# Chapter 12

Cash Flow Estimation and Risk Analysis
Learning Objectives
After reading this chapter, students should be able to:
 Analyze an expansion project and make a decision whether the project should be accepted on the basis
of standard capital budgeting techniques.
 Discuss difficulties and releant considerations in estimating net cash flows, and explain how project
cash flow differs from accounting income.
 Define the following terms: incremental cash flow, replacement analysis, sunk cost, opportunity cost,
externalities, and cannibalization effect.
 !dentify and briefly explain three separate and distinct types of risk.
 Demonstrate sensitiity and scenario analyses and explain "onte #arlo simulation.
 \$xplain how risk is incorporated in capital budgeting through either the certainty equialent or risk%
Chapter 12 Cash Flow Estimation and Risk Analysis Learning Objectives !"
Lect#re \$#ggestions
&his chapter coers some important but relatiely technical topics. 'ote too that this chapter is more
modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of
continuity. &herefore, if you are experiencing a time crunch, you could skip sections of the chapter.
(hat we coer, and the way we coer it, can be seen by scanning the slides and !ntegrated #ase
solution for #hapter )*, which appears at the end of this chapter solution. +or other suggestions about the
lecture, please see the ,-ecture .uggestions/ in #hapter *, where we describe how we conduct our classes.
%A&\$ O' C(A)*ER + OF ,- %A&\$ .,/0min#te periods1
!- Lecture Suggestions Chapter 12 Cash Flow Estimation and Risk Analysis
Answers to End0o20Chapter 3#estions
1201 0nly cash can be spent or reinested, and since accounting profits do not represent cash, they are of
less fundamental importance than cash flows for inestment analysis. 1ecall that in the stock aluation
chapter we focused on diidends, which represent cash flows, rather than on earnings per share.
1202 #apital budgeting analysis should only include those cash flows that will be affected by the decision.
.unk costs are unrecoerable and cannot be changed, so they hae no bearing on the capital budgeting
decision. 0pportunity costs represent the cash flows the firm gies up by inesting in this project rather
than its next best alternatie, and externalities are the cash flows 2both positie and negatie3 to other
projects that result from the firm taking on this project. &hese cash flows occur only because the firm
took on the capital budgeting project4 therefore, they must be included in the analysis.
120+ (hen a firm takes on a new capital budgeting project, it typically must increase its inestment in
receiables and inentories, oer and aboe the increase in payables and accruals, thus increasing
its net operating working capital 2'0(#3. .ince this increase must be financed, it is included as an
outflow in 5ear 6 of the analysis. At the end of the project7s life, inentories are depleted and
receiables are collected. &hus, there is a decrease in '0(#, which is treated as an inflow in the
final year of the project7s life.
120! &he costs associated with financing are reflected in the weighted aerage cost of capital. &o include
interest expense in the capital budgeting analysis would ,double count/ the cost of debt financing.
120, Daily cash flows would be theoretically best, but they would be costly to estimate and probably no
more accurate than annual estimates because we simply cannot forecast accurately at a daily leel.
&herefore, in most cases we simply assume that all cash flows occur at the end of the year.
8oweer, for some projects it might be useful to assume that cash flows occur at mid%year, or een
quarterly or monthly. &here is no clear upward or downward bias on '9: since both reenues and
costs are being recognized at the end of the year. ;nless reenues and costs are distributed
radically different throughout the year, there should be no bias.
1204 !n replacement projects, the benefits are generally cost saings, although the new machinery may also
permit additional output. &he data for replacement analysis are generally easier to obtain than for new
products, but the analysis itself is somewhat more complicated because almost all of the cash flows are
incremental, found by whether the project is a new expansion or a replacement project. A new
e5pansion project is defined as one where subtracting the firm inests in new assets to increase sales.
8ere the incremental cash flows are simply the cash inflows and outflows. !n effect, the company is
comparing what its alue looks like with and without the proposed project. <y contrast, a replacement
project occurs when the firm replaces an existing asset with a new one in order to reduce operating
costs, to increase output, or to improe product quality. !n this case, the incremental cash flows are the
additional inflows and outflows that result from replacing the old asset. !n a replacement analysis, the
company is comparing its alue if it makes the replacement ersus its alue if it continues to use the
existing asset.
)
new cost numbers from the old numbers. .imilarly, differences in depreciation and any
other factor that affects cash flows must also be determined.
) +or more discussion on replacement analysis, refer to (eb Appendix )*A on the Fundamentals (eb site,
http66brigham7swlearning7com and click on the tab for the ,1eplacement Analysis/ worksheet in )*
#hapter "odel.xls. &he main point to remember when analyzing replacement decisions is that incremental
cash flows represent changes in such items as sales, operating costs, depreciation, and taxes. &his means
that more arithmetic is inoled in replacement than in expansion decisions, but the concepts are exactly the
same.
Chapter 12 Cash Flow Estimation and Risk Analysis Answers and Solutions !8
'ew E5pansion
)roject A new
inestment designed to
increase sales.
Replacement )roject
An inestment to replace
old equipment and
thereby reduce costs,
increase output, or
improe quality.
120" .tand%alone risk is the project7s risk if it is held as a lone asset. !t disregards the fact that it is but
one asset within the firm7s portfolio of assets and that the firm is but one stock in a typical inestor7s
portfolio of stocks. .tand%alone risk is measured by the ariability of the project7s expected returns.
#orporate, or within%firm, risk is the project7s risk to the corporation, giing consideration to the fact
that the project represents only one in the firm7s portfolio of assets, hence some of its risk will be
eliminated by diersification within the firm. #orporate risk is measured by the project7s impact on
uncertainty about the firm7s future earnings. "arket, or beta, risk is the riskiness of the project as
seen by well%diersified stockholders who recognize that the project is only one of the firm7s assets
and that the firm7s stock is but one small part of their total portfolios. "arket risk is measured by the
project7s effect on the firm7s beta coefficient.
120- !t is often difficult to quantify market risk. 0n the other hand, we can usually get a good idea of a
project7s stand%alone risk, and that risk is normally correlated with market risk: &he higher the
stand%alone risk, the higher the market risk is likely to be. &herefore, firms tend to focus on stand%
alone risk, then deal with corporate and market risk by making subjectie, judgmental modifications
to the calculated stand%alone risk.
1208 .imulation analysis inoles working with continuous probability distributions, and the output of a
simulation analysis is a distribution of net present alues or rates of return. .cenario analysis
inoles picking seeral points on the arious probability distributions and determining cash flows or
rates of return for these points. .ensitiity analysis inoles determining the extent to which cash
flows change, gien a change in one particular input ariable. .imulation analysis is expensie.
&herefore, it would more than likely be employed in the decision for the =>66 million inestment in a
satellite system than in the decision for the =?6,666 truck.
1201/ .cenario analyses, and especially simulation analyses, would probably be resered for ery important
,make%or%break/ decisions. &hey would not be used for eery project decision because it is costly 2in
terms of money and time3 to perform the necessary calculations and it is challenging to gather all the
required information for a full analysis. .imulation analysis, in particular, requires data from many
different departments about costs and projections, including the probability distributions corresponding to
those estimates and the correlation coefficients between arious ariables.
,/ Answers and Solutions Chapter 12 Cash Flow Estimation and Risk Analysis
\$ol#tions to End0o20Chapter )roblems
1201 a7 \$quipment = @,666,666
'0(# !nestment ?,666,666
!nitial inestment outlay =)*,666,666
b7 'o, last year7s =>6,666 expenditure is considered a sunk cost and does not represent an
incremental cash flow. 8ence, it should not be included in the analysis.
c7 &he potential sale of the building represents an opportunity cost of conducting the project in that
building. &herefore, the possible after%tax sale price must be charged against the project as a cost.
1202 a7 0perating cash flows: t A )
.ales reenues =)6,666,666
0perating costs B,666,666
Depreciation *,666,666
0perating income before taxes = ),666,666
&axes 2C6D3 C66,666
0perating income after taxes = E66,666
Add back depreciation *,666,666
0perating cash flow = *,E66,666
b7 &he cannibalization of existing sales needs to be considered in this analysis on an after%tax
basis, because the cannibalized sales represent sales reenue the firm would realize without
the new project but would lose if the new project is accepted. &hus, the after%tax effect would
be to reduce the firm7s operating cash flow by =),666,6662) F &3 A =),666,66626.E3 A =E66,666.
