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