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Chapter 12 (11ed-11) Cash Flow Estimation and Risk Analysis

Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in Shrieves’ main plant. The machinery’s invoice price would be approximately $200,000; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling which places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use. The new line would generate incremental sales of 1,250 units per year for four years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net operating working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. a. Define “incremental cash flow.”

Answer: This is the firm’s cash flow with the project minus the firm’s cash flow without the project. a. 1. Should you subtract interest expense or dividends when calculating project cash flow?

Answer: The cash flow statement should not include interest expense or dividends. The return required by the investors furnishing the capital is already accounted for when we apply the 10 percent cost of capital discount rate, hence including financing flows would be "double counting." Put another way, if we deducted capital costs in the table, and thus reduced the bottom line cash flows, and then discounted those CFS by the cost of capital, we would, in effect, be subtracting capital costs twice. a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this cost be included in the analysis? Explain.

Mini Case: 11 - 1

000(1 . Should this be considered in the analysis? If so. Note also that externalities can be positive as well as negative. then if Shrieves accepts this project. a 3-year project is depreciated over 4 calendar years: YEAR 1 2 3 4 RATE 0. and presumably also expensed for tax purposes. If the firm's sales would be reduced by $50. this is an "externality" which must be considered in the analysis.000 in annual cash flows.Answer: The $100. then the net cash flow loss would be a cost to the project.000(0. because Shrieves would save on cash operating costs if its sales dropped. Disregard the assumptions in part a.000.15 0. Now assume that the plant space could be leased out to another firm at $25.000.6) = $15. b.000 cost to rehabilitate the production line site was incurred last year. it would forgo the opportunity to receive $25. Note that this annual loss would not be the full $50. Since. it is a sunk cost. how? Answer: If the plant space could be leased out to another firm.45 0. so it would be a $25. Finally. it should not be included in the analysis. Note that because of the halfyear convention. 3. What is Shrieves’ depreciable basis? Answer: Get the depreciation rates from table 11-2 in the book.000 a year. assume that the new product line is expected to decrease sales of the firm’s other lines by $50. a. 4.000 per year.000 annual outflow. This represents an opportunity cost to the project.07 × BASIS $240 240 240 240 = DEPRECIATION $ 79 108 36 17 $240 Mini Case: 11 .2 . Note that the opportunity cost cash flow must be net of taxes. and it should be included in the analysis.t) = $25. Should this be included in the analysis? If so.33 0. how? Answer: If a project affects the cash flows of another project. a.

you should inflate cash flows and then discount at the nominal rate.00 $257.000 $125.500 $128. the annual revenues and costs are: Units Unit Price Unit Cost Sales Costs Year 1 1250 $200.225 $273.18 $106. you should always discount nominal cash flows with a nominal rate. you could do either way and get the correct answer.00 $100. then the resulting NPV is too low. nominal rate.613 $136. Calculate the annual sales revenues and costs (other than depreciation).e.750 Year 3 1250 $212. Why is it important to include inflation when estimating cash flows? Answer: With an inflation rate of 3%.188 $132. real cash flows with the high. However. it includes a premium for inflation. Calculate the annual sales revenues and costs (other than depreciation). and real cash flows with a real rate. it is larger than the real cost of capital.27 $265.3 . the annual revenues and costs are: Here are the annual operating cash flows (in thousands of dollars): Net Revenues Depreciation Before-Tax Income Taxes (40%) Net Income Plus Depreciation Net Operating CF 1 $125 79 $ 46 18 $ 28 79 $107 2 $125 108 $ 17 7 $ 10 108 $118 3 $125 36 $ 89 36 $ 53 36 $ 89 4 $125 17 $108 43 $ 65 17 $ 82 Mini Case: 11 .c.588 The cost of capital is a nominal cost.00 $250. Therefore. c.00 $103. nominal cash flows (those that are inflated) are larger than real cash flows. Why is it important to include inflation when estimating cash flows? Answer: With an inflation rate of 3%. Similarly.09 Year 4 1250 $218..55 $109. In theory.000 Year 2 1250 $206. If you discount the low. In other words. Therefore. i. there is no accurate way to convert a nominal cost of capital to a real cost.