&hus, the firm7s 0#+ would now be =*,666,666 rather than =*,E66,666.
c7 !f the tax rate fell to ?6D, the operating cash flow would change to:
0perating income before taxes =),666,666
&axes 2?6D3 ?66,666
0perating income after taxes = B66,666
Add back depreciation *,666,666
0perating cash flow =*,B66,666
&hus, the firm7s operating cash flow would increase by =)66,666.
120+ \$quipment7s original cost =*6,666,666
Depreciation 2G6D3 )E,666,666
<ook alue = C,666,666
Hain on sale A =>,666,666 F =C,666,666 A =),666,666.
&ax on gain A =),666,66626.C3 A =C66,666.
A& net salage alue A =>,666,666 F =C66,666 A =C,E66,666.
Chapter 12 Cash Flow Estimation and Risk Analysis Answers and Solutions ,1
120! a7 &he applicable depreciation alues are as follows for the two scenarios:
.cenario ) .cenario *
5ear 2.traight%-ine3 2"A#1.3
) =*66,666 =*EC,666
* *66,666 ?E6,666
? *66,666 )*6,666
C *66,666 >E,666
b7 &o find the difference in net present alues under these two methods, we must determine the
difference in incremental cash flows each method proides. &he depreciation expenses cannot
simply be subtracted from each other, as there are tax ramifications due to depreciation
expense. &he full depreciation expense is subtracted from 1eenues to get operating income,
and then taxes due are computed &hen, depreciation is added to after%tax operating income to
get the project7s operating cash flow. &herefore, if the tax rate is C6D, only E6D of the
depreciation expense is actually subtracted out during the after%tax operating income
calculation and the full depreciation expense is added back to calculate operating income. .o,
there is a tax benefit associated with the depreciation expense that amounts to C6D of the
depreciation expense. &herefore, the differences between depreciation expenses under each
scenario should be computed and multiplied by 6.C to determine the benefit proided by the
depreciation expense.
Depreciation \$xpense Depreciation \$xpense
5ear Difference 2* F )3 Diff. × 6.C 2"A#1.3
) = EC,666 =*>,E66
* )E6,666 EC,666
? %G6,666 %?*,666
C %)CC,666 %>B,E66
'ow to find the difference in '9: to be generated under these scenarios, just enter the cash
flows that represent the benefit from depreciation expense and sole for net present alue
based upon a (A## of )6D.
#+6 A 64 #+) A *>E664 #+* A EC6664 #+? A %?*6664 #+C A %>BE664 and !I51 A )6. .ole for
'9: A =)*,BG).EC
.o, all else equal the use of the accelerated depreciation method will result in a higher '9: 2by
=)*,BG).EC3 than would the use of a straight%line depreciation method.
120, \$2'9:3 A 6.6>2%=B63 J 6.*62%=*>3 J 6.>62=)*3 J 6.*62=*63 J 6.6>2=?63
A %=?.> J %=>.6 J =E.6 J =C.6 J =).>
A =?.6 million.
σ'9: A K6.6>2%=B6 F =?3
*
J 6.*62%=*> F =?3
*
J 6.>62=)* F =?3
*
J 6.*62=*6 F =?3
*
J 6.6>2=?6 F =?3
*
L
M
A =*?.E** million.
. GBC . B
6 . ? =
E** . *? =
#: = =
1204 a7 &he net cost is =)BG,666:
#ost of inestment at t A 6:
,2 Answers and Solutions Chapter 12 Cash Flow Estimation and Risk Analysis
<ase price 2=)C6,6663
"odification 2?6,6663
!ncrease in '0(# 2G,6663
#ash outlay for new machine 2=)BG,6663
b7 &he operating cash flows follow:
5ear ) 5ear * 5ear ?
After%tax saings =?6,666 =?6,666 =?6,666
Depreciation tax saings **,CC6 ?6,E66 )6,*66
'et operating cash flow =>*,CC6 =E6,E66 =C6,*66
'otes:
). &he after%tax cost saings is =>6,6662) F &3 A =>6,66626.E3 A =?6,666.
*. &he depreciation expense in each year is the depreciable basis, =)B6,666, times the
"A#1. allowance percentages of 6.??, 6.C>, and 6.)> for 5ears ), *, and ?, respectiely.
Depreciation expense in 5ears ), *, and ? is =>E,)66, =BE,>66, and =*>,>66. &he
depreciation tax saings is calculated as the tax rate 2C6D3 times the depreciation expense
in each year.
c7 &he terminal cash flow is =CG,BE6:
.alage alue =E6,666
&ax on .:N 2)@,*C63
1eturn of '0(# G,666
=CG,BE6
N&ax on .: A 2=E6,666 F =)),@66326.C3 A =)@,*C6.
1emaining <: in 5ear C A =)B6,66626.6B3 A =)),@66.
d7 &he project has an '9: of 2=)@,>C@3. &hus, it should not be accepted.
5ear 'et #ash +low 9: O )*D
6 2=)BG,6663 2=)BG,6663
) >*,CC6 CE,G*)
* E6,E66 CG,?)6
? GG,@E6 E?,?*6
'9: A 2= )@,>C@3
Alternatiely, place the cash flows on a time line:
6 ) * ?
P P P P
%)BG,666 >*,CC6 E6,E66 C6,*66
CG,BE6
GG,@E6
(ith a financial calculator, input the cash flows into the cash flow register, !I51 A )*, and then
sole for '9: A %=)@,>CG.E> ≈ %=)@,>C@.
120" a7 &he =>,666 spent last year on exploring the feasibility of the project is a sunk cost and should
not be included in the analysis.
Chapter 12 Cash Flow Estimation and Risk Analysis Answers and Solutions ,+
)*D
b7 &he net cost is =)*E,666:
9rice 2=)6G,6663
"odification 2)*,>663
!ncrease in '0(# 2>,>663
#ash outlay for new machine 2=)*E,6663
c7 &he operating cash flows follow:
5ear ) 5ear * 5ear ?
). After%tax saings =*G,E66 =*G,E66 =*G,E66
*. Depreciation tax saings )?,@)G )G,@B@ E,?*E
'et cash flow =C*,>)G =CB,>B@ =?C,@*E
'otes:
). &he after%tax cost saings is =CC,6662) F &3 A =CC,66626.E>3 A =*G,E66.
*. &he depreciation expense in each year is the depreciable basis, =)*6,>66, times the "A#1.
allowance percentages of 6.??, 6.C>, and 6.)> for 5ears ), *, and ?, respectiely. Depreciation
expense in 5ears ), *, and ? is =?@,BE>, =>C,**>, and =)G,6B>. &he depreciation tax saings is
calculated as the tax rate 2?>D3 times the depreciation expense in each year.
d7 &he terminal cash flow is =>6,B6*:
.alage alue =E>,666
&ax on .:N 2)@,B@G3
1eturn of '0(# >,>66
=>6,B6*
N&ax on .: A 2=E>,666 F =G,C?>326.?>3 A =)@,B@G.
<: in 5ear C A =)*6,>6626.6B3 A =G,C?>.
e7 &he project has an '9: of =)6,GC)4 thus, it should be accepted.
5ear 'et #ash +low 9: O )*D
6 2=)*E,6663 2=)*E,6663
) C*,>)G ?B,@E?
* CB,>B@ ?B,@?6
? G>,E*G E6,@CG
'9: A = )6,GC)
Alternatiely, place the cash flows on a time line:
6 ) * ?
P P P P
%)*E,666 C*,>)G CB,>B@ ?C,@*E
>6,B6*
G>,E*G
(ith a financial calculator, input the appropriate cash flows into the cash flow register, input
!I51 A )*, and then sole for '9: A =)6,GC6.>) ≈ =)6,GC).
120- a7 \$xpected annual cash flows:
9roject A: 9robable
9robability Q #ash +low A #ash +low
,! Answers and Solutions Chapter 12 Cash Flow Estimation and Risk Analysis
)*D
6.* =E,666 =),*66
6.E E,B>6 C,6>6
6.* B,>66 ),>66
\$xpected annual cash flow A =E,B>6
9roject <: 9robable
9robability Q #ash +low A #ash +low
6.* = 6 = 6
6.E E,B>6 C,6>6
6.* )G,666 ?,E66
\$xpected annual cash flow A =B,E>6
#oefficient of ariation:
'9: \$xpected alue \$xpected
deiation .tandard
#:
'9:
σ
= =
9roject A:
. ?C . CBC = 26.*3 2=B>63 26.E3 2=63 26.*3 2%=B>63
* * *
A
= + + = σ
9roject <:
=>,B@B.GC. 26.*3 2=)6,?>63 26.E3 2%=@663 26.*3 2%=B,E>63
* * *
<
= + + = σ
#:A A =CBC.?CI=E,B>6 A 6.6B6?.
