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Tool Kit for Capital Budgeting: Estimating Cash Flows and Analyzing Risk

Enter Terminal Year of Projection = 2006

Model for Evaluating A New Capital Budgeting Project:

The first section of this worksheet contains a model for evaluating new projects. In Part 1, we first list the key inputs
used in the calculations. Part 2 goes on to calculate depreciation schedules for the building and for the equipment.
Part 3 then determines the after-tax salvage values (i.e., net cash flows) that will come from disposing of the
building and the equipment at the end of the project's life. Part 4 calculates the estimated cash flows over each year of
the project's life. Part 5 then uses the estimated cash flows to estimate the key outputs, the project's NPV, IRR, MIRR,
and Payback. Finally, in Parts 6 and 7, we consider the riskiness of the project by showing how changes in the inputs
result in changes in the key outputs.

Identifying the relevant cash flows

For a new project, the incremental cash flows can be divided into the following categories: initial investment outlay,
operating cash flows over the project's life, and terminal year cash flows. In addition to the input data, we have included the firm's
Depreciation Schedule for 39-year (building) and 5-year (equipment) depreciation, and a table outlining the
determination of net salvage values to be incorporated into our cash flow estimation.

Analysis of a New (Expansion) Project

Part 1. Input Data (in thousands of dollars)

Key Output: NPV = $4,943
Building cost (= Depreciable basis) $12,000
Equipment cost (= Depreciable basis) $8,000 Market value of building in future date $7,500
Net Operating WC / Sales 10% Market value of equip. in future date $2,000
First year sales (in units) 20,000 Tax rate 40%
Growth rate in units sold 0.0% WACC 12%
Sales price per unit $3.00 Inflation: growth in sales price 2.0%
Variable cost per unit $2.10 Inflation: growth in VC per unit 2.0%
Fixed costs $8,000 Inflation: growth in fixed costs 1.0%

Part 2. Depreciation Schedule a Years Cumulative

1 2 3 4 Depr'n
Building Depr'n Rate 1.3% 2.6% 2.6% 2.6%
Building Depr'n $156 $312 $312 $312
Ending Book Val: Cost - Cum. Depr'n 11,844 11,532 11,220 $10,908

Equipment Depr'n Rate 20.0% 32.0% 19.0% 12.0%

Equipment Depr'n $1,600 $2,560 $1,520 $960
Ending Book Val: Cost - Cum. Depr'n 6,400 3,840 2,320 $1,360
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Part 3. Net Salvage Values in 2006

Building Equipment Total
Estimated Market Value in future date $7,500 $2,000
Book Value in future dateb 10,908 1,360
Expected Gain or Lossc -3,408 640
Taxes paid or tax credit 0 256
Net cash flow from salvaged $7,500 $1,744 $9,244

b
Book value equals depreciable basis (initial cost in this case) minus accumulated firms depreciation. For the
building, accumulated depreciation equals $1,092, so book value equals $12,000 - $1,092 = $10,908. For the equipment,
accumulated depreciation equals $6,640, so book value equals $8,000 - $6,640 = $1,360.

c
Building: $7,500 market value - $10,908 book value = -$3,408 a loss. This represents a shortfall in depreciation taken versus "true"
depreciation, and it is treated as an operating expense for future date. Equipment: $2,000 market value-

$1,360 book value = $640 profit. Here the depreciation charge exceeds the "true" depreciation, and the difference is called "depreciation
recapture". It is taxed as ordinary income in future date. The actual book value at the time of disposition
depends on the month of disposition. We have simplified the analysis and assumed that there will be a full year of depreciation in future
date.

d
Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results in a tax credit, so
net salvage value = $7,500 - (-$1,363) = $8,863.

