Cash Flow Estimation

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• Chapter 12
• Cash Flow Estimation
• And Risk Analysis

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• Chapter 11 provides the various methods of
  analyzing project CFs, once the CFs are
  determined.
• Chapter 12 backs up and shows us how to determine
  those CFs.
• Project CFs are incremental CFs, defined as

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• A projects incremental CFs are divided into
  three segments
• The following example involves the most common
  type of capital budgeting problem replacement

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Replacement DecisionInfo on Old Machine

• A machine purchased two years ago for 50,000 may
  be sold today for 20,000.
• If kept, the machine will add 30,000 to annual
  sales and 12,000 to annual operating costs for
  each of the next three years of use.
• It was being depreciated as macrs 3-year
  property. It will be salvages after three years
  for zero dollars (which will also be its book
  value at that time).
• If kept, no additional w/c will be required.

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Info on New Machine

• The new equipment will cost 95,000 plus another
  5,000 for installation.
• Additional working capital will be needed for
  increases in inventory (20,000), receivables
  (5,000) and accounts payable (15,000).
• The new machine will add 130,000 to annual sales
  and 40,000 to annual operating costs for its 3
  years of use.
• It will be depreciated as macrs 3-year property
  and salvaged after three years (t3) for an
  estimated 35,000.

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Other Info

• Additional earnings are taxed at a 40 rate.
• The cost of capital for replacement decisions is
  15.
• A marketing survey costing 10,000 was conducted
  to determine that the new equipments products
  would be well-received by consumers. The cost has
  been expensed for tax purposes.
• Sales from the new project will not impact sales
  of other company products.

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I. The Initial Investment Outlay

• Which items will be part of the initial
  investment (CF0)?

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II. Annual Operating CFs

• What will be the pro forma income statements for
  each of the next 3 years?
• What will be the incremental depreciation charges
  for each year?
• How do we convert the project NI figures to CF
  figures?

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III. Terminal CF

• What is the after-tax salvage value for the old
  and new machines in year 3?
• What is the difference in these salvage
  values?
• What other CFs will occur in year 3?

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CF Summary and Final Project Evaluation

• What are the incremental cash flows for this
  project?
• Should this project be accepted or rejected?

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Worksheet Guidelines

• Financing costs, such as interest expense and
  dividend payments, are omitted from the project
  CFs.
• Financing costs are captured in the
  wacc.
• The cost of the marketing survey is omitted from
  the project CFs as a sunk cost, because it occurs
  whether or not the project is accepted.

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• Project CFs are on an after-tax basis because
  taxes are a cash outflow that affect value, and
  this is consistent with the wacc
  construction.
• Some CFs may be foregone if the project is
  accepted. These CFs are called opportunity costs
  and are shown as outflows in the worksheet.

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• Externalities, such as the impact of the new
  product on existing product sales, are called
  externalities, and are included in the project
  CFs.
• Management options, such as abandonment, are
  included in the project CFs.

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• Project CFs could be expressed on a real
  (inflation omitted) or nominal (inflation
  included) basis, but it is much easier to express
  all CFs on a nominal basis. The wacc, by design,
  is expressed on a nominal basis.
• To avoid bias, the project should not be
  evaluated by anyone with a vested interest in the
  projects acceptance.

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TREATMENT OF RISKSensitivity Analysis

• Sensitivity analysis involves changing each
  variable, one at a time, to its worst-case value
  and observing the effect on the projects
  NPV.
• Sensitivity analysis requires that spreadsheets
  be constructed with formulas, so that all
  remaining values automatically recalculate when
  an input value is changed.

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Scenario Analysis

• Scenario analysis involves selecting a limited
  set of possible scenarios, estimating the
  probability of each scenario, then working with
  the CF values expected under each scenario.
• By observing the final dispersion in npvs, the
  projects risk may be profiled.

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• What two scenarios are all companies considering
  this fall?

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Simulation Analysis

• Simulation analysis involves developing a
  probability distribution of values for each input
  variable, then (through computer iteration)
  generating a probability distribution for the
  project npv.
• One common approach to simulation is the Monte
  Carlo method.

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Probability Density
x x x x x x x x x x x x x x x x x x x x x x x x
x x x x
?NPV
x x x x x x x
x x x x x x x x x x x
x x x x x x x x x x x x x x x x x x x x x x x x x
0 E(NPV) NPV
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• A unique difficulty with simulation is capturing
  the interdependence of each input variables
  probability distribution.
• For example, it the selling price is higher due
  to a stronger economy, the cost of labor and
  materials will also likely be higher.

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Using the CAPM

• Another approach to risk analysis in capital
  budgeting is to use the CAPM to adjust the wacc
  for project risk
• CF0 (1200) CF1-4 625
• beta 2.00 rRF6 rM12
• finance 40 debt / 60 equity
• rd 10 tax rate 40

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Weaknesses of Risk Treatments

• Most of these techniques of treating risk in
  capital budgeting decisions only profile the
  project risk. They do not lead to a final
  accept-reject decision.

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Levels of Measuring Risk

• Most companies measure risk at the project level.
• Measuring risk at the company level is too
  difficult to specify due to the many different
  inter-correlations.
• Using the CAPM is an example of expressing the
  risk at the shareholder level.

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• Expressing risk at the project level gives an
  approximation of the risk at the company level,
  since most project CFs are highly correlated with
  the companys existing CFs.
• Expressing risk at the project level gives an
  approximation of risk at the shareholder level
  since shareholder returns and project CFs will be
  highly correlated with the economy.