Session 7-Chapter 13

7/23/2019 Session 7-Chapter 13

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Cash Flow Estimationand Risk Analysis

Relevant Cash FlowsIncorporating Infation

Types o RiskRisk Analysis

Master o ManagementFaculty o Economics an !usiness

"niversitas #a$ah Maa Accreite%y&



'ropose 'ro$ect

• Total eprecia%le cost

– E(uipment& )*++,+++

– -hipping an installation& ).+,+++

• Changes in operating working capital – Inventories will rise %y )*/,+++

– Accounts paya%le will rise %y )/,+++

•E0ect on operations – ew sales& 1++,+++ units2year 3 )*2unit

– 4aria%le cost& 5+6 o sales

178*



'ropose 'ro$ect

• 9ie o the pro$ect – Economic lie& . years

– :eprecia%le lie& MACR- 78year class

– -alvage value& )*/,+++

• Ta; rate& .+6

• <ACC& 1+6

1787



:etermining 'ro$ect 4alue

• Estimate relevant cash fows

– Calculating annual operating cash fows=

– Ientiying changes in net operating working

capital= – Calculating terminal cash fows& ater8ta;

salvage value an return o ><C=

Initial >CF1 >CF* >CF7 >CFCosts ?

Terminal CFs

FCF+ FCF1 FCF* FCF7 FCF

+ 1 * 7 .

178.



Initial @ear Investment>utlays

• Fin ∆><C= – in inventories o )*/,+++ – Fune partly %y an in A2' o )/,+++ –

∆><C )*/,+++ B )/,+++ )*+,+++• Initial year outlays&E(uipment cost 8)*++,+++Installation 8.+,+++

CA'E 8*.+,+++∆><C 8*+,+++FCF+ 8)*5+,+++

178/



:etermining Annual :epreciation

E;pense

@earRate ; !asis :eprec= 1 +=77 ; )*.+ ) D * +=./ ; *.+ 1+

7 +=1/ ; *.+ 75 . +=+D ; *.+ 1D1=++ )*.+

:ue to the MACR- G8yearconvention, a 78year asset isepreciate over . years=

1785



'ro$ect >perating CashFlows

(Thousands of

dollars)

1 * 7 .

Revenues *++=+ *++=+ *++=+

*++=+

B >p= costs 81*+=+

81*+=+

81*+=

+

81*+=

+

B :epreciation 8D=* 8

1+=+

875=+

815=

E!IT += 8*=+ ..=+ 57=*

B Ta;es H.+6+=7

811=*

1D=5

*/=7

E!ITH1 B T +=/ 815= *5=. 7D=178D



Terminal Cash Flows

-alvage value )*/

B Ta; on -4 H.+6 1+

AT salvage value )1/? ∆><C

Terminal CF )7/ *+

(Thousands of dollars)

FCF. E!ITH1 B T ? :E' B CA'E B ∆><C

)/.=D ? )7/ )=D

178



Terminal Cash Flows

J= Kow is ><C recovereL

J= Is there always a ta; on -4L

J= Is the ta; on -4 ever a positivecash fowL

178



-houl nancing e0ects %e inclue

in cash fowsL

• o, iviens an intereste;pense shoul not %e inclue inthe analysis=

• Financing e0ects have alreay%een taken into account %yiscounting cash fows at the

<ACC o 1+6=• :eucting interest e;pense an

iviens woul %e Nou%le

countingO nancing costs=1781+



-houl a )/+,+++ improvement cost rom theprevious year %e inclue in the analysisL

• o, the %uiling improvement costis a sunk cost an shoul not %econsiere=

• This analysis shoul only inclueincremental investment=

17811



I the acility coul %e lease out or )*/,+++per year, woul this a0ect the analysisL

• @es, %y accepting the pro$ect, the rmoregoes a possi%le annual cash fow o)*/,+++, which is an opportunity cost

to %e charge to the pro$ect=• The relevant cash fow is the annual

ater8ta; opportunity cost=

A8T opportunity cost&

)*/,+++H1 B T

)*/,+++H+=5

)1/,+++

1781*

I th t li th



I the new prouct line ecreases thesales o the rmPs other lines, woul thisa0ect the analysisL

• @es= The e0ect on other pro$ectsPCFs is an Ne;ternality=O

• et CF loss per year on other lines

woul %e a cost to this pro$ect=• E;ternalities can %e positive Hin

the case o complements or

negative Hsu%stitutes=

17817



'ropose 'ro$ectPs Cash Flow Time

9ine

• Enter CFs into calculator CF9> register, anenter I2@R 1+6=

'4 8).=+7IRR =76

MIRR =56

'ay%ack 7=7 years

+

8*5+

1 * 7 .

