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Cash Flow Estimation and
Risk Analysis
Relevant Cash Flows
Incorporating Inflation
Types of Risk
Risk Analysis
Chapter 12 12- 1
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Proposed Project
- Total depreciable cost
- Equipment: $200,
- Shipping and installation: $40,
- Changes in operating working capital
- Inventories will rise by $25,
- Accounts payable will rise by $5,
- Effect on operations
- New sales: 100,000 units/year @ $2/unit
- Variable cost: 60% of sales 12- 2
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Determining Project Value
- Estimate relevant cash flows
- Calculating annual operating cash flows.
- Identifying changes in net operating working capital.
- Calculating terminal cash flows:^ after-tax salvage value and return of NOWC. 12- 4 Initial OCF 1 OCF 2 OCF 3 Costs + Terminal CFs FCF 0 FCF 1 FCF 2 FCF 3 0 1 2 3 4
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Initial Year Investment Outlays
- Find^ NOWC.
- ^ in inventories of $25,
- Funded partly by an^ ^ in A/P of $5,
- NOWC = $25,000 – $5,000 = $20,
- Initial year outlays: Equipment cost -$200, Installation -40, CAPEX -240, NOWC -20, FCF 0 -$260, 12- 5
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Project Operating Cash Flows
(Thousands of dollars) 1 2 3 4 Revenues 200.0 200.0 200. 0
0
0
0
- Depreciation -79.2 - 108.0 -36.0 -16. EBIT 0.8 -28.0 44.0 63.
- Taxes (40%) 0.3 -11.2 17.6 25.312-^7
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Terminal Cash Flows
12- 8 Salvage value $
AT salvage value $
(Thousands of dollars) FCF 4
= EBIT(1 – T) + DEP – CAPEX – NOWC
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Should financing effects be included in
cash flows?
- No, dividends and interest expense should not be included in the analysis.
- Financing effects have already been taken into account by discounting cash flows at the WACC of 10%.
- Deducting interest expense and dividends would be “double counting” financing costs. 12- 10
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Should a $50,000 improvement cost
from the previous year be included in
the analysis?
- No, the building improvement cost is a sunk cost and should not be considered.
- This analysis should only include incremental investment. 12- 11
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If the new product line decreases the 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 (in the case of complements) or negative (substitutes). 12- 13
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Proposed Project’s Cash Flow Time Line
- Enter CFs into calculator CFLO register, and enter I/YR = 10%. NPV = -$4. IRR = 9.3% MIRR = 9.6% Payback = 3.3 years 12- 14 0
1 2 3 4 79.7 91.2 62.4 89. (Thousands of dollars)
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What are the 3 types of project risk?
- Stand-alone risk
- Corporate risk
- Market risk 12- 16
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What is stand-alone risk?
- The project’s total risk, if it were operated independently.
- Usually measured by standard deviation (or coefficient of variation).
- However, it ignores the firm’s diversification among projects and investors’ diversification among firms. 12- 17
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What is market risk?
- The project’s risk to a well-diversified investor.
- Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder diversification. 12- 19
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Which type of risk is most relevant?
- Market risk is the most relevant risk for capital projects, because management’s primary goal is shareholder wealth maximization.
- However, since corporate risk affects creditors, customers, suppliers, and employees, it should not be completely ignored. 12- 20