#:< A =>,B@B.GCI=B,E>6 A 6.B>B@.
b7 9roject < is the riskier project because it has the greater ariability in its probable cash flows,
whether measured by the standard deiation or the coefficient of ariation. 8ence, 9roject < is
ealuated at the )*D cost of capital, while 9roject A requires only a )6D cost of capital.
;sing a financial calculator, input the appropriate expected annual cash flows for 9roject A into
the cash flow register, input !I51 A )6, and sole for '9:A A =)6,6?E.*>.
;sing a financial calculator, input the appropriate expected annual cash flows for 9roject < into
the cash flow register, input !I51 A )*, and sole for '9:< A =)),E*C.6).
9roject < has the higher '9:4 therefore, the firm should accept 9roject <.
c7 &he portfolio effects from 9roject < would tend to make it less risky than otherwise. &his would
tend to reinforce the decision to accept 9roject <. Again, if 9roject < were negatiely correlated
with the HD9 29roject < is profitable when the economy is down3, then it is less risky and
9roject <Rs acceptance is reinforced.
1208 !f actual life is > years:
;sing a time line approach:
6 ) * ? C >
P P P P P P
!nestment outlay 2?E,6663
Chapter 12 Cash Flow Estimation and Risk Analysis Answers and Solutions ,,
)6D
0perating cash flows
excl. deprec. 2A&3 B,*66 B,*66 B,*66 B,*66 B,*66
Depreciation saings *,GG6 *,GG6 *,GG6 *,GG6 *,GG6
'et cash flow 2?E,6663 )6,6G6 )6,6G6 )6,6G6 )6,6G6 )6,6G6
'9:)6D A =*,*)).)?.
!f actual life is C years:
;sing a time line approach:
6 ) * ? C
P P P P P
!nestment outlay 2?E,6663
0perating cash flows
excl. deprec. 2A&3 B,*66 B,*66 B,*66 B,*66
Depreciation saings *,GG6 *,GG6 *,GG6 *,GG6
&ax saings on loss *,GG6
'et cash flow 2?E,6663 )6,6G6 )6,6G6 )6,6G6 )*,@E6
'9:)6D A %=*,6G6.EG.
!f actual life is G years:
;sing a time line approach:
6 ) > E B G
P P • • • P P P P
!nestment outlay 2?E,6663
0perating cash flows
excl. deprec. 2A&3 B,*66 B,*66 B,*66 B,*66 B,*66
Depreciation saings *,GG6 *,GG6
'et cash flow 2?E,6663 )6,6G6 )6,6G6 B,*66 B,*66 B,*66
'9:)6D A =)?,?*G.@?.
!f the life is as low as C years 2an unlikely eent3, the inestment will not be desirable. <ut, if the
inestment life is longer than C years, the inestment will be a good one. &herefore, the decision
will depend on the managersR confidence in the life of the tractor. Hien the low probability of the
tractorRs life being only C years, it is likely that the managers will decide to purchase the tractor.
,4 Answers and Solutions Chapter 12 Cash Flow Estimation and Risk Analysis
)6D
)6D
1201/ a7 6 ) * ? C >
!nitial inestment 2=*>6,6663
'et oper. (# 2*>,6663
#ost saings =@6,666 = @6,666 =@6,666 =@6,666 =@6,666
Depreciation
a
G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. inc. before taxes = B,>66 2= **,>663 =>*,>66 =B*,>66 =@6,666
&axes 2C6D3 ?,666 2@,6663 *),666 *@,666 ?E,666
0per. !nc. 2A&3 = C,>66 2= )?,>663 =?),>66 =C?,>66 =>C,666
Add: Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. #+ =GB,666 = @@,666 =E@,666 =E),666 =>C,666
1eturn of '0(# =*>,666
.ale of "achine *?,666
&ax on sale 2C6D3 2@,*663
'et cash flow 2=*B>,6663 =GB,666 = @@,666 =E@,666 =E),666 =@*,G66
'9: A =?B,6?>.)?
!11 A )>.?6D
"!11 A )*.G)D
9ayback A ?.?? years
'otes:
a
Depreciation .chedule, <asis A =*>6,666
"A#1. 1ate
× <asis A
5ear <eg. <k. :alue "A#1. 1ate Depreciation \$nding <:
) =*>6,666 6.?? = G*,>66 =)EB,>66
* )EB,>66 6.C> ))*,>66 >>,666
? >>,666 6.)> ?B,>66 )B,>66
C )B,>66 6.6B )B,>66 6
=*>6,666
b7 !f saings increase by *6D, then saings will be 2).*32=@6,6663 A =)6G,666.
!f saings decrease by *6D, then saings will be 26.G32=@6,6663 A =B*,666.
Chapter 12 Cash Flow Estimation and Risk Analysis Answers and Solutions ,"
2)3 .aings increase by *6D:
6 ) * ? C >
!nitial inestment 2=*>6,6663
'et oper. (# 2*>,6663
#ost saings =)6G,666 =)6G,666 =)6G,666 =)6G,666 =)6G,666
Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. inc. before taxes = *>,>66 2= C,>663 = B6,>66 = @6,>66 =)6G,666
&axes 2C6D3 )6,*66 2),G663 *G,*66 ?E,*66 C?,*66
0per. !nc. 2A&3 = )>,?66 2= *,B663 = C*,?66 = >C,?66 = EC,G66
Add: Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. #+ = @B,G66 =)6@,G66 = B@,G66 = B),G66 = EC,G66
1eturn of '0(# = *>,666
.ale of "achine *?,666
&ax on sale 2C6D3 2@,*663
'et cash flow 2=*B>,6663 = @B,G66 =)6@,G66 = B@,G66 = B),G66 =)6?,E66
'9: A =BB,@B>.E?
2*3 .aings decrease by *6D:
6 ) * ? C >
!nitial inestment 2=*>6,6663
'et oper. (# 2*>,6663
#ost saings =B*,666 = B*,666 =B*,666 =B*,666 =B*,666
Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. inc. before taxes 2=)6,>663 2= C6,>663 =?C,>66 =>C,>66 =B*,666
&axes 2C6D3 2C,*66 3 2)E,*663 )?,G66 *),G66 *G,G66
0per. !nc. 2A&3 2= E,?663 2= *C,?663 =*6,B66 =?*,B66 =C?,*66
Add: Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. #+ =BE,*66 = GG,*66 =>G,*66 =>6,*66 =C?,*66
1eturn of '0(# =*>,666
.ale of "achine *?,666
&ax on sale 2C6D3 2@,*663
'et cash flow 2=*B>,6663 =BE,*66 = GG,*66 =>G,*66 =>6,*66 =G*,666
'9: A %=?,@6>.?B
,- Answers and Solutions Chapter 12 Cash Flow Estimation and Risk Analysis
c7 (orst%case scenario:
6 ) * ? C >
!nitial inestment 2=*>6,6663
'et oper. (# 2?6,6663
#ost saings =B*,666 = B*,666 =B*,666 =B*,666 =B*,666
Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. inc. before taxes 2=)6,>663 2= C6,>663 =?C,>66 =>C,>66 =B*,666
&axes 2C6D3 2C,*66 3 2)E,*663 )?,G66 *),G66 *G,G66
0per. !nc. 2A&3 2= E,?663 2= *C,?663 =*6,B66 =?*,B66 =C?,*66
a
G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. #+ =BE,*66 = GG,*66 =>G,*66 =>6,*66 =C?,*66
1eturn of '0(# =?6,666
.ale of "achine )G,666
&ax on sale 2C6D3 2B,*663
'et cash flow 2=*G6,6663 =BE,*66 = GG,*66 =>G,*66 =>6,*66 =GC,666
'9: A %=B,EE?.>*
<ase%case scenario:
&his was worked out in part a. '9: A =?B,6?>.)?.