D=D 1=* 5*=. =D


1781.



I this were a replacement rather than anew pro$ect, woul the analysis changeL

• @es, the ol e(uipment woul %e sol, annew e(uipment purchase=

• The incremental CFs woul %e the changes

rom the ol to the new situation=• The relevant epreciation e;pense woul

%e the change with the new e(uipment=

• I the ol machine was sol, the rm woul

not receive the -4 at the en o themachinePs lie= This is the opportunity costor the replacement pro$ect=

1781/



<hat are the 7 types o pro$ect riskL

• -tan8alone risk

• Corporate risk

•

Market risk

17815



<hat is stan8alone riskL

• The pro$ectPs total risk, i it wereoperate inepenently=

• "sually measure %y stanareviation Hor coeQcient ovariation=

• Kowever, it ignores the rmPs

iversication among pro$ects aninvestorsP iversication amongrms=

1781D



<hat is corporate riskL

• The pro$ectPs risk whenconsiering the rmPs otherpro$ects, i=e=, iversication within

the rm=

• Corporate risk is a unction o thepro$ectPs '4 an stanar

eviation an its correlation withthe returns on other rm pro$ects=

1781



<hat is market riskL

• The pro$ectPs risk to a well8iversie investor=

• Theoretically, it is measure %ythe pro$ectPs %eta an it consiers%oth corporate an stockholeriversication=

1781



<hich type o risk is most relevantL

• Market risk is the most relevantrisk or capital pro$ects, %ecausemanagementPs primary goal is

shareholer wealth ma;imiation=

• Kowever, since corporate riska0ects creitors, customers,

suppliers, an employees, itshoul not %e completely ignore=

178*+



<hich risk is the easiest to

measureL

• -tan8alone risk is the easiest tomeasure= Firms oten ocus onstan8alone risk when making

capital %ugeting ecisions=

• Focusing on stan8alone risk is nottheoretically correct, %ut it oes

not necessarily lea to poorecisions=

178*1



Are the three types o risk generally

highly correlateL

• @es, since most pro$ects the rmunertakes are in its core%usiness, stan8alone risk is likely

to %e highly correlate with itscorporate risk=

• In aition, corporate risk is likely

to %e highly correlate with itsmarket risk=

178**



<hat is sensitivity analysisL

• -ensitivity analysis measures thee0ect o changes in a varia%le onthe pro$ectPs '4=

• To perorm a sensitivity analysis,all varia%les are ;e at theire;pecte values, e;cept or the

varia%le in (uestion which isallowe to fuctuate=

• Resulting changes in '4 are

note=178*7



<hat are the avantages anisavantages o sensitivity analysisL

• Avantage – Ienties varia%les that may have

the greatest potential impact on

prota%ility an allows managementto ocus on these varia%les=

• :isavantages –

:oes not refect the e0ects oiversication=

– :oes not incorporate any inormationa%out the possi%le magnitue o the

orecast errors=1*8*.



Evaluating 'ro$ects with "ne(ual

9ives

• Machines A an ! are mutually e;clusive,an will %e repurchase= I <ACC 1+6,which is %etterL

E;pecte et CFs

@ear Machine A Machine !+ H)/+,+++ H)/+,+++

1 1D,/++ 7.,+++

* 1D,/++ *D,/++

7 1D,/++ B

. 1D,/++ B

178*/

- l i i h



-olving or '4 with oRepetition

• Enter CFs into calculator CF9>register or %oth pro$ects, an enterI2@R 1+6= – '4A )/,.D*=5/ – '4! )7,575=75

• Is Machine A %etterL –

ee replacement chain an2ore(uivalent annual annuity analysis=

178*5



Replacement Chain

• "se the replacement chain to calculate ane;tene '4! to a common lie=

• -ince Machine ! has a *8year lie an

Machine A has a .8year lie, the commonlie is . years=

'4! )5,5.1=5* Hon e;tene %asis

8/+,+++ 7.,+++ *D,/++8/+,+++ 7.,+++

*D,/++8**,/++

+ 1 * 71+6

.

