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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. 1 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 2 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 3 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 4 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 5