<est%case scenario:
6 ) * ? C >
!nitial inestment 2=*>6,6663
'et oper. (# 2*6,6663
#ost saings =)6G,666 =)6G,666 =)6G,666 =)6G,666 =)6G,666
Depreciation G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. inc. before taxes = *>,>66 2= C,>663 = B6,>66 = @6,>66 =)6G,666
&axes 2C6D3 )6,*66 2),G663 *G,*66 ?E,*66 C?,*66
0per. !nc. 2A&3 = )>,?66 2= *,B663 = C*,?66 = >C,?66 = EC,G66
a
G*,>66 ))*,>66 ?B,>66 )B,>66 6
0per. #+ = @B,G66 =)6@,G66 = B@,G66 = B),G66 = EC,G66
1eturn of '0(# = *6,666
.ale of "achine *G,666
&ax on sale 2C6D3 2)),*663
'et cash flow 2=*B6,6663 = @B,G66 =)6@,G66 = B@,G66 = B),G66 =)6),E66
'9: A =G),B??.B@
9rob. '9: 9rob. × '9:
(orst%case 6.?> 2= B,EE?.>*3 2= *,EG*.*?3
<ase%case 6.?> ?B,6?>.)? )*,@E*.?6
<est%case 6.?6 G),B??.B@ *C,>*6 .)C
\$2'9:3 =?C,G66 .*)
σ'9: A K26.?>32%=B,EE?.>* F =?C,G66.*)3
*
J 26.?>32=?B,6?>.)? F =?C,G66.*)3
*
J 26.?63
2=G),B??.B@ F =?C,G66.*)3
*
L
M
A K=E?),)6G,@*B.@? J =),BCG,*6?.>@ J =EE6,G*G,*B@.C@L
M
Chapter 12 Cash Flow Estimation and Risk Analysis Answers and Solutions ,8
A =?>,@EB. GC.
#: A =?>,@EB.GCI=?C,G66.*) A ).6?.
4/ Answers and Solutions Chapter 12 Cash Flow Estimation and Risk Analysis
Note to Instructors:
*he sol#tion to this problem is not provided to st#dents at the back o2 their te5t7 9nstr#ctors can
access the Excel 2ile on the te5tbook:s ;eb site or the 9nstr#ctor:s Reso#rce C%7
12011 a7
Operating cash flow \$70,800 \$79,200 \$58,200
Terminal Year Cash Flows:
Return of net operating working capital 20,000
After-tax salage alue !",900
#otal ter\$ination cash flows \$"",900
%et &ash 'low (#i\$e line of cash flows) (\$!95,000) \$70,800 \$79,200 \$92,!00
b7 &he =?6,666 1SD costs are sunk costs. &herefore, these costs will hae no effect on '9: and
other profitability measures.
c7 !f the new project will reduce cash flows from the firmRs other projects, then this is a negatie
externality and must be considered in the analysis. #onsequently, these should be considered
costs of the new project and would reduce the projectRs '9:. !f the project can be housed in an
empty building that the firm owns and could sell if it were not used for the project, then this is an
opportunity cost which should also be considered as a TcostT of this project. &he after%tax sales
amount for this building will reduce the projectRs '9:.
d7 &he projectRs cash flows are likely to be positiely correlated with returns on the firmRs other
projects and with the economy. &he firm is inoled with materials and caulking compound is a
building material, so it is a similar product to the firmRs other products. !n addition, when the
economy is booming, housing starts increaseUwhich would mean an increase in sales of the
caulking compound. (hether a project is positiely or negatiely correlated with the firmRs other
projects impacts the risk of the project and the releant cost of capital at which it should be
ealuated.
e7
Chapter 12 Cash Flow Estimation and Risk Analysis ComprehensiveSpreadsheet !roblem 41
*e+ Output, %-. / \$0,0!0
1RR / !!2!!3
41RR / !02753
*e+ Output, %-. / \$0,0!0
1RR / !!2!!3
-art !2 *e+ 1nput 5ata 41RR / !02753
67uip\$ent cost plus installation \$!75,000 4arket alue of e7uip\$ent in 2008 \$!5,000
1ncrease in current assets \$"5,000 #ax rate 003
1ncrease in current lia8ilities \$!5,000 9A&& !03
:nit sales !!5,000
;ales price per unit \$"225
.aria8le cost per unit <03
.aria8le cost per unit (in =ollars) \$!295
'ixe= costs \$70,000
-art "2 %et ;alage .alues, in 2005 67uip\$ent
6sti\$ate= 4arket .alue in 2008 \$!5,000
>ook .alue in 2008 !2,250
6xpecte= ?ain or @oss 2,750
#axes pai= or tax cre=it !,!00
%et cash flow fro\$ salage \$!",900
-art 22 5epreciation an= A\$ortiAation ;che=ule Accu\$B=
Cear 1nitial &ost ! 2 " 5eprn
!75,000
67uip\$ent 5eprn Rate ""203 05203 !5203
67uip\$ent 5eprn, 5ollars \$57,750 \$78,750 \$2<,250 \$!<2,750
6n=ing >k .al, &ost - Accu\$B= 5eprn \$!2,250
Cears
42 ComprehensiveSpreadsheet !roblem Chapter 12 Cash Flow Estimation and Risk Analysis
-art 02 -roDecte= %et &ash 'lows (#i\$e line of annual cash flows)
0 ! 2 "
2005 200< 2007 2008
Investment Outlays at Time Zero:
67uip\$ent (!75,000)
1ncrease in %et Operating 9& (20,000)
Operating Cash Flows over the Project's Lie:
:nits sol= !!5,000 !!5,000 !!5,000
;ales price \$"225 \$"225 \$"225
;ales reenue \$"7",750 \$"7",750 \$"7",750
.aria8le costs 220,250 220,250 220,250
'ixe= operating costs 70,000 70,000 70,000
5epreciation (e7uip\$ent) 57,750 78,750 2<,250
Oper2 inco\$e 8efore taxes (6>1#) 2!,750 750 5",250
#axes on operating inco\$e (003) 8,700 "00 2!,"00
%et Operating -rofit After #axes (%O-A#) !",050 050 "!,950
A== 8ack =epreciation 57,750 78,750 2<,250
Operating cash flow \$70,800 \$79,200 \$58,200
Terminal Year Cash Flows:
Return of net operating working capital 20,000
After-tax salage alue !",900
#otal ter\$ination cash flows \$"",900
%et &ash 'low (#i\$e line of cash flows) (\$!95,000) \$70,800 \$79,200 \$92,!00
Cears, !-0 8asis
Cears, actual +ear 8asis
-art 52 *e+ Output, Appraisal of the -ropose= -roDect
%et -resent .alue (at !03) \$0,0!0
1RR !!2!!3
41RR !02753
Applies 41% function to Row 8! to fin= first +ear when pa+8ack
-a+8ackE see calculation 8elow) 2209 is positie2
5ata for -a+8ack Cears 0 ! 2 "
&u\$ulatie &' fro\$ Row 5" (!95,000) (!20,200) (05,000) 07,!00
1' 'unction to fin= pa+8ack 'A@;6 'A@;6 2209
27
g7 'ote that Tbest%caseT alues for ariable costs, fixed costs, (A##, and equipment cost are
*6D less than base%case alues, while the Tworst%caseT alues for ariable costs, fixed costs,
(A##, and equipment cost are *6D higher than base%case alues.
Chapter 12 Cash Flow Estimation and Risk Analysis ComprehensiveSpreadsheet !roblem 4+
3 5eiation 3 5eiation
fro\$ :nits %-. fro\$ %-.
>ase &ase ;ales \$0,0!0 >ase &ase 9A&& 0,0!0
-203 92,000 -\$00,<00 -203 8203 \$!!,5<9
-!03 !0",500 -\$!8,29" -!03 9203 \$7,7""
03 !!5,000 \$0,0!0 >ase &ase 03 !0203 \$0,0!0
!03 !2<,500 \$2<,"2! !03 !!203 \$007
203 !"8,000 \$08,<28 203 !2203 -\$",09"
3 5eiation 3 5eiation
fro\$ .aria8le %-. fro\$ ;ales %-.
>ase &ase &osts \$0,0!0 >ase &ase -rice \$0,0!0
-203 \$!25< \$70,9"5 -203 \$22<0 -\$00,<00
-!03 \$!27< \$"7,075 -!03 \$229" -\$!8,29"
03 \$!295 \$0,0!0 >ase &ase 03 \$"225 \$0,0!0
!03 \$22!5 -\$29,00< !03 \$"258 \$2<,"2!
203 \$22"0 -\$<2,907 203 \$"290 \$08,<28
3 5eiation 3 5eiation
fro\$ 'ixe= %-. fro\$ 67uip\$ent %-.
