Professional Documents
Culture Documents
CHAPTER 8
Cash Flow Estimation and Risk
Analysis
Estimating cash flows:
Relevant cash flows
Working capital treatment
Inflation
Risk Analysis: Sensitivity Analysis, Scenario
Analysis, and Simulation Analysis
What
What is
is
Capital
Capital Budgeting?
Budgeting?
2-2
The
The Capital
Capital
Budgeting
Budgeting Process
Process
Select projects based on a value-
maximizing acceptance criterion.
Reevaluate implemented
investment projects continually
and perform postaudits for
completed projects.
2-3
Classification
Classification of
of Investment
Investment
Project
Project Proposals
Proposals
1. New products or expansion of
existing products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)
2-4
Screening
Screening Proposals
Proposals
and
and Decision
Decision Making
Making
1. Section Chiefs
2. Plant Managers Advancement
to the next
3. VP for Operations level depends
4. Capital Expenditures on cost
Committee and strategic
importance.
5. President
6. Board of Directors
2-5
Estimating
Estimating After-Tax
After-Tax
Incremental
Incremental Cash
Cash Flows
Flows
Basic characteristics of
relevant project flows
Cash (not accounting income) flows
Operating (not financing) flows
After-tax flows
Incremental flows
2-6
Estimating
Estimating After-Tax
After-Tax
Incremental
Incremental Cash
Cash Flows
Flows
Principles that must be adhered
to in the estimation
Ignore sunk costs
Include opportunity costs
Include project-driven changes in
working capital net of spontaneous
changes in current liabilities
2-7
Include effects of inflation
8-8
CASH FLOW ESTIMATION
price elasticity,
advertising effects,
the state of the economy,
competitors’ reactions, and
trends in consumers’ tastes.
8-9
2. +Noncash Charges
An Example
8 - 24
8 - 25
8 - 26
Why is it important to include inflation
when estimating cash flows?
Nominal r > real r. The cost of capital, r, includes a
premium for inflation.
Nominal CF > real CF. This is because nominal cash
flows incorporate inflation.
If you discount real CF with the higher nominal r,
then your NPV estimate is too low.
Continued…
8 - 27
Inflation (Continued)