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Chapter12 cashflowestimation 7952, Study Guides, Projects, Research of Finance

Cash flow estimation theory

Typology: Study Guides, Projects, Research

2015/2016

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© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.
Cash Flow Estimation and
Risk Analysis
Relevant Cash Flows
Incorporating Inflation
Types of Risk
Risk Analysis
Chapter 12
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© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

Cash Flow Estimation and

Risk Analysis

Relevant Cash Flows

Incorporating Inflation

Types of Risk

Risk Analysis

Chapter 12 12- 1

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

Project Operating Cash Flows

(Thousands of dollars) 1 2 3 4 Revenues 200.0 200.0 200. 0

0

  • Op. costs -
     - 

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

Terminal Cash Flows

12- 8 Salvage value $

  • Tax on SV (40%)

AT salvage value $

  • NOWC Terminal CF

(Thousands of dollars) FCF 4

= EBIT(1 – T) + DEP – CAPEX – NOWC

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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)

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

What are the 3 types of project risk?

  • Stand-alone risk
  • Corporate risk
  • Market risk 12- 16

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a

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