>ase &ase &osts \$0,0!0 >ase &ase &ost \$0,0!0
-203 \$5<,000 \$20,900 -203 \$!00,000 \$27,290
-!03 \$<",000 \$!0,059 -!03 \$!57,500 \$!5,<50
03 \$70,000 \$0,0!0 >ase &ase 03 \$!75,000 \$0,0!0
!03 \$77,000 -\$<,0"! !03 \$!92,500 -\$7,<25
203 \$80,000 -\$!<,875 203 \$2!0,000 -\$!9,2<5
9A&&
.AR1A>@6 &O;#;
6F:1-46%# &O;#
;A@6; -R1&6
'1G65 &O;#;
:%1# ;A@6;
;ensitiit+ Anal+sis
(\$50,000)
(\$"0,000)
(\$!0,000)
\$!0,000
\$"0,000
\$50,000
\$70,000
-203 -!03 03 !03 203
%-.
.&
67uip\$ent &ost
'&
;ales -rice
9A&&
5eiation
fro\$ ;ales .aria8le :nit 'ixe= 67uip\$ent
>ase &ase -rice &osts ;ales &osts 9A&& &ost
-203 (\$00,<00) \$70,9"5 (\$00,<00) \$20,900 \$!!,5<9 \$27,290
-!03 (\$!8,29") \$"7,075 (\$!8,29") \$!0,059 \$7,7"" \$!5,<50
03 \$0,0!0 \$0,0!0 \$0,0!0 \$0,0!0 \$0,0!0 \$0,0!0
!03 \$2<,"2! (\$29,00<) \$2<,"2! (\$<,0"!) \$007 (\$7,<25)
203 \$08,<28 (\$<2,907) \$08,<28 (\$!<,875) (\$",09") (\$!9,2<5)
Range 89,228 !"",802 89,228 0!,779 !0,<<2 0<,559
%-. at 5ifferent 5eiations fro\$ >ase
&he scenario analysis suggests that the project could be highly profitable, but also that it is quite
risky. &here is a *>D probability that the project would result in a loss of =**B,@6*. &here is
also a *>D probability that it could produce an '9: of =?*C,*CC. &he standard deiation is
high, at =)@E,C>G, and the coefficient of ariation is a high B.>?.
4! ComprehensiveSpreadsheet !roblem Chapter 12 Cash Flow Estimation and Risk Analysis
82 &ontinuous Approxi\$ation
-ro8a8ilit+ 5ensit+
(227,902) 0 2<,09" "20,200
%-. (\$)
0,0!0
;7uare=
5eiation
;ales .aria8le :nit 'ixe= 67uip\$ent #i\$es
-ro8a8ilit+ -rice &osts ;ales &osts 9A&& &ost %-. -ro8a8ilit+
253 \$"290 \$!25< !"8,000 \$5<,000 83 \$!00,000 \$"20,200 2222"<057<"
503 \$"225 \$!295 !!5,000 \$70,000 !03 \$!75,000 \$0,0!0 20"729<70
253 \$22<0 \$22"0 92,000 \$80,000 !23 \$2!0,000 (\$227,902) !<!28"288"0
"8595<<02<7
6xpecte= %-. / su\$, pro8 ti\$es %-. \$2<,09"
;tan=ar= 5eiation / ;7 Root of colu\$n H su\$ \$!9<,058
&oefficient of .ariation / ;t= 5e I 6xpecte= %-. 725"
9orst &ase
>ase &ase
>est &ase
;cenario
a2 -ro8a8ilit+ ?raph
-ro8a8ilit+
503
253
(227,902) 0 2<,09" "20,200
%-. (\$)
4ost @ikel+ 4ean of =istri8ution
0,0!0
9ntegrated Case
12012
Allied Food )rod#cts
Capital "udgeting and Cash #low Estimation
Allied Food )rod#cts is considering e5panding into the 2r#it j#ice b#siness with a new
2resh lemon j#ice prod#ct7 Ass#me that yo# were recently hired as assistant to the
director o2 capital b#dgeting< and yo# m#st eval#ate the new project7
*he lemon j#ice wo#ld be prod#ced in an #n#sed b#ilding adjacent to Allied:s
Fort =yers plant> Allied owns the b#ilding< which is 2#lly depreciated7 *he re?#ired
e?#ipment wo#ld cost @2//<///< pl#s an additional @!/</// 2or shipping and
installation7 9n addition< inventories wo#ld rise by @2,<///< while acco#nts payable
wo#ld increase by @,<///7 All o2 these costs wo#ld be inc#rred at t A /7 By a special
r#ling< the machinery co#ld be depreciated #nder the =ACR\$ system as +0year
property7 *he applicable depreciation rates are ++C< !,C< 1,C< and "C7
*he project is e5pected to operate 2or ! years< at which time it will be terminated7
*he cash in2lows are ass#med to begin 1 year a2ter the project is #ndertaken< or at t A
1< and to contin#e o#t to t A !7 At the end o2 the project:s li2e .t A !1< the e?#ipment is
e5pected to have a salvage val#e o2 @2,<///7
Dnit sales are e5pected to total 1//</// #nits per year< and the e5pected sales
price is @27// per #nit7 Cash operating costs 2or the project .total operating costs
less depreciation1 are e5pected to total 4/C o2 dollar sales7 Allied:s ta5 rate is !/C<
and its ;ACC is 1/C7 *entatively< the lemon j#ice project is ass#med to be o2
e?#al risk to Allied:s other assets7
&o# have been asked to eval#ate the project and to make a recommendation
as to whether it sho#ld be accepted or rejected7 *o g#ide yo# in yo#r analysis< yo#r
boss gave yo# the 2ollowing set o2 ?#estions7
*able 9C 12017Allied:s Lemon E#ice )roject
.*otal Cost in *ho#sands1
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case 4,
End o2 &ear / 1 2 + !
44 Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
97 9nvestment O#tlay
E?#ipment cost
9nstallation
9ncrease in inventory
9ncrease in acco#nts payable
*otal net investment
997 Operating Cash Flows
Dnit sales .tho#sands1 1//
)rice6#nit @ 27// @ 27//
*otal reven#es @2//7/
Operating costs<
e5cl#ding depreciation @12/7/
%epreciation +47/ 147-
*otal costs @18872 @22-7/
Operating income be2ore ta5es .EB9*1 @ !!7/
*a5es on operating income /7+ 2,7+
Operating income a2ter ta5es .'O)A*1 @ 247!
%epreciation "872 +47/
Operating cash 2low @ /7/ @ "87" @ ,!7"
9997 *erminal &ear Cash Flows
Ret#rn o2 net operating working capital
\$alvage val#e
*a5 on salvage val#e
*otal termination cash 2lows
9F7 )roject Cash Flows
)roject cash 2low .@24/7/1 @ -87"
F7 Res#lts
')F A
9RR A
=9RR A
)ayback A
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case 4"
A7 Allied has a standard 2orm that is #sed in the capital b#dgeting process>
see *able 9C 12017 )art o2 the table has been completed< b#t yo# m#st
replace the blanks with the missing n#mbers7 Complete the table in the
2ollowing steps
.11 Fill in the blanks #nder &ear / 2or the initial investment o#tlay7
Answer G\$how \$1201 thro#gh \$120, here7H *his answer is straight2orward7 'ote
that acco#nts payable is an o22set to the inventory b#ild#p< so the net
operating working capital re?#irement is @2/<///< which will be
recovered at the end o2 the project:s li2e7 G\$ee completed table in the
A7 .21 Complete the table 2or #nit sales< sales price< total reven#es< and
operating costs e5cl#ding depreciation7
Answer *his answer re?#ires no e5planation7 \$t#dents may note< tho#gh< that
in2lation is not re2lected at this point7 9t will be later7 G*he completed
table is shown below in the answer to A.,17H
A7 .+1 Complete the depreciation data7
Answer G\$how \$1204 here7H *he only thing that re?#ires e5planation here is the
#se o2 the depreciation tables in Appendi5 12A7 (ere are the rates 2or +0
year property> they are m#ltiplied by the depreciable basis< @2!/<///< to
calc#late the ann#al depreciation allowances
.%ollars in tho#sands1
&ear 1 /7++ × @2!/ A @ "872
&ear 2 /7!, × @2!/ A 1/-7/
&ear + /71, × @2!/ A +47/
&ear ! /7/" × @2!/ A 14 7-
17// @2!/ 7/
4- Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
A7 .!1 'ow complete the table down to 'O)A*< and then down to operating
cash 2lows7
Answer G\$how \$120" here7H *his is straight2orward7 *he only even slightly
complicated item is adding back depreciation to calc#late net CF7 G*he
completed table is shown below in the answer to A.,17H
A7 .,1 'ow 2ill in the blanks #nder &ear ! 2or the terminal cash 2lows< and
complete the project cash 2low line7 %isc#ss working capital7 ;hat
wo#ld have happened i2 the machinery were sold 2or less than its book
val#eI
Answer G\$how \$120- here7H *hese are all straight2orward7 'ote that the net
operating working capital re?#irement is recovered at the end o2 &ear !7
Also< the salvage val#e is 2#lly ta5able< beca#se the asset has been
depreciated to a Jero book val#e7 92 book val#e were something other
than Jero< the ta5 e22ect co#ld be positive .i2 the asset were sold 2or less
than book val#e1 or negative7
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case 48
*able 9C 12017 Allied:s Lemon E#ice )roject
.*otal Cost in *ho#sands1
9np#ts )rice @27// ;ACC 1/C 9n2l /7/C
FC rate 4/7/C *0rate !/C
End o2 &ear / 1 2 + !