Part 4. Projected Net Cash Years

Flows (Time line of annual cash flows) 0 1 2 3 4
2002 2003 2004 2005 2006
Investment Outlays: Long-Term Assets
Building ($12,000)
Equipment (8,000)

Operating Cash Flows over the Project's Life

Units sold 20,000 20,000 20,000 20,000
Sales price $3.00 $3.06 $3.12 $3.18
Sales revenue $60,000 $61,200 $62,424 $63,672
Variable costs 42,000 42,840 43,697 44,571
Fixed operating costs 8,000 8,080 8,161 8,242
Depreciation (building) 156 312 312 312
Depreciation (equipment) 1,600 2,560 1,520 960
Oper. income before taxes (EBIT) 8,244 7,408 8,734 9,587
Taxes on operating income (40%) 3,298 2,963 3,494 3,835
Net Operating Profit After Taxes (NOPAT) 4,946 4,445 5,241 5,752
Add back depreciation 1,756 2,872 1,832 1,272
Operating cash flow $6,702 $7,317 $7,073 $7,024

Cash Flows Due to Net Operating Working Capital

Net Operating Working Capital (based on sales) $6,000 $6,120 $6,242 $6,367 $0
Cash flow due to investment in NOWC ($6,000) ($120) ($122) ($125) $6,367

Salvage Cash Flows: Long-Term Assets

Net salvage cash flow: Building $7,500
Net salvage cash flow: Equipment 1,744
Total salvage cash flows $9,244

Net Cash Flow (Time line of cash flows) ($26,000) $6,582 $7,194 $6,948 $22,636

Part 5. Key Output and Appraisal of the Proposed Project

Net Present Value (at 12%) $4,943

IRR 19.04%
MIRR 16.98% Years
0 1 2 3 4
Cumulative cash flow for payback (26,000) (19,418) (12,223) (5,275) 17,360
Cum. CF > 0, hence Payback Year: 0.00 0.00 0.00 0.00 3.23
Payback found with Excel function = 3.23
Check: Payback = 3 + 5,275/23,999 = 3.22
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Based on the firm's 12% weighted average cost of capital, this project has a NPV of $5,809. Since the NPV is positive,
we tentatively conclude that the project should be accepted. The IRR and MIRR confirm this decision because both
exceed the cost of capital. Note, though, that no risk analysis has been conducted. It is possible that the firm's
managers, after appraising the project's risk, might conclude that its projected return is insufficient to compensate
for its risk, and reject it.

Part 6. Evaluating Risk: Sensitivity Analysis

Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome.
For example, if there were a high probability that the $5,166 expected NPV as calculated above will actually turn
out to be negative, then the project would be classified as relatively risky. The reason for a worse-than-expected
outcome is, typically, because sales were lower than expected, costs were higher than expected, or the project turned
out to have a higher than expected initial cost. In other words, if the assumed inputs turn out to be worse than expected,
then the output will likewise be worse than expected. In Part 6 we use Excel to examine the project's sensitivity to
changes in the input variables.

I. Sensitivity of NPV and to Variations in Unit Sales.

NPV for different unit sales, holding other thing constant.

% Deviation WACC % Deviation 1st YEAR UNIT SALES

from NPV from Units NPV
Base Case WACC 4,943 Base Case Sold $4,943
-30% 8.4% $8,043 -30% 14,000 -$4,495
-15% 10.2% $6,437 -15% 17,000 $224
0% 12.0% $4,943 Base Case 0% 20,000 $4,943
15% 13.8% $3,550 15% 23,000 $9,662
30% 15.6% $2,251 30% 26,000 $14,381

% Deviation VARIABLE COSTS % Deviation GROWTH RATE, UNITS

from Variable NPV from Growth NPV
Base Case Cost $4,943 Base Case Rate % $4,943
-30% $1.47 $28,538 -30% -30% -$32,620
-15% $1.79 $16,740 -15% -15% -$15,791
0% $2.10 $4,943 Base Case 0% 0% $4,943
15% $2.42 -$6,854 15% 15% $30,065
30% $2.73 -$18,651 30% 30% $60,057

% Deviation SALES PRICE % Deviation FIXED COSTS

from Sales NPV from Fixed NPV
Base Case Price $4,943 Base Case Costs $4,943
-30% $2.10 -$28,089 -30% $5,600 $9,377
-15% $2.55 -$11,573 -15% $6,800 $7,160
0% $3.00 $4,943 Base Case 0% $8,000 $4,943
15% $3.45 $21,459 15% $9,200 $2,726
30% $3.90 $37,975 30% $10,400 $510

We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:
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Figure 12-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)

$40,000
Column C
$30,000 Column D
Column E
Column F
$20,000
Column G
Column H
$10,000
NPV ($)
$0