178*D



E(uivalent Annual Annuity

• "sing the previously solve pro$ect '4s,the EAA is the annual payment that thepro$ect woul provie i it were an annuity=

•

Machine A – Enter ., I2@R 1+, '4 8/.D*=5/, F4 +S

solve or 'MT EAAA )1,D*5=.5=

• Machine ! –

Enter *, I2@R 1+, '4 87575=75, F4 +Ssolve or 'MT EAA! )*,+/=*.=

• Machine ! is %etter

178*



I e;pecte infation e(uals /6 is

'4 %iaseL

• @es, infation causes the iscountrate to %e upwarly revise=

• Thereore, infation creates aownwar %ias on '4=

• Infation shoul %e %uilt into CForecasts=

178*



'ro$ect >perating Cash Flows, I E;pecteInfation /6

(Thousands of dollars) 1 * 7 .

Revenues *1+ **+ *7* *.7>p= costs H5+6 81*5 817* 817 81.5

B:epreciation 8D 81+ 875 81DE!IT / 8*+ /D +

BTa;es H.+6 * 8 *7 7*E!ITH1 B T 7 81* 7. .

?:epreciation D 1+ 75 1DE!ITH1 B T ? :E' * 5 D+ 5/

1787+



Consiering Infation&

'ro$ect CFs, '4, an IRR

• Enter CFs into calculator CF9> register,

an enter I2@R 1+6='4 )1/=+=

IRR 1*=56=

MIRR 11=56=

'ay%ack 7=1 years=

+

8*5+ *=1 5=1 D+=+ 5/=1

7/=+1++=1


D+=+ 5=1 *=1 8*5+FCFs

1 * 7 .

17871



'erorm a -cenario Analysis o the 'ro$ect,!ase on Changes in the -ales Forecast

• -uppose we are conent o allthe varia%le estimates, e;ceptunit sales= The actual unit sales

are e;pecte to ollow theollowing pro%a%ility istri%ution&Case 'ro%a%ility "nit -ales

<orst +=*/ D/,+++

!ase +=/+ 1++,+++!est +=*/ 1*/,+++

1787*



-cenario Analysis

• All other actors shall remainconstant an the '4 uner eachscenario can %e etermine=

Case 'ro%a%ility '4

<orst +=*/ H)*D=FI!ase +=/+ 1/=+!est +=*/ /D=F

17877



:etermining E;pecte '4, σ'4, an C4'4

rom the -cenario Analysis

1787.

+=1/)

IF=/DH)*/=+I+=1/H)/=+IF=*D)8H*/=+EH'4I

=

++=

7=7+)

UI+=1/)+=*/H)/D=F I+=1/)+=/H)1/=+I+=1/)=FV+=*/H8)*D

12**

**

'4

=

−+

−+−=σ

*=++)7+=72)1/=C4'4 ==

'4



'4 range is 1=*/81=D/, woul thispro$ect have high, average, or lowriskL

• <ith a C4'4 o *=+, this pro$ect

woul %e classie as a high8riskpro$ect=

• 'erhaps, some sort o riskcorrection is re(uire or properanalysis=

1787/

Is this pro$ect likely to %e correlate with the



Is this pro$ect likely to %e correlate with thermPs %usinessL Kow woul it contri%ute to thermPs overall riskL

• <e woul e;pect a positivecorrelation with the rmPsaggregate cash fows=

• As long as correlation is notperectly positive Hi=e=, W ≠ 1, wewoul e;pect it to contri%ute to

the lowering o the rmPs overallrisk=

17875

I the pro$ect ha a high correlation with



I the pro$ect ha a high correlation withthe economy, how woul corporate anmarket risk %e a0ecteL

• The pro$ectPs corporate risk woulnot %e irectly a0ecte= Kowever,when com%ine with the pro$ectPs

high stan8alone risk, correlationwith the economy woul suggestthat market risk H%eta is high=

1787D



I the rm uses a ?2876 risk a$ustment or thecost o capital, shoul the pro$ect %e accepteL

• Reevaluating this pro$ect at a 176cost o capital Hue to high stan8alone risk, the '4 o the pro$ect

is 8)*=*=• I, however, it were a low8risk

pro$ect, we woul use a D6 cost o

capital an the pro$ect '4 is)7.=1=

1787



<hat su%$ective risk actors shoul %econsiere %eore a ecision is maeL

• umerical analysis sometimesails to capture all sources o riskor a pro$ect=

• I the pro$ect has the potential ora lawsuit, it is more risky thanpreviously thought=

• I assets can %e reeploye orsol easily, the pro$ect may %eless risky than otherwise thought=

17 7

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Session 7-Chapter 13