97 9nvestment o#tlay
E?#ipment cost .@2//1
9nstallation .!/1
9ncrease in inventory .2,1
9ncrease in acco#nts payable ,
*otal net investment .24/ 1
997 Operating cash 2lows
Dnit sales .tho#sands1 1// 1// 1// 1//
)rice6#nit @ 27// @ 27// @ 27// @ 27//
*otal reven#es @2//7/ @2//7/ @2//7/ @2//7/
Operating costs<
e5cl#ding depreciation @12/7/ @12/7/ @12/7/ @12/7/
%epreciation "872 1/-7/ +47/ 147-
*otal costs @18872 @22-7/ @1,47/ @1+47-
Operating income be2ore ta5es @ /7- .@ 2-7/1 @ !!7/ @ 4+72
*a5es on operating income /7+ .11721 1"74 2,7+
Operating income a2ter ta5es @ /7, .@ 147-1 @ 247! @ +"78
%epreciation "872 1/-7/ +47/ 147-
Operating cash 2low @ /7/ @ "87" @ 8172 @ 427! @ ,!7"
9997 *erminal year cash 2lows
Ret#rn o2 net operating working capital 2/7/
\$alvage val#e 2,7/
*a5 on salvage val#e .1/7/ 1
*otal termination cash 2lows @ +,7/
9F7 )roject cash 2lows
)roject cash 2low .@24/7/1 @ "87" @ 8172 @ 427! @ -87"
C#m#lative cash 2low
2or payback .24/7/1 .1-/7+1 .-8711 .247"1 4+7/
Compo#nded in2lows 2or =9RR 1/471 11/7! 4-74 -87"
*erminal val#e o2 in2lows +"!7-
F7 Res#lts
')F A 0@!7/
9RR A 87+C
=9RR A 874C
)ayback A +7+ years
"/ Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
B7 .11 Allied #ses debt in its capital str#ct#re< so some o2 the money #sed to
2inance the project will be debt7 Kiven this 2act< sho#ld the projected
cash 2lows be revised to show projected interest chargesI E5plain7
Answer G\$how \$1208 here7H *he projected cash 2lows in the table sho#ld not be
revised to show interest charges7 *he e22ects o2 debt 2inancing are
re2lected in the cost o2 capital< which is #sed to disco#nt the cash
2lows7 9ncl#ding interest charges wo#ld constit#te a Ldo#ble co#ntingM
o2 the cost o2 debt 2inancing7
B7 .21 \$#ppose yo# learned that Allied had spent @,/</// to renovate the
b#ilding last year< e5pensing these costs7 \$ho#ld this cost be re2lected
in the analysisI E5plain7
Answer G\$how \$1201/ here7H *his e5pendit#re is a s#nk cost< hence it wo#ld not
a22ect the decision and sho#ld not be incl#ded in the analysis7
B7 .+1 'ow s#ppose yo# learned that Allied co#ld lease its b#ilding to another
party and earn @2,</// per year7 \$ho#ld that 2act be re2lected in the
analysisI 92 so< howI
Answer G\$how \$12011 here7H *he rental payment represents an opport#nity cost<
and as s#ch its a2ter0ta5 amo#nt< @2,<///.1 N *1 A @2,<///./741 A @1,<///<
sho#ld be s#btracted 2rom the cash 2lows the company wo#ld otherwise
have7
B7 .!1 'ow ass#me that the lemon j#ice project wo#ld take away pro2itable
sales 2rom Allied:s 2resh orange j#ice b#siness7 \$ho#ld that 2act be
re2lected in yo#r analysisI 92 so< howI
Answer G\$how \$12012 here7H *he decreased sales 2rom Allied:s 2resh orange
j#ice b#siness sho#ld be acco#nted 2or in the analysis7 *his is an
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case "1
e5ternality to AlliedOthe lemon j#ice project will a22ect the cash 2lows
to its orange j#ice b#siness7 \$ince the lemon j#ice project will take
b#siness away 2rom its orange j#ice b#siness< the reven#es as shown
in this analysis are overstated< and th#s they need to be red#ced by the
amo#nt o2 decreased reven#es 2or the orange j#ice b#siness7
E5ternalities are o2ten di22ic#lt to ?#anti2y< b#t they need to be
considered7
C7 %isregard all the ass#mptions made in part B< and ass#me there was no
alternative #se 2or the b#ilding over the ne5t ! years7 'ow calc#late the
project:s ')F< 9RR< =9RR< and payback7 %o these indicators s#ggest
that the project sho#ld be acceptedI
Answer G\$how \$1201+ here7H ;e re2er to the completed time line and e5plain
how each o2 the indicators is calc#lated7 ;e base o#r e5planation on
2inancial calc#lators< b#t it wo#ld be e?#ally easy to e5plain #sing a
reg#lar calc#lator and either e?#ations or spreadsheets7
/ 1 2 + !
P P P P P
.24/1 "87" 8172 427! -87"
')F A 0@!7/7 ')F is negative> do not accept7
9RR A
7 /
1 9RR 1 .
" 7 -8 @
1 9RR 1 .
! 7 42 @
1 9RR 1 .
2 7 81 @
1 9RR 1 .
" 7 "8 @
24/ @ 0
! + 2 1
=
+
+
+
+
+
+
+
+
9RR A 87+C7 9RR is less than the cost o2 capital> do not accept7
"2 Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
1/C
=9RR / 1 2 + !
P P P P P
.24/1 "87" 8172 427! -87"
4-74
11/7!
