates the annual payments that a project
will provide if it is an annuity. When comparing projects with
unequal lives, the one with the higher EAA should be chosen
because the project with the higher EAA will always have the
higher NPV when extended out to any common life.
 UNEQUAL PROJECT LIVES
The two approaches will always result to the same decision.
Advantages of using the Replacement Chain Approach:
Easier to explain to senior managers.
Easier to make modifications to the replacement chain data to deal
with anticipated productivity improvements and asset price changes.
Used when working with both engineers and non-engineers.
Advantages of using the Equivalent Annual Annuity
Approach:
Easier to implement, especially when the longer project does not
have exactly twice the life of the shorter one and hence more than
two cycles are needed to find a common life.
Used when working with engineers, but rarely with non-engineers.
 UNEQUAL PROJECT LIVES
Unequal life analysis:
Does not have to be done if projects are
INDEPENDENT.
May arise if MUTUALLY EXCLUSIVE projects with
significantly different lives are compared
Is NOT ALWAYS APPROPRIATE even if projects are
mutually exclusive.
Should only be done IF THERE IS HIGH
PROBABILITY THAT THE PROJECTS WILL
ACTUALLY BE REPEATED at the end of their initial
lives.
 UNEQUAL PROJECT LIVES
Weaknesses of unequal life analysis:
If inflation is expected, then replacement equipment will have a
higher price. Moreover, both sales price and operating costs
will probably change. Thus, the static conditions built into the
analysis would be invalid.
Replacements that occur down the road will probably employ
new technology, which in turn might change the cash flows.
This factor can be built into the replacement chain analysis but
not the EAA approach.
It is difficult enough to estimate the lives of most projects so
estimating the lives of a series of projects is often just a
speculation.
S and L are mutually exclusive and will be
repeated. r = 10%. Which is better?
Expected Net CFs

Year Project S Project L

0 ($100,000) ($100,000)

1 59,000 33,500

2 59,000 33,500

3 -- 33,500

4 -- 33,500
Using Replacement Chain Analysis:
Using Equivalent Annual Annuity
Approach:
Additional Problems to Answer
 Additional Problem 1
Wobby Inc. is considering a new project whose data are shown below. The
equipment that would be used has a 3-year tax life, and the allowed
depreciation rates for such property are 33%, 45%, 15%, and 7% for Years
1 through 4. Revenues and other operating costs are expected to be
constant over the projects 10-year expected life. What is the Year 1 cash
flow?

Equipment cost (depreciable basis) $65,000

Sales revenues, each year $60,000
Operating costs (excl. deprec.) $25,000
Tax rate 35.0%
 Additional Problem 2
Empuerto Inc. is now at the end of the final year of a project.
The equipment originally cost $22,500, of which 75% has been
depreciated. The firm can sell the used equipment today for
$6,000, and its tax rate is 40%. What is the equipments after-
tax salvage value for use in a capital budgeting analysis? Note
that if the equipments final market value is less than its book
value, the firm will receive a tax credit as a result of the sale.
 Additional Problem 3
Jollibee Inc. is considering some new equipment whose data are shown below. The
equipment has a 3-year tax life and would be fully depreciated by the straight-line
method over 3 years, but it would have a positive pre-tax salvage value at the end of
Year 3, when the project would be closed down. Also, some new working capital
would be required, but it would be recovered at the end of the projects life.
Revenues and other operating costs are expected to be constant over the projects
3-year life. What is the projects NPV?

WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Straight-line deprec. Rate 33.333%
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%
 Additional Problem 4
Goliath Company is considering the purchase of a new machine for
$50,000, installed. The machine has a tax life of 5 years, and it can be
depreciated according to the following rates. The firm expects to operate
the machine for 4 years and then to sell it for $12,500. If the marginal tax
rate is 40%, what will the after-tax salvage value be when the machine is
sold at the end of Year 4?
Year Depreciation Rate
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
 Additional Problem 5
Miracle Company is considering a new project whose data are shown below. The
equipment to be used has a 3-year tax life, would be depreciated on a straight-line
basis over the projects 3-year life, and would have a zero salvage value after Year
3. No new working capital would be required. Revenues and other operating costs
will be constant over the projects life, and this is just one of the firms many projects,
so any losses on it can be used to offset profits in other units. If the number of cars
washed declined by 40% from the expected level, by how much would the projects
NPV decline?

WACC 10.0%
Net investment cost (depreciable basis) $60,000
Number of cars washed 2,800
Average price per car $25.00
Fixed op. cost (excl. deprec.) $10,000
Variable op. cost/unit (i.e., VC per car washed) $5.375
Annual depreciation $20,000
Tax rate 35.0%
 Additional Problem 6
As one of its major projects for the year, Christopher Company is considering
opening up a new store. The companys CFO has collected the following
information, and is proceeding to evaluate the project.

The building would have an up-front cost (at t = 0) of $14 million. For tax purposes,
this cost will be depreciated over seven years using straight-line depreciation.
The store is expected to remain open for five years. At t = 5, the company plans to
sell the store for an estimated pre-tax salvage value of $8 million.
The project also requires the company to spend $5 million in cash at t = 0 to
purchase additional inventory for the store. After purchasing the inventory, the
companys net operating working capital will remain unchanged until t = 5. At t = 5,
the company will be able to fully recover this $5 million.
The store is expected to generate sales revenues of $15 million per year at the end
of each of the next five years. Operating costs (excluding depreciation) are
expected to be $10 million per year.
The companys tax rate is 40 percent.

What is the projects internal rate of return (IRR)?

 Additional Problem 7
Rachel Inc. encounters significant uncertainty with its sales volume and price in its
primary product. The firm uses scenario analysis in order to determine an expected
NPV, which it then uses in its budget. The base-case, best-case, and worst-case
scenarios and probabilities are provided in the table below. What is Rachels
expected NPV (in thousands of dollars), standard deviation of NPV (in thousands of
dollars), and coefficient of variation of NPV?

Probability Unit Sales Sales NPV

of Outcome Volume Price (In Thousands)
Worst case 0.30 6,000 $3,600 -$6,000
Base case 0.50 10,000 4,200 +13,000
Best case 0.20 13,000 4,400 +28,000
 Additional Problem 8
Projects X and Y have the following expected net cash flows:

Project X Project Y
Time Cash Flow Cash Flow
0 -$500,000 -$500,000
1 250,000 350,000
2 250,000 350,000
3 250,000

Assume that both projects have a 10 percent cost of capital, and each of the projects
can be indefinitely repeated with the same net cash flows. What is the 6-year
extended NPV of the project that creates the most value?