Chapter 12

Estimation Cash flow

Depreciation base (Cost): Price + Installation + shipping costs

Inventories will rise when we acquire new machines to work the machine.

Salvage value: Value of selling machine after it has been totally depreciated. (when Book Value = 0)

MACRS: Depreciation method at a given class

Side Note on MACRS (not required by the professor, just for my knowledge):
There are eight classes for MACRS which are: 3, 5, 7, 10, 15, 20, 27.5, and 39 recovery periods 1

Half-year convention: Government assumes that assets are purchased halfway through the year,
regardless of its actual purchase date. (if 3 years it will depreciate over 4 years)

Example: Asset bought May 2019, given a Recovery period of 3 year, According to MACRS 3-year class
the asset will be depreciated as follows
Period Years
May 2019 - December 2019 1
Jan 2020 - December 2020 1
Jan 2021 - December 2021 1
Jan 2022 – May 2022 1

So, the asset was depreciated over 4 years

0 1 2 3 4

Initial
Costs OCF1 OCF2 OCF3 OCF4
(CF0)
+Terminal
CF
NCF0 NCF1 NCF2 NCF3 NCF4

Terminal Cf is the additional cash flow collected from selling the machine for scraps. (salvage value)
ΔNOWC =Increase ∈Inventory −Increase ∈Account Payable
gain∨loss ¿ selling FA =S elling price−Book value If positive (gain) if negative (loss)

1
Recovery Periods are years that the asset will depreciate by
Example including everything:
 Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost = $240,000
 Inventories will rise by $25,000 and payables by $5,000
 Economic life = 4 years
 Salvage Value = $25,000
 MACRS 3-year class
 Sales: 100,000 units/year @ $2
 Variable cost = 60% of sales
 Tax rate= 40%
 WACC= 10%

Investment at t = 0:
Equipment -$200
Installation and shipping -40
Increase in inventories -25
Increase in AP 5
Net CF0 -$260
X

Year Rate Basis Depreciation

1 0.33 240 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
1.00 240

As stated before, due to half year convention 3 year class where depreciated over 4 years.

Operating Cash Flows:

1 2 3 4
Revenues 200 200 200 200
Op. Costs 60% -120 -120 -120 -120
Depreciation -79 -108 -36 -17
Op. inc. (BT) 1 -28 44 63
Tax 40% 0.4 -11 18 25
Op. inc. (AT) 0.6 -17 26 39
Add Depr 79 108 36 17
Op. CF 79.6 91 62 55

Net Terminal CF at t = 4
Recovery of NOWC $20
Salvage value 25
Tax on SV (40%) -10
Net Termination CF $35
0 1 2 3 4
 79.7 91.2 62.4 54.7
-260 +
35

-260 79.7 91.2 62.4 89.7

With K= 10%, NPV = -4.03 , IRR = 9.3%, with a negative NPV the project is rejected. Also, IRR < K so it is
also rejected on that account.

General info:
 Cash flows do not account for interest expense and dividends, WACC already accounts for both, so
accounting for them in our cash flow would be considered as DOUBLE COUNTING
 Previous costs that improve FA before taking the decision of going ahead with the project are
considered Sunk Costs. However, if we improve our current FA to accommodate for the new FA that
will be attained. This will count as Installation costs and would be accounted for.
 We must also account for any opportunity cost that may occur, for example if a plant can be leased
out for $25,000 a year that value after tax is considered as an Opportunity cost.
 If a new product directly affects the sales of another, this is considered as an Externality, so the net
CF loss per year of the old product would be considered as a cost to the new product. Externalities
can be positive or negative.

Consider the previous investment with 5% inflation:

 1 2 3 4
Revenues 210 220 232 243
Op. Costs 60% -126 -132 -139 -146
Depreciation -79 -108 -36 -17
Op. inc. (BT) 5 -20 57 80
Tax 40% 2 -8 23 32
Op. inc. (AT) 3 -12 34 48
Add Depr 79 108 36 17
Op. CF 82 96 70 65

0 1 2 3 4

K= 10%

CF
82.1 96.1 70.0 65.1
-260 +
35

NCF
-260 82.1 96.1 70.0 100.1

Types of Risks:

 Stand-alone risk: it is the project’s total risk if we invest all our money in one project, it ignores the
firm’s diversification among projects and investor’s diversification amongst firms. (usually measured
by standard deviation or coefficient of variation)
 Corporate risk: The project’s risk with consideration to the firm’s other projects. It is a function of the
project’s NPV and standard deviation. Corporate risk can be minimized through proper
diversification within the firm.
 Market risk: The project’s risk to a well-diversified investor (a well-diversified investor has zero
corporate risk). It is theoretically measured by the project’s beta and it considers both corporate and
stockholder diversification

Total risk =C orporate risk + M arket risk

Market Risk is the most relevant risk for capital projects (since rational investors will diversify their
portfolio and eliminate corporate risk). However, since total risk affects creditors, customers and
suppliers it should not be ignored completely.
Stand-alone risk is the easiest to measure. Firms often focus on stand alone risk when making capital
budgeting decisions.

The aforementioned three types of risks are highly correlated. Since most projects the firm undertake
are in its core business.

What is Sensitivity analysis: Sensitivity analysis measures the effect of changes in a variable on the
project’s NPV

Advantages of sensitivity analysis: Sensitivity analysis identifies variables that may have the greatest
potential impact on profitability. This allows management to focus on those variables that are most
important.

Disadvantages of sensitivity analysis:

 Sensitivity analysis doesn’t reflect the effects of diversification.
 Sensitivity analysis doesn’t incorporate any information about the possible magnitudes of the
forecast error.

Example on sensitivity analysis:

Assume that we are confident of all the variables that affect the cash flows, except unit sales. We expect
unit sales to adhere to the following profile:
Case Probability Unit sales
Worst 0.25 75,000
Base 0.5 100,000
Best 0.25 125,000

If cash costs are to remain 60% of revenues, and all other factors are constant, we can solve for project
NPV under each scenario.
Worst Scenario:
1 2 3 4
Revenues 157.5 165.375 173.64 182.32
Op. Costs 60% -94.5 -99.225 -104.1 -109
Depreciation -79 -108 -36 -17
Op. inc. (BT) -16 -41.85 33.54 56.32
Tax 40% -6.4 -16.74 13.416 22.528
Op. inc. (AT) -9.6 -25.11 20.124 33.792
Add Depr 79 108 36 17
Op. CF 69.4 82.89 56.124 50.792

NPV: Sum of PVCF – Cash outflow

NPV= (51.54)
Expected NPV:

E ( NPV ) =( Probability 1 ) ( NPV 1 )+ ( probability 2 ) ( NPV 2 )+( Probability 3)( NPV 3)

Standard deviation NPV:

√ 2
ơ NPV = ∑ ( NPV ( i )−ENPV ) × Probability (i)

Coefficient Variation NPV: the measurement for risk per 1 dollar expected NPV. The value collected from
the following equation will be compared to the company’s coefficients of variation. If it is above the
range then it is High Risk is it is below the range then it is low Risk.

CV ơ NPV
NPV =¿ ¿
ENPV