d.783 Calculate the after-tax salvage cash flow.188 $32.000.188 $132.320 $27. the equipment can be sold for $25.750 $108. taxes must be paid on the full salvage value.450 Year 3 Year 4 $265.225 $273. Answer: When the project is terminated at the end of year 4.800 $38.645 $47. Year 0 Sales NOWC (% of sales) CF due to NOWC) f.450 $108.967 $88.800 $93.680 Year 2 $257.500 $31.000 $125.783 $0 ($956) $32.000 Mini Case: 11 .750 $8.000 $30. since it has been depreciated to a $0 book value. Year 1 $250.000 ($30.000 $79.000) Year 1 $250. $30.000 $16.225 $273.900 ($900) Year 2 $257.000 (10.200 $106.500 $128. Estimate the required net operating working capital for each year.800 $96.613 $136.967 $71.612 $119.880 $36.588 $36. For this project.300 $12. Answer: Construct annual incremental operating cash flow statements.920 $57. EBIT Taxes (40%) NOPAT Depreciation Net Operating CF e.680 Sales Costs Depreciation Op.4 . But. and the cash flow due to investments in net operating working capital.800 $18.000 $16. Answer: The project requires a level of net operating working capital in the amount equal to 12% of the next year’s sales.480 $79. and any decrease is a positive cash flow.200 $45.000) $15.000 $120.000 $20. the after-tax salvage cash flow is: Salvage Value Tax On Salvage Value Net After-Tax Salvage Cash Flow $25. Any increase in NOWC is a negative cash flow.827 ($927) Year 3 Year 4 $265.

and payback? Do these indicators suggest that the project should be undertaken? Answer: The net cash flows are: Initial Outlay Operating Cash Flows CF Due To NOWC Salvage Cash Flows Net Cash Flows Year 0 ($240.0% 2. Similarly. it is possible to look back at historical data and to statistically analyze the riskiness of the investment. Calculate the net cash flows for each year? Based on these cash flows. judgmental estimates? Answer: Risk throughout finance relates to uncertainty about future events. what are the project’s NPV. for example. but you must recognize at the outset that some of the data used in the analysis will necessarily be based on subjective judgments rather than on hard statistical observations.9% 18.000) ($270. is the quantification based primarily on statistical analysis of historical data or on subjective.523 $93. This is often true when the investment involves an expansion decision. and marketing new products. MIRR.5 .000 $136. not much relevant historical data for assessing the riskiness of the project would be available. if Citibank were opening a new branch. For certain types of projects.780 Year 2 Year 3 Year 4 $88. IRR. in turn would have to rely on their experience in developing. and in capital budgeting.680 $32.5 What does the term “risk” mean in the context of capital budgeting. or if GM were expanding its Chevrolet plant.783 $15.000) ($30. and they. then past experience could be a useful guide to future risk.030 23.011 NPV = IRR = MIRR = Payback = h.g. manufacturing. if Sears were opening a new store. this means the future profitability of a project. We will try to quantify risk analysis. GM would have to rely primarily on the judgment of its executives. However. Rather. if GM were considering the development of an electric auto.000) Year 1 $106. $88. and when risk is quantified. for example. Mini Case: 11 .680 ($900) $105. there are times when it is impossible to obtain historical data regarding proposed investments.463 $120.967 ($927) ($956) $119.450 $93. to what extent can risk be quantified. a company that is considering going into a new business might be able to look at historical data on existing firms in that industry to get an idea about the riskiness of its proposed investment.

