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FINANCIAL

MANAGEMENT
BAFB3013

Topic 1:
Cash Flow Estimation and Risk Analysis

LO1. The Principles of Cash Flow


Estimation

To evaluate investment decisions there are


some principles of cash flow estimation which
must be adhered to:
1. Only cash can be spent or reinvested, and
since accounting profits do not represent
cash, they are of less fundamental
importance than cash flows for investment
analysis CASH IS KING

2.Capital budgeting analysis should only include those


cash flows that will be affected by the decision.
a.Sunk costs
b.Opportunity costs
c.Externalities
3.When a firm takes on a new capital budgeting project:
increase its investment in receivables and inventories,
increase in payables and accruals,
increasing its net operating working capital (NOWC).

NOWC = CA - CL
Since this increase must be financed, it is included as an outflow in Year
0 of the analysis.
At the end of the projects life, inventories are depleted and receivables
are collected. Thus, there is a decrease in NOWC, which is treated as
an inflow in the final year of the projects life.

4. The costs associated with financing are reflected in


the weighted average cost of capital (WACC).
Should interest and dividend include in cash
flows?
What is the issue of double count.
5. 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 level.
Therefore, in most cases we simply assume that all
cash flows occur at the end of the year. However, for
some projects it might be useful to assume that cash
flows occur at mid-year, or even quarterly or monthly.

Irrelevant and Relevant CF


LO2. To identify the irrelevant or relevant cash flow, you need to
understand the terms:
1.

incremental cash flow,

2.
3.
4.

net operating working capital,


sunk cost,
opportunity cost

5.

externalities.

Relevant Cash Flows

Incremental cash flows

only cash flows associated with the investment

effects on the firms other investments must also be


considered

With replacement projects, incremental cash flows


must be computed by subtracting existing project cash

flows from those expected from the new project.

Relevant Cash Flows

Sunk costs are irrelevant to the decision process.

Opportunity costs, which are cash flows that could

be realized from the best alternative use of the


asset, are relevant.

Externalities (or sometime called cannibalization) are


effect of a project on Cash Flows in other parts of
the firm. Externalities are often very difficult to
quantify, but they should be considered and must be
included in the estimate of the operating cash flow.

Net working capital


Is current asset less current liabilities.
Is affected by decision to accept capital
projects for expansion
Current assets that will likely increase:
additional inventories and accounts receivable
Current liabilities that will likely increase:
accounts payable and accruals
If increase in current assets is greater than
current liabilities, funding in addition to the
capital project will be needed. It is additional
cash outflows for accepting the project.

Relevant Cash Flows

Examples of relevant cash flows:

cash inflows, outflows, and opportunity


costs

changes in working capital

installation, removal and training costs

terminal values

Relevant Cash Flows

Categories of Cash Flows:

Initial Cash Flows are cash flows resulting initially


from the project.
Operating Cash Flows are the cash flows generated
by the project during its operation.
Terminal Cash Flows result from selling the project.

Relevant Cash Flows

Should financing effects be included in cash flows?

No, dividends and interest expense should


not be included in the analysis.
Financing effects have already been taken
into account by discounting cash flows at the
WACC of 10%.
Deducting interest expense and dividends
would be double counting financing costs.

Should a $50,000 improvement cost from the


previous year be included in the analysis?
No, the building improvement cost is a
sunk cost and should not be
considered.
This analysis should only include
incremental investment.

If the facility could be leased out for $25,000


per year, would this affect the analysis?
Yes, by accepting the project, the firm
foregoes a possible annual cash flow of
$25,000, which is an opportunity cost to be
charged to the project.
The relevant cash flow is the annual after-tax
opportunity cost.
A-T opportunity cost = $25,000 (1 T)
= $25,000(0.6)
= $15,000

If the new product line were to decrease


the sales of the firms other lines, would
this affect the analysis?
Yes. The effect on other projects CFs is an
externality.
Net CF loss per year on other lines would be
a cost to this project.
Externalities can be positive (in the case of
complements) or negative (substitutes).

If this were a replacement rather than a new project,


would the analysis change?
Yes, the old equipment would be sold, and new
equipment purchased.
The incremental CFs would be the changes from
the old to the new situation.
The relevant depreciation expense would be the
change with the new equipment.
If the old machine was sold, the firm would not
receive the SV at the end of the machines life.
This is the opportunity cost for the replacement
project.

What are the 3 types of project risk?

Stand-alone risk
Corporate risk
Market risk/Systematic Risk

What is stand-alone risk?

The projects total risk, if it were operated


independently.
Usually measured by standard deviation (or
coefficient of variation).
However, it ignores the firms diversification
among projects and investors diversification
among firms.

What is corporate risk?

The projects risk when considering the


firms other projects, i.e., diversification
within the firm.
Corporate risk is a function of the projects
NPV and standard deviation and its
correlation with the returns on other
projects in the firm.

What is market risk?

The projects risk to a well-diversified


investor.
Theoretically, it is measured by the projects
beta and it considers both corporate and
stockholder diversification.

Which type of risk is most relevant?