($10,000)

($20,000)

($30,000)
-30% -15% 0% 15% 30%
Deviation from Base-Case Value (%)

Deviation NPV at Different Deviations from Base

from Sales Variable Growth Year 1 Fixed
Base Case Price Cost/Unit Rate Units Sold Cost WCC
-30% ($28,089) $28,538 ($32,620) ($4,495) $9,377 $8,043
-15% ($11,573) $16,740 ($15,791) $224 $7,160 $6,437
0% $4,943 $4,943 $4,943 $4,943 $4,943 $4,943
15% $21,459 ($6,854) $30,065 $9,662 $2,726 $3,550
30% $37,975 ($18,651) $60,057 $14,381 $510 $2,251

Range

We see from the tables and graph that NPV is most sensitive to changes in the sales price and variable
costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not very sensitive to
changes in WACC and fixed costs. Thus, the real issue is our confidence in the forecasts of the sales
price and variable costs, as well as the first-year sales and the growth rate in units sold.

NPV can change dramatically if the key input variables change, but we do not know how much the
variables are likely to change. For example, if we were buying components under a fixed price contract,
then variable costs might be locked in and not likely to rise more than say 5%, and we might have a firm
contract to sell the projected number of units at the indicated price per unit. In that case, the "bad
conditions" would not materialize, and a positive NPV would be pretty well guaranteed. We go on to look at
the probabilities of different conditions in Part 7.

Part 7. Evaluating Risk: Scenario Analysis

Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a time, hence
to see the combined effects of changes in several variables on NPV, and (2) It allows us to bring in the probabilities of
changes in the key variables.

We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales, and the unit
growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base case levels and then
examine the situation when the key variables change. We assume that the company regards the worst case as one
where each of the three variables is 30% worse than the base level, and the best case has each variable 30% better
than base. We also assume that there is a 25% chance of the best and worst cases, and a 50% chance of base case
levels.
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Scenario Analysis (Dollars in Thousands) Squared

Deviation
Sales Unit Variable Growth Times
Scenario Probability Price Sales Costs Rate NPV Probability

Best Case 25% 30%

Base Case 50% 0%
Worst Case 25% -30%

Expected NPV = sum, prob times NPV

Standard Deviation = Sq Root of column I sum
Coefficient of Variation = Std Dev / Expected NPV
a. Probability Graph
Probability

50%

25%

0 0 0 0
0 NPV ($)
Most Likely Mean of distribution

b. Continuous Approximation

Probability Density

0 0 0 0
NPV ($)
0

The scenario analysis suggests that the project could be highly profitable, but also that it is quite risky. There is a
25% probability that the project would result in a loss of $32 million. There is also a 25% probability that it could
produce an NPV of $146 million. The standard deviation is high, at $68 million, and the coefficient of variation is a
high 2.17.

Note that the expected NPV in the scenario analysis is much higher than the base case value. This occurs because
under good conditions we have high numbers multiplied by other high numbers, giving a very high result.

This analysis suggest that the project is relatively risky, hence that the base case NPV should be recalculated using a
higher WACC. At a WACC of 15% (versus 12% for an average risk project), the base case NPV is: $3,454
That number is not very high in relation to the project's cost.

Changing the WACC would also change the scenario analysis. Here are new figures:

Probability NPV Dev. Sqd^2

Worst Case 25%
Base Case 50%
Best Case 25%

Expected NPV:
Standard Deviation:
Coefficient of Variation:
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At this point, the project looks risky but acceptable. There is a good chance that it will produce an NPV of $3,454, but
there is also a chance that the NPV could be dramatically higher or lower.

If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large company.

We indicate at the start that this project's returns would be highly correlated with the firm's other projects'
returns and also with the general stock market. Thus, its stand-alone risk (which is what we have been analyzing)
also reflects its within-firm and market risk. If this were not true, then we would need to make further risk
adjustments.