which is the slope of the regression line formed by plotting returns on the project versus returns on the market. and it is measured by the project’s corporate beta. However.i. Within-firm risk is the total riskiness of the project giving consideration to the firm’s other projects. It is measured by the project’s market beta. In this situation. However. a project’s stand-alone risk is likely to be highly correlated with its within-firm risk. It is the contribution of the project to the firm’s total risk. a project’s within-firm risk should not be completely ignored. How is each of these risk types measured. customers. and employees are all affected by a firm’s total risk. that is. hence it considers the diversification inherent in stockholders’ portfolios. 1. by far the easiest type of risk to measure is a project’s stand-alone risk. 3. such as IRR and MIRR. and how do they relate to one another? Answer: Here are the three types of project risk: • Stand-alone risk is the project’s total risk if it were operated independently. which is the slope of the regression line formed by plotting returns on the project versus returns on the firm. which in turn is likely to be highly correlated with its market risk. Thus. Stand-alone risk is measured either by the project’s standard deviation of NPV (σNPV) or its coefficient of variation of NPV (CVNPV). and it is a function of (a) the project’s standard deviation of NPV and (b) the correlation of the projects’ returns with those of the rest of the firm. • • i. to diversification within the firm. Market risk is the riskiness of the project to a well-diversified investor. Standalone risk ignores both the firm’s diversification among projects and investors’ diversification among firms. because most projects that a firm undertakes are in its core business. What are the three types of risk that are relevant in capital budgeting? 2. Since these parties influence the firm’s profitability. can also be used to obtain stand-alone risk estimates. the most relevant risk for capital projects is market risk. Mini Case: 11 . Note that other profitability measures. Within-firm risk is often called corporate risk. How is each type of risk used in the capital budgeting process? Answer: Because management’s primary goal is shareholder wealth maximization. firms often focus on this type of risk when making capital budgeting decisions. Unfortunately. creditors. this focus does not necessarily lead to poor decisions.6 . suppliers.

value by plus and minus 10.288 $100. and 30 percent.567 $91. 2.916 Units Sold $16.392 176.060 Salvage $84. say revenues. or expected. and cost of capital for the project.) j. all variables are fixed at their expected values except one. and the resulting effect on NPV is noted. To perform a sensitivity analysis.030 $76.493 $88. (One could allow more than one variable to change. 20. This one variable is then changed.030 $123.371 47. Perform a sensitivity analysis on the unit sales.147 Mini Case: 11 . often by specified percentages. salvage value.030 $89.348 $88. but this then merges sensitivity analysis into scenario analysis. on a project’s NPV.310 $88. Assume that each of these variables can vary from its base case. and discuss the results.956 $86. 1.668 $52.j. What is sensitivity analysis? Answer: Sensitivity analysis measures the effect of changes in a particular variable. Answer: The sensitivity data are given here in tabular form (in thousands of dollars): NPV Deviation From Base Case Deviation From Base Case -30% -15% 0% 15% 30% Range WACC $113.103 6.7 .398 $65. Include a sensitivity diagram.711 $159.

because a higher cost of capital leads to a lower NPV.000 $80. Since all other variables are set at their base case. the plot for cost of capital is downward sloping. indicating that higher variable values lead to higher NPVs.000 $160.000 $140. the zero change situation is the base case.xls.573.000 $120.000 $20. Mini Case: 11 . The sensitivity lines intersect at 0% change and the base case NPV. Sensitivity Analysis $180. The plots for unit sales and salvage value are upward sloping.000 $40. This indicates that NPV is more sensitive to changes in unit sales than to changes in salvage value. The plot of unit sales is much steeper than that for salvage value.000 $0 -40% NPV WACC Units Sold Salvage -20% 0% 20% 40% Deviation from Base-Case Value A.000 $60. $81. or expected values.We generated these data with a spreadsheet model in the file ch 11 mini case.000 $100. C.8 . B. Conversely.

Thus. sensitivity analysis is not a particularly good indicator of risk. a 25 percent chance of excellent acceptance. Steeper sensitivity lines indicate greater risk. j. Sidney believes that there is a 25 percent chance of poor acceptance. and this helps management focus its attention on those variables that are probably most important. What is the primary weakness of sensitivity analysis? What is its primary usefulness? Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the effects of diversification and (2) that it does not incorporate any information about the possible magnitudes of the forecast errors. hence its revenues. Answer: Scenario analysis examines several possible situations. but if the project’s sales.600 units and a unit price of $240. What is scenario analysis? k. sensitivity analysis does identify those variables which potentially have the greatest impact on profitability. a sensitivity analysis might indicate that a project’s NPV is highly sensitive to the sales forecast. 3. It provides a range of possible outcomes. usually worst case. 1. It also ignores any relationships between variables. Mini Case: 11 . unit sales would be only 900 units a year and the unit price would only be $160.D. then sales variations may actually contribute little to the project’s risk. Therefore. such as unit sales and sales price. are fixed by a longterm contract.9 . Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project’s cash flows except unit sales and sales price: if product acceptance is poor. and best case. hence that the project is quite risky. in comparing two projects. Thus. the one with the steeper lines is considered to be riskier. k. However. in many situations. most likely case. a strong consumer response would produce sales of 1. and a 50 percent chance of average acceptance (the base case).