Market risk is the most relevant risk for


capital projects, because managements
primary goal is shareholder wealth
maximization.
However, since total risk affects creditors,
customers, suppliers, and employees, it
should not be completely ignored.

Which risk is the easiest to measure?


Stand-alone risk is the easiest to measure. Firms often focus on
stand-alone risk when making capital budgeting decisions.
Focusing on stand-alone risk is not theoretically correct, but it does
not necessarily lead to poor decisions.

Are the three types of risk generally highly


correlated?
Yes, since most projects the firm undertakes
are in its core business, stand-alone risk is
likely to be highly correlated with its
corporate risk.
In addition, corporate risk is likely to be
highly correlated with its market risk.

LO3. Illustrate an expansion project and make a decision whether


the project should be accepted on the basis of standard capital
budgeting techniques.

The Net Investment/Initial Investment


is the net cash outflows required to ready a project for its basic operation.
The net investment includes:

Cost of any assets


+ Any incidental costs to put the asset to use example delivery costs and
installation costs
+ Any required increase in net working capital
After-tax salvage value from replaced assets (or disposal of existing assets)

Continued

The Net Cash Flows are the future cash flows generated from a project
once it commences operation. The net cash flows are expected to
continue throughout the projects economic life.
The basic net cash flow for each year is:

Sales revenue
Operating expenses*
Depreciation
= Earnings before taxes x (1 tax rate)
(Less) Taxes
= Earnings After taxes
+ Depreciation**

+ Terminal Year Non-Operating Cash Flow (And for Terminal Year


only)***

= Cash Inflows

Continued
* Interest expense is generally not included in the net cash flows
since it will be taken into account later through the firms required rate
of return
** Depreciation shelters income from taxes. Thus, greater
depreciation reduces taxes.

Depreciation is not an out-of-pocket expense. Thus an increase in


depreciation will reduce profit but increase cash flow. Depreciation can be
calculate as:
Straight line basis or
The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation
system in the United States

Continued
*** Terminal Non-operating Cash Flow. These are special onetime cash flows that only occur at the end of a projects life. They
are added to a projects last net cash flow. They include:
After-tax salvage value of the projects assets
Taxes owed on salvage value depend upon the salvage price relative to the
assets book value.
As assets book value is the assets original acquisition cost minus all
depreciation taken on the asset (accumulated depreciation).
If an asset is sold for its book value then no taxes are owed.
If an asset is sold for more than book value, then taxes are owed on this
excess.
If an asset is sold for less than book value, then taxes are reduced. The loss
acts as a tax shelter, reducing taxes by an amount equal to the firms marginal
tax rate times the deficit.

Return of any increased net working capital

Example:

Illustration:
You have been asked by the president of your company to evaluate the proposed
acquisition of new equipment. The equipments basic price is RM193000, and
shipping costs will be RM7700. It will cost another RM23200 to modify it for special
use by your firm and an additional RM13500 to install the equipment. The equipment
falls in the MACRS 3-year class, and it will be sold after 3 years for RM30900. The
equipment is expected to generate revenue of RM178000 per year with annual
operating costs (excluding depreciation) of RM84000. The firms tax rate is 28% and
its cost of capital is 10%..
REQUIRED:
What is the firms initial investment of the machine and
What is the operating cash flow form Year 1 - 3?
Should the company invest in this new equipment?
Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second
year, 15% in third year and 7% in fourth year.

Example

Initial Investment (Cash Outflow)


Y0
RM
Price of Equipment
193000
ADD:
Shipping costs
7700
Modification costs
23200
Installation
13500
Initial Outlay
237400

Yearly Cash Inflow

Y1

Y2

Y3

Revenue

178000

178000

178000

Operating Expenses

-84000

-84000

-84000

Depreciation

-78342

-106830

-35610

Net Profit Before Tax

15658

-12830

58390

(Tax Payable) / Tax -4384.24


Saving 28%

3592.4

-16349.2

Profit After Tax

11273.76

-9237.6

42040.8

Add: Depreciation

78342

106830

35610

Cash Inflow

89615.76

97592.4

77650.8

PV Factor, Lump Sum, 0.9091


10%

0.8264

0.7513

PV of Inflow

80650.36 58339.05 220459.1

81469.69

Total

Terminal Year
Cash Flow Y3

RM
Cost Of Equipment

237400

Less: Accumulated Depreciation

-220782

Book Value

16618

Disposal Price

-30900

Gain on Disposal

14282

Tax on Gain 28%

-4000

Net Gain

10282

30900

-4000

After Tax Salvage Value

26900

PV Factor, Lump Sum, 10%

0.7513

Present Value

20201

Net Present Value

RM

Initial Outlay

-237400

Present Value of Future Cash 220459.09


Inflows
Present Value Terminal Cash Flow 20201
Y3
NPV

3260.09

Decision invest in the new equipment since the NPV is positive.

The advantages
The advantage when you know your cash position now and in the
future:

Enough cash to purchase sufficient inventory for seasonal cycles


Take advantage of discount and special purchase
Properly plan for equipment purchases for replacement or expansion
Prepare for adequate future financing and determine the type of financing
(s/t credit, permanent w/c or l/t debt)
Show lenders your ability to plan and repay financing.