Finally, recall that we stated at the start that if the firm undertakes the project, it will be committed to operate it for the
full 4-year life. That is important, because if it were not so committed, then if the bad conditions occurred during the
first year of operations, the firm could simply close down operations. This would cut its losses, and the worse case
scenario would not be nearly as bad as we indicated. Then, the expected NPV would be higher, and the standard
deviation and coefficient of variation would be lower. We explain abandonment options in Chapter 13.
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DEPRECIATION

Recovery Allowance Percentage for Personal Property

Class of Investment
Ownership
Year 3-Year 5-Year 7-Year 10-Year

1 33% 20% 14% 10%

2 45% 32% 25% 18%
3 15% 19% 17% 14%
4 7% 12% 13% 12%
5 11% 9% 9%
6 6% 9% 7%
7 9% 7%
8 4% 7%
9 7%
10 6%
11 3%
100% 100% 100% 100%

MACRS for Residential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8 9
1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364% 1.061%
2-27 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
28 1.970% 2.273% 2.576% 2.879% 3.182% 3.458% 3.636% 3.636% 3.636%
29 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.152% 0.455% 0.758%
99.99% 99.99% 99.99% 99.99% 99.99% 99.96% 99.99% 99.99% 99.99%

MACRS for Nonresidential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8 9
1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963% 0.749%
2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564%
40 0.107% 0.321% 0.535% 0.749% 0.963% 1.177% 1.391% 1.605% 1.819%
100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Rounded Percentages Used in Analysis

Property Life (in years): 39
Depreciation in Year 1 (assuming half-year convention): 1.30%
Rounded Depreciation in Years 2-39: 2.60%
Depreciation in Year 40: 1.30%
 10 11 12
0.758% 0.455% 0.152%
3.636% 3.636% 3.636%
3.636% 3.636% 3.636%
1.061% 1.364% 1.667%
99.99% 99.99% 99.99%

10 11 12
0.535% 0.321% 0.107%
2.564% 2.564% 2.564%
2.033% 2.247% 2.461%
100.00% 100.00% 100.00%
 A B C D E F G H
1 REPLACEMENT ANALYSIS
2
3 In this model, we analyze the issue of whether a piece of equipment should be replaced. While the mechanics
4 of the analysis are somewhat different from the analysis for a new project, the process is similar in that we are
5 concerned with incremental cash flows. In this instance, we will be looking at a case that consists of net salvage value
6 being an intial benefit of the project. This replacement project is deemed by the firm to be of relatively low
7 risk, and is evaluated with a cost of capital of 11.5%
8
9 Input Data
10
11 Cost of the new machine $12,000
12 Reduction in operating costs $5,000
13 New machine's salvage value at end of Year 5 $2,000
14 Old machine's current market value $1,000
15 Old machine's current book value $2,500
16 Increase in Net Operating WC $1,000
17 Tax rate 40%
18 WACC 11.5%
19
20 MACRS 3-year Depreciation Schedule
21
22 Year 1 2 3 4
23 Depr. Rate 33% 45% 15% 7%
24 Depr. Exp.
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26 Replacement Project Net Cash Flow Schedule
27 Year: 0 1 2 3 4
28 Section I. Investment Outlay
29 Cost of new equipment
30 Market value of old equipment
31 Tax savings on old equipment sale
32 Increase in net operating WC
33
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35 Section II. Operating Inflows over the Project's Life
36 After-tax decrease in costs
37 Depreciation on new machine
38 Depreciation on old machine
39 Change in depreciation
40 Tax savings from depreciation
41 Net operating cash flows
42
43 Section III. Terminal Year Cash Flows
44 Estimated salvage value of new machine
45 Tax on salvage value (40%)
46 Return of net operating WC
47 Total termination cash flows
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49 Section IV. Net Cash Flow
 A B C D E F G H
50 Cumulative cash flows (for payback)
51
52 Section V. Capital Budgeting Analysis
53 Net Present Value (11.5%)
54 IRR
55 MIRR
56 Payback (in years)
57
58 This project carries much less risk than the firm's average project, hence it was only evaluated at 11.5%.
59 The project's NPV is positive; therefore, it should be accepted. A review of the IRR and MIRR also indicate
60 that this project should be accepted because their values are greater than the 11.5% cost of capital. In
61 addition, the payback period for this project is not very long, so if the required payback for this project were
62 3 years then according to the payback criterion this project would also be accepted.
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rocess is similar4in that we are
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only evaluated58
at 11.5%.
IRR and MIRR59 also indicate
.5% cost of capital.
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payback for this61project were
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