1/4 71
*erminal val#e .*F1 @+"! 7-
)F o2 *F @24/
')F @ /
=9RR is less than the cost o2 capital> do not accept7
)ayback &ear Cash Flow C#m#lative Cash Flow
1 "87" .1-/7+1
2 8172 .-8711
+ 427! .247"1
! -87" 4+7/
)ayback A + years Q @247"6@-87" A +7+ years7
Based on the analysis to this point< the project sho#ld not be #ndertaken7
(owever< this may not be correct< as we will see shortly7
%7 92 this project had been a replacement rather than an e5pansion project<
how wo#ld the analysis have changedI *hink abo#t the changes that
wo#ld have to occ#r in the cash 2low table7
Answer G\$how \$1201! here7H 9n a replacement analysis< we m#st 2ind
di22erences in cash 2lows< i7e7< the cash 2lows that wo#ld e5ist i2 we take
on the project vers#s i2 we do not7 *h#s< in the table there wo#ld need
to be< 2or each year< a col#mn 2or no change< a col#mn 2or the new
project< and 2or the di22erence7 *he di22erence col#mn is the one that
wo#ld be #sed to obtain the ')F< 9RR< etc7
E7 .11 ;hat are the three levels< or types< o2 project risk that are normally
consideredI
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case "+
=9RR A 874C
× .171/1
+
× .171/1
2
1/C
× 171/
Answer G\$how \$1201, thro#gh \$1201- here7H (ere are the three types o2 project
risk
17 \$tand0alone risk is the projectRs total risk i2 it were operated
independently7 \$tand0alone risk ignores both the 2irmRs
diversi2ication among projects and investorsR diversi2ication
among 2irms7 \$tand0alone risk is meas#red either by the projectRs
standard deviation .σ')F1 or its coe22icient o2 variation o2 ')F
.CF')F17
27 ;ithin02irm .corporate1 risk is the total riskiness o2 the project
giving consideration to the 2irmRs other projects< that is< to
diversi2ication within the 2irm7 9t is the contrib#tion o2 the project
to the 2irmRs total risk< and it is a 2#nction o2 .a1 the projectRs
standard deviation o2 ')F and .21 the correlation o2 the projectsR
ret#rns with those o2 the rest o2 the 2irm7 ;ithin02irm risk is o2ten
called corporate risk< and it is meas#red by the beta o2 the
projectRs ROA vers#s the 2irmRs ROA7
+7 =arket risk is the riskiness o2 the project to a well0diversi2ied
investor7 *heoretically< it is meas#red by the projectRs beta< and it
considers both corporate risk and stockholder diversi2ication7
E7 .21 ;hich type is most relevantI
Answer G\$how \$12018 here7H Beca#se managementRs primary goal is
shareholder wealth ma5imiJation< the most relevant risk 2or capital
projects is market risk7 (owever< creditors< c#stomers< s#ppliers< and
employees are all a22ected by a 2irmRs total risk7 \$ince these parties
in2l#ence the 2irmRs pro2itability< a projectRs within02irm risk sho#ld not
be completely ignored7
E7 .+1 ;hich type is easiest to meas#reI
"! Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
Answer G\$how \$1202/ here7H By 2ar the easiest type o2 risk to meas#re is a
projectRs stand0alone risk7 *h#s< 2irms o2ten 2oc#s primarily on this type
o2 risk when making capital b#dgeting decisions7 *his 2oc#s is not
theoretically correct< b#t it does not necessarily lead to poor decisions<
beca#se most projects that a 2irm #ndertakes are in its core b#siness7
E7 .!1 Are the three types o2 risk generally highly correlatedI
Answer G\$how \$12021 here7H Beca#se most projects that a 2irm #ndertakes are
in its core b#siness< a projectRs stand0alone risk is likely to be highly
correlated with its corporate risk< which in t#rn is likely to be highly
correlated with its market risk7
F7 .11 ;hat is sensitivity analysisI
Answer G\$how \$12022 here7H \$ensitivity analysis meas#res the e22ect o2
changes in a partic#lar variable< say reven#es< on a projectRs ')F7 *o
per2orm a sensitivity analysis< all variables are 2i5ed at their e5pected
val#es e5cept one7 *his one variable is then changed< o2ten by
speci2ied percentages< and the res#lting e22ect on ')F is noted7 .One
co#ld allow more than one variable to change< b#t this then merges
sensitivity analysis into scenario analysis71
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case ",
F7 .21 (ow wo#ld one per2orm a sensitivity analysis on the #nit sales< salvage
val#e< and ;ACC 2or the projectI Ass#me that each o2 these variables
deviates 2rom its base0case< or e5pected< val#e by pl#s and min#s 1/C<
2/C< and +/C7 E5plain how yo# wo#ld calc#late the ')F< 9RR< =9RR<
and payback 2or each case< b#t don:t do the analysis #nless yo#r
instr#ctor asks yo# to7
Answer *he base case val#e 2or #nit sales was 1//> there2ore< i2 yo# were to
ass#me that this val#e deviated by pl#s and min#s 1/C< 2/C< and +/C<
the #nit sales val#es to be #sed in the sensitivity analysis wo#ld be "/<
-/< 8/< 11/< 12/< and 1+/ #nits7 &o# wo#ld then go back to the table at
the beginning o2 the problem< insert the appropriate sales #nit n#mber<
say "/ #nits< and rework the table 2or the change in sales #nits arriving at
di22erent net cash 2low val#es 2or the project7 Once yo# had the net cash
2low val#es< yo# wo#ld calc#late the ')F< 9RR< =9RR< and payback as
yo# did previo#sly7 .'ote that sensitivity analysis involves making a
change to only one variable to see how it impacts other variables71 *hen<
yo# wo#ld go back and repeat the same steps 2or -/ #nitsOthis wo#ld
be done 2or each o2 the #nit sales val#es7 *hen< yo# wo#ld repeat the
same proced#re 2or the sensitivity analysis on salvage val#e and on cost
o2 capital7 .'ote that 2or the cost o2 capital analysis< the net cash 2lows
wo#ld remain the same< b#t the cost o2 capital #sed in the ')F and =9RR
calc#lations wo#ld be di22erent71
Excel
\$
is ideally s#ited 2or sensitivity analysis7 9n 2act we created a
spreadsheet to obtain this project:s net cash 2lows and its ')F< 9RR<
=9RR< and payback7 Once a model has been created< it is very easy to
change the val#es o2 variables and obtain the new res#lts7 *he res#lts
o2 the sensitivity analysis on the projectRs ')F .2or the ,C in2lation
case< #sing *able 9C 12021 ass#ming the pl#s and min#s 1/C< 2/C< and
+/C deviations are shown below7
"4 Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
;e generated these data with a spreadsheet model7
17 *he sensitivity lines intersect at /C change and the base case
')F< at appro5imately @1,<///7 \$ince all other variables are set at
their base case< or e5pected< val#es< the Jero change sit#ation is
the base case7
27 *he plots 2or #nit sales and salvage val#e are #pward sloping<
indicating that higher variable val#es lead to higher ')Fs7
Conversely< the plot 2or ;ACC is downward sloping< beca#se a
higher ;ACC leads to a lower ')F7
+7 *he plot o2 #nit sales is m#ch steeper than that 2or salvage val#e7
*his indicates that ')F is more sensitive to changes in #nit sales
than to changes in salvage val#e7
!7 \$teeper sensitivity lines indicate greater risk7 *h#s< in comparing
two projects< the one with the steeper lines is considered to be
riskier7
B6
E6
>6
C6
?6
*6
)6
6
%?6D %*6D )6D *6D %)6D 6D ?6D
'9:
2&housands of Dollars3
#ost of #apital
.alage :alue
;nit .ales
.ensitiity Hraph
%)6
%*6
%?6
%C6

#hange from <ase -eel
*he sensitivity data are given here in tab#lar 2orm .in tho#sands o2
dollars1
Change 2rom Res#lting ')F a2ter the 9ndicated Change in
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case ""
Base Level Dnit \$ales \$alvage Fal#e ;ACC

0+/C .@+47!1 @1178 @+!71
02/ .187+1 1278 2"7,
01/ .2711 1+78 2171
/ 1,7/ 1,7/ 1,7/
Q1/ +271 147/ 87/
Q2/ !872 1"7/ +7+
Q+/ 447+ 1-7/ .2721
F7 .+1 ;hat is the primary weakness o2 sensitivity analysisI ;hat are its
Answer G\$how \$1202+ here7H *he two primary disadvantages o2 sensitivity
analysis are .11 that it does not re2lect the e22ects o2 diversi2ication and
.21 that it does not incorporate any in2ormation abo#t the possible
magnit#des o2 the 2orecast errors7 *h#s< a sensitivity analysis might
indicate that a projectRs ')F is highly sensitive to the sales 2orecast<
hence that the project is ?#ite risky< b#t i2 the projectRs sales< hence its
reven#es< are 2i5ed by a long0term contract< then sales variations may
act#ally contrib#te little to the projectRs risk7
*here2ore< in many sit#ations< sensitivity analysis is not a
partic#larly good indicator o2 risk7 (owever< sensitivity analysis does
identi2y those variables that potentially have the greatest impact on
pro2itability< and this helps management 2oc#s its attention on those
variables that are probably most important7
;ork o#t ?#antitative answers to the remaining ?#estions only i2 yo#r instr#ctor
asks yo# to7 Also< note that it wo#ld take a long time to do the calc#lations #nless
yo# are #sing an Excel model7
K7 Ass#me that in2lation is e5pected to average ,C over the ne5t ! years<
and this e5pectation is re2lected in the ;ACC7 =oreover< in2lation is
e5pected to increase reven#es and variable costs by this same ,C7
"- Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
%oes it appear that in2lation has been dealt with properly in the initial
analysis to this pointI 92 not< what sho#ld be done< and how wo#ld the
re?#ired adj#stment a22ect the decisionI
Answer G\$how \$1202! thro#gh \$12024 here7H 9t is apparent 2rom the data in the
previo#s table that in2lation has not been re2lected in the calc#lations7
9n partic#lar< the sales price is held constant rather than rising with
in2lation7 *here2ore< reven#es and costs .e5cept depreciation1 sho#ld
both be increased by ,C per year7 \$ince reven#es are larger than
operating costs< in2lation will ca#se cash 2lows to increase7 *his will
lead to a higher ')F< 9RR< and =9RR< and to a shorter payback7 *able 9C
1202 re2lects the changes< and it shows the new cash 2lows and the new
indicators7 ;hen in2lation is properly acco#nted 2or the project is seen
to be pro2itable7
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case "8
*able 9C 12027Allied:s Lemon E#ice )roject Considering ,C 9n2lation
.*otal Cost in *ho#sands1
9np#ts )rice @27// ;ACC 1/C 9n2l ,7/C
FC rate 4/7/C *0rate !/C
End o2 &ear / 1 2 + !
