Download Ch. 12 CF Estimation and Risk Analysis Incremental Incremental

Ch. 12 CF Estimation and Risk Analysis
Topics
Estimating Cash Flows
Project Risk
Sensitivity Analysis
Scenario Analysis
Incremental Cash Flows
Cash Flows:
Cash flows matter, not accounting earnings.
Incremental cash flows matter.
Sunk costs don’t matter.
Opportunity costs matter.
Externalities:
Side effects like halo effect, cannibalization / erosion matter.
Taxes matter since we want incremental afterafter-tax cash
flows.
Inflation matters.
Estimating Cash Flows
Cash Flows from Operations
Operating Cash Flow = EBIT – Taxes + Depreciation and Other
non--cash expenses
non
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a return of
net working capital.
Net Capital Spending
Don’t forget (after tax) salvage value.
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Estimating Cash Flows
CF from Operation = EBIT - Taxes + Depreciation
CF from NWC = - Changes in NWC
CF from sale of scrap capital equipment
= After
After--tax cash proceeds from the sale
= Cash proceeds from the sale - Taxes on profits
Total CF = CF from Operation + CF from NWC + CF from
Capital Investment
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 company’s cost of capital.
Deducting interest expense and dividends would be
“double counting” financing costs.
Three Types of Project Risk
StandStand-alone risk
Corporate risk
Market risk
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Project Risk
Stand
Stand--alone risk
The project’s total risk, if it were operated independently.
Usually measured by standard deviation (or coefficient of
variation).
However, it ignores the firm’s diversification among projects
and investor’s diversification among firms.
Corporate risk
The project’s risk when considering the firm’s other projects,
i.e., diversification within the firm.
Corporate risk is a function of the project’s NPV and
standard deviation and its correlation with the returns on
other projects in the firm.
Project Risk
Market risk
The project’s risk to a wellwell-diversified investor.
Theoretically, it is measured by the project’s beta and it
considers both corporate and stockholder diversification.
Since most projects the firm undertakes are in its core
business, standstand-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.
How To Handle StandStand-alone Risk
Uncertainty in capital budgeting projects can be analyzed by
performing:
Sensitivity Analysis
Scenario Analysis
Simulation Analysis
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Sensitivity Analysis
Sensitivity Analysis:
Analysis:
One-atOneat-a-time analysis of the effects of changes in sales,
costs, etc. on a project.
Expresses cash flows in terms of unknown variables and then
calculates the consequences of misestimating those
variables.
Expected
Optimistic
Pessimistic
Sensitivity Analysis
Example: Determine NPV of the following project
Example:
assuming 8% cost of capital.
Investment
Sales
Variable costs
Fixed costs
Depreciation
Pretax profit
Taxes at 40%
Net income
CF from operations
Net cash flow
Year 0
-$5,400
Years 1-12
-5,400
16,000
13,000
2,000
450
550
220
330
780
780
Sensitivity Analysis
Possible Outcomes
Range
Variable Pessimistic Expected Optimistic
Investment (000s)
6,200
5,400
5,000
Sales(000s )
14,000
16,000
18,000
Var Cost (% of sales)
Fixed Costs(000s)
83%
2,100
81.25%
2,000
80%
1,900
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Sensitivity Analysis
NPV Possibilities
NPV (000 s )
Expected Optimistic
478
778
Variable
Investment (000s)
Pessimisti c
- 121
Sales(000s )
Var Cost (% of sales)
- 1,218
- 788
478
478
2,174
1,382
Fixed Costs(000s )
26
478
930
Scenario Analysis
Scenario Analysis: Project analysis given a particular
combination of assumptions.
assumptions.
Expected case
Best case
Worst case
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