What is the worst-case NPV? The best-case NPV? 3. Answer: We used a spreadsheet model to develop the scenarios (in thousands of dollars). most likely.684 0.628 $75. and best-case NPVs and probabilities of occurrence to find the project’s expected NPV. standard deviation. k. which are summarized below: Scenario Best Case Base Case Worst Case Probability 25% 50% 25% Unit Sales 1600 1250 900 Unit Price $240 $200 $160 Expected NPV = Standard Deviation = Coefficient Of Variation = Std Dev / Expected NPV = NPV $278. Use the worst-.030 ($48.965 $88. and coefficient of variation.10 . 2.k.74 Mini Case: 11 .514) $101.

1. nor simulation analysis provides a decision rule--they may indicate that a project is relatively risky.11 . Simulation provides the decision maker with a better idea of the profitability of a project than does scenario analysis because it incorporates many more possible outcomes. along with the correlations over time.57.l.000. Simulation analysis is a type of scenario analysis which uses a relatively powerful financial planning software such as interactive financial planning system (IFPs) or @risk (a spreadsheet add-in).2-0. scenario.000 values.2-0. average risk. Once all of the variable values have been selected. and most projects have an almost infinite number of possible outcomes. scenario.4. Would the new line be classified as high risk. they are combined. say 1. which is above the average range of 0. Although simulation analysis is technically refined. Answer: Scenario analysis examines several possible scenarios. Obviously the world is much more complex. Thus. but they do not indicate whether the project’s expected return is sufficient to compensate for its risk.4. with new values selected from the distributions for each run. The software can graph the distribution as well as print out summary statistics such as expected NPV and σ NPV. the computer uses a random number generator to select values for the uncertain variables on the basis of their designated distributions. Further. so it falls into the high risk category. Finally. Are there problems with scenario analysis? Define simulation analysis. If managers are unable to do this with much confidence. usually worst case. or low risk? What type of risk is being measured here? Answer: The project has a CV of 0. Simple simulations can also be conducted with other spreadsheet add-ins. and simulation analyses all focus on stand-alone risk. Recognize also that neither sensitivity. most likely case. Assume that Shrieves’ average project has a coefficient of variation in the range of 0. The process is repeated many times. the correlations among the uncertain variables must be specified. Then. Mini Case: 11 . Here the uncertain cash flow variables (such as unit sales) are entered as continuous probability distribution parameters rather than as point values. and best case. its usefulness is limited because managers are often unable to accurately specify the variables’ probability distributions. The end result is a probability distribution of NPV based on a sample of 1. remember that sensitivity. it usually considers only 3 possible outcomes. then the results of simulation analyses are of limited value. m. and discuss its principal advantages and disadvantages. and an NPV is calculated. such as Simtools. The CV measures a project’s stand-alone risk-it is merely a measure of the variability of returns (as measured by NPV) about the expected return. which is not the most relevant risk in capital budgeting analysis.

then. Mini Case: 11 .12 . If it were a low risk project. cost of capital would be 13 percent. Should the new furniture line be accepted? Answer: Since the project is judged to have above-average risk.975. then it might be riskier than first assessed. or project. its NPV would be $60. Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Also. and it would be an even more profitable project on a risk-adjusted basis. If the project has a potential for bringing on harmful lawsuits. its NPV would be $104. 2. Are there any subjective risk factors that should be considered before the final decision is made? Answer: A numerical analysis such as this one may not capture all of the risk factors inherent in the project. as a result of “abandonment possibilities.m.” the project may be less risky than the analysis indicates. 3. m.541. its cost of capital would be 7 percent. if the project’s assets can be redeployed within the firm or can be easily sold. so it would still be acceptable. its differential risk-adjusted. At this discount rate.