Intro to Financial Management

Cash Flow and Risk in Capital Budgeting

Review

• Homework• Methods of evaluating a project

– Payback Period– Discounted Payback Period– NPV– PI– IRR– MIRR

• Criteria for accepting a project

Free Cash Flows

• Interested in after-tax cash flows, not profits. Why?• Interested in incremental cash flows.

– Do not count if take cash from existing products/services– Can count synergistic effects of a new project– Include incremental expenses– “Sunk costs are sunk”

• Interested in free cash flows– Cash generated by operations– Cash available to pay creditors or owners

• Separate the investment decision from the financing– How is the cost of financing already incorporated?

Free Cash FlowInitial Outlay

• Initial outlay– Initial start-up costs– Increases in working capital– Sale prices of any replaced assets– Capital gains taxes due to sale above/below depreciated value

initial outlay = cost of new assets

+ sale price of replaced assets

+/- tax impact of sale of replaced assets

Free Cash FlowAnnual and Terminal Flows

• Annually– Look at cash from operations – Adjust for

• Depreciation impact on taxes

– Depreciation is not cash but is a cost and lowers taxes

• Interest expenses

• Changes in net working capital

– E.g. if have greater accounts receivable or inventory or payables

• When project ends– Calculate terminal (final) value of assets

Projects in Practice

• Projects may end up being delayed– Due to economic reasons– Due to political reasons– Due to technological reasons

• Projects may be expanded• Projects may be canceled

– Due to economic reasons– Due to political reasons– Due to technological reasons

Project Risk

• Stand alone risk– All projects have risk, uncertainty

• Contribution-to-firm risk– Project add risk to firm– Project risk can be diversified with other projects

• Systematic risk– From viewpoint of shareholder– A project risk can be diversified by other shareholder investments

• Text says that theoretically only systematic risk is important– Not from the viewpoint of the firm!– Not from the viewpoint of a project manager!

Risk and Capital Budgeting

• Incorporate risk into discount rate– Increase hurdle rate to account for risk– Greater risk requires greater return

• Can try to calculate systematic risk– Calculate a beta for the project– But there are no historical returns– Two approaches:

1. Can try comparing past division results to benchmark (accounting method)

2. Pure play method – use the beta of a firm that looks like the project

Use Simulations to Evaluate Risk

• Have multiple factors that all have risk and a range of outcomes– Market size– Market share– Costs

• Evaluate a scenario– Select values for each factor and compute a result– Get an IRR or NPV

• Evaluate many (thousands) of scenarios– Get a distribution of outcomes for IRR or NPV– Can get a “probability” distribution for IRR or NPV