97 9nvestment o#tlay
E?#ipment cost .@2//1
9nstallation .!/1
9ncrease in inventory .2,1
9ncrease in acco#nts payable ,
*otal net investment .24/ 1
997 Operating cash 2lows
Dnit sales .tho#sands1 1// 1// 1// 1//
)rice6#nit @ 271/ @272/, @27+1, @27!+1
*otal reven#es @21/7/ @22/7, @2+17, @2!+71
Operating costs<
e5cl#ding depreciation @1247/ @1+27+ @1+-78 @1!,78
%epreciation "872 1/-7/ +47/ 147-
*otal costs @2/,72 @2!/7+ @1"!78 @1427"
Operating income be2ore ta5es @ !7- .@ 187-1 @ ,474 @ -/7!
*a5es on operating income 178 ."781 2274 +271
Operating income a2ter ta5es @ 278 .@ 11781 @ +!7/ @ !-7+
%epreciation "872 1/-7/ +47/ 147-
Operating cash 2low @ /7/ @ -271 @ 8471 @ "/7/ @ 4,71
9997 *erminal year cash 2lows
Ret#rn o2 net operating working capital 2/7/
\$alvage val#e 2,7/
*a5 on salvage val#e .1/7/ 1
*otal termination cash 2lows @ +,7/
9F7 )roject cash 2lows
)roject cash 2low .@24/7/1 @ -271 @ 8471 @ "/7/ @1//71
C#m#lative cash 2low
2or payback .24/7/1 .1""781 .-17-1 .117-1 --7+
Compo#nded in2lows 2or =9RR 1/872 1147+ ""7/ 1//71
*erminal val#e o2 in2lows !/274
F7 Res#lts
')F A @1,7/
9RR A 1274C
=9RR A 1174C
)ayback A +71 years
-/ Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
(7 *he e5pected cash 2lows< considering in2lation .in tho#sands o2 dollars1<
are given in *able 9C 12027 Allied:s ;ACC is 1/C7 Ass#me that yo# are
con2ident abo#t the estimates o2 all the variables that a22ect the cash 2lows
e5cept #nit sales7 92 prod#ct acceptance is poor< sales wo#ld be only
",</// #nits a year< while a strong cons#mer response wo#ld prod#ce
sales o2 12,</// #nits7 9n either case< cash costs wo#ld still amo#nt to
4/C o2 reven#es7 &o# believe that there is a 2,C chance o2 poor
acceptance< a 2,C chance o2 e5cellent acceptance< and a ,/C chance o2
average acceptance .the base case17 )rovide n#mbers only i2 yo# are
#sing a comp#ter model7
.11 ;hat is the worst0case ')FI *he best0case ')FI
Answer G\$how \$1202" and \$1202- here7H ;e #sed a spreadsheet model to
develop the scenarios .in tho#sands o2 dollars1< which are s#mmariJed
below
Case )robability ')F .///s1
;orst /72, .@2"7-1
Base /7,/ 1,7/
Best /72, ,"7-
(7 .21 Dse the worst< most likely .or base1< and best0case ')Fs< with their
probabilities o2 occ#rrence< to 2ind the projectRs e5pected ')F<
standard deviation< and coe22icient o2 variation7
Answer G\$how \$12028 here7H *he e5pected ')F is @1!<84- .ro#nded to the
nearest tho#sand below17
E.')F1 A /72,.0@2"7-1 Q /7,/.@1,7/1 Q /72,.@,"7-1 A @1,7
*he standard deviation o2 ')F is @+/7+
σ')F A G/72,.0@2"7- N @1,1
2
Q /7,/.@1, N @1,1
2
Q /72,.@,"7- N @1,1
2
H
S
A G814H
S
A @+/7+<
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case -1
and the projectRs coe22icient o2 variation is 27/
CF')F A
7 / 7 2
1, @
+ 7 +/ @
E.')F1
')F
= =
σ
97 Ass#me that AlliedRs average project has a coe22icient o2 variation .CF1
in the range o2 172, to 17",7 ;o#ld the lemon j#ice project be classi2ied
as high risk< average risk< or low riskI ;hat type o2 risk is being
meas#red hereI
Answer G\$how \$120+/ here7H *he project has a CF o2 27/< which is m#ch higher
than the average range o2 172, to 17",< so it 2alls into the high0risk
category7 *he CF meas#res a projectRs stand0alone riskOit is merely a
meas#re o2 the variability o2 ret#rns .as meas#red by σ')F1 abo#t the
e5pected ret#rn7
E7 Based on common sense< how highly correlated do yo# think the
project wo#ld be with the 2irmRs other assetsI .Kive a correlation
coe22icient< or range o2 coe22icients< based on yo#r j#dgment71
Answer G\$how \$120+1 here7H 9t is reasonable to ass#me that i2 the economy is
strong and people are b#ying a lot o2 lemon j#ice< then sales wo#ld be
strong in all o2 the companyRs lines< so there wo#ld be positive
correlation between this project and the rest o2 the b#siness7 (owever<
each line co#ld be more or less s#ccess2#l< so the correlation wo#ld be
less than Q17/7 A reasonable g#ess might be Q/7"< or within a range o2
Q/7, to Q/787
T7 (ow wo#ld this correlation coe22icient and the previo#sly calc#lated σ
combine to a22ect the projectRs contrib#tion to corporate< or within02irm<
riskI E5plain7
Answer G\$how \$120+2 here7H 92 the projectRs cash 2lows are likely to be highly
-2 Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis
correlated with the 2irmRs aggregate cash 2lows< which is generally a
reasonable ass#mption< then the project wo#ld have high corporate
risk7 (owever< i2 the projectRs cash 2lows were e5pected to be totally
#ncorrelated with the 2irmRs aggregate cash 2lows< or positively
correlated b#t less than per2ectly positively correlated< then accepting
the project wo#ld red#ce the 2irmRs total risk< and in that case< the
riskiness o2 the project wo#ld be less than s#ggested by its stand0alone
risk7 92 the projectRs cash 2lows were e5pected to be negatively
correlated with the 2irmRs aggregate cash 2lows< then the project wo#ld
red#ce the total risk o2 the 2irm even more7
L7 Based on yo#r j#dgment< what do yo# think the projectRs correlation
coe22icient wo#ld be with respect to the general economy and th#s with
ret#rns on Uthe marketUI (ow wo#ld correlation with the economy
a22ect the project:s market riskI
Answer 9n all likelihood< this project wo#ld have a positive correlation with
ret#rns on other assets in the economy< and speci2ically with the stock
market7 Allied Food )rod#cts prod#ces 2ood items< and s#ch 2irms
tend to have less risk than the economy as a wholeOpeople m#st eat
regardless o2 the national economic sit#ation7 (owever< people wo#ld
tend to spend more on non0essential types o2 2ood when the economy
is good and to c#t back when the economy is weak7 A reasonable
g#ess might be Q/7"< or within a range o2 Q/7, to Q/787 92 an asset
.project< in this case1 has a high correlation with the market< it has a
high beta< and hence high market risk7
=7 Allied typically adds or s#btracts +C to its ;ACC to adj#st 2or risk7
A2ter adj#sting 2or risk< sho#ld the lemon j#ice project be acceptedI
\$ho#ld any s#bjective risk 2actors be considered be2ore the 2inal
decision is madeI E5plain7
Chapter 12 Cash Flow Estimation and Risk Analysis Integrated Case -+
Answer G\$how \$120++ and \$120+! here7H \$ince the project is j#dged to have
above0average risk< its di22erential risk0adj#sted< or project< cost o2
capital wo#ld be 1+C7 At this disco#nt rate< its ')F wo#ld be 0@2<224<
so it wo#ld not be acceptable7 92 it were a low0risk project< its cost o2
capital wo#ld be "C< its ')F wo#ld be @+!<11"< and it wo#ld be a
pro2itable project on a risk0adj#sted basis7 (owever< a n#merical
analysis s#ch as this one may not capt#re all o2 the risk 2actors
inherent in the project7 92 the project has a potential 2or bringing on
harm2#l laws#its< then it might be riskier than 2irst assessed7 Also< i2
the projectRs assets can be redeployed within the 2irm or can be easily
sold< then the project may be less risky than the analysis indicates7
-! Integrated Case Chapter 12 Cash Flow Estimation and Risk Analysis

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