A B C D E F G H I

1 7/21/2006
2
3 Chapter 12. Tool Kit for Cash Flow Estimation and Risk Analysis
4
5 ESTIMATING CASH FLOWS (Section 12.1)
6 For a new project, the incremental cash flows usually can be divided into the following categories: initial investment
7 outlay, operating cash flows over the project's life, NOWC cash flows, and salvage cash flows occuring at the project's
8 termination.
9
10 PROJECT ANALYSIS: AN EXAMPLE (Section 12.2)
11
12 In Part 1, we first list the key inputs used in the calculations. Part 2 goes on to calculate depreciation schedules for the
13 building and for the equipment. Part 3 then determines the after-tax salvage values (i.e., net cash flows) that will come
14 from disposing of the building and the equipment at the end of the project's life. Part 4 calculates the estimated cash
15 flows over each year of the project's life. Part 5 then uses the estimated cash flows to estimate the key outputs,
16 including the project's NPV, IRR, MIRR, and payback.
17
18 Note that all dollars are shown in thousands; this is done for convenience.
19
20
21 Table 12-1. Analysis of a New (Expansion) Project (Dollars in thousands)
22
23
24 Part 1. Input Data
25 Key Output: NPV = $5,809
26 Building cost (= Depreciable basis) $12,000
27 Equipment cost (= Depreciable basis) $8,000 Market value of building at salvage $7,500
28 Net Operating WC / Sales 10% Market value of equip. at salvage $2,000
29 First year sales (in units) 20,000 Tax rate 40%
30 Growth rate in units sold 0.0% WACC 12.0%
31 Sales price per unit $3.00 Inflation: growth in sales price 2.0%
32 Variable cost per unit $2.10 Inflation: growth in VC per unit 2.0%
33 Fixed costs $8,000 Inflation: growth in fixed costs 1.0%
34
35 Part 2. Depreciation Schedulea Years
36 1 2 3 4 Cumulative
37 2009 2010 2011 2012 Depr'n
38 Building depr'n rate 1.3% 2.6% 2.6% 2.6%
39 Building depr'n $156 $312 $312 $312 $1,092
40 Ending book val: Cost - cum. depr'n 11,844 11,532 11,220 $10,908
41
42 Equipment depr'n rate 20.0% 32.0% 19.0% 12.0%
43 Equipment depr'n $1,600 $2,560 $1,520 $960 $6,640
44 Ending book val: Cost - cum. depr'n 6,400 3,840 2,320 $1,360
45
46 aThe depreciation rates a re multiplied by the depre ciable basis ($12,000 for the building and $8,000 for the equipment) to dete rmine the yea rly
47 de precia tion expense . The correct de preciation percentages for the building depend upon the month tha t the building is put in service . Because this
48 analysis assume s that all cash flows occur at the end of the ye ar, and to prevent unnecessary complexity, we have rounded the de preciation
pe rcentages for the building. Se e the Worksheet named DeprTa ble s for more details.
49
50
51 Part 3. Net Salvage Values at End of Project
52 Building Equipment Total
53 Market value when salvaged $7,500 $2,000
54 Book value when salvagedb 10,908 1,360
55 Expected gain or lossc -3,408 640
56 Taxes paid or tax credit -1,363 256
57 Net cash flow from salvage d $8,863 $1,744 $10,607
58
59 b Book value equa ls de preciable ba sis (initia l cost in this case ) minus accumulated MACRS de preciation. For the building, accumula ted depre ciation
60 equals $1,092, so book value equa ls $12,000 - $1,092 = $10,908. For the equipment, accumula ted deprecia tion equa ls $6,640, so book value equals
61 $8,000 - $6,640 = $1,360.
62 c
Building: $7,500 ma rke t value - $10,908 book va lue = -$3,408, a loss. This represents a shortfall in de precia tion ta ken versus "true " depre ciation,
63 and it is treated a s an opera ting expense for Year 4. Equipme nt: $2,000 market value - $1,360 book value = $640, a profit. Here the de precia tion
64 charge e xce eds the "true " depre cia tion, and the diffe rence is called "de preciation reca pture." It is taxed a s ordinary income in Ye ar 4. The actual book
65 value at the time of disposition depends on the month of disposition. We have simplif ied the ana lysis and assume d that the re w ill be a full year of
de precia tion in Year 4.
66
67 d
Net cash flow from salvage equa ls sa lvage (ma rke t) va lue minus taxes. For the building, the loss results in a ta x credit, so net sa lvage value = $7,500
68 - (-$1,363) = $8,863.
69
70
71 Part 4. Projected Net Cash Flows Years
72 0 1 2 3 4
73 2008 2009 2010 2011 2012
74 Investment Outlays: Long-Term Assets
75 Building ($12,000)
76 Equipment (8,000)
77
78 Operating Cash Flows over the Project's Life
79 Units sold 20,000 20,000 20,000 20,000
80 Sales price $3.00 $3.06 $3.12 $3.18
81 Sales revenue $60,000 $61,200 $62,424 $63,672
82 Variable costs 42,000 42,840 43,697 44,571
83 Fixed operating costs 8,000 8,080 8,161 8,242
84 Depreciation (building) 156 312 312 312
85 Depreciation (equipment) 1,600 2,560 1,520 960
86 Oper. income before taxes (EBIT) 8,244 7,408 8,734 9,587
87 Taxes on operating income (40%) 3,298 2,963 3,494 3,835
88 Net operating profit after taxes (NOPAT) 4,946 4,445 5,241 5,752
89 Add back depreciation 1,756 2,872 1,832 1,272
90 Operating cash flow $6,702 $7,317 $7,073 $7,024
91
92 Cash Flows Due to Net Operating Working Capital
93 Net operating working capital (based on sales) $6,000 $6,120 $6,242 $6,367 $0
94 Cash flow due to investment in NOWC ($6,000) ($120) ($122) ($125) $6,367
95
96 Salvage Cash Flows: Long-Term Assets
97 Net salvage cash flow: Building $8,863
98 Net salvage cash flow: Equipment 1,744
99 Total salvage cash flows $10,607
100
101 Net cash flow (Time line of cash flows) ($26,000) $6,582 $7,194 $6,948 $23,999
102
103
104 Part 5. Key Output and Appraisal of the Proposed Project (WACC = 12%)
105
106 Net Present Value $5,809
107 IRR 20.12%
108 MIRR 17.79%
109 PI 1.22
110
111 Years
112 0 1 2 3 4
113 Cumulative cash flow for payback (19,418) (12,223) (5,275) 18,723
114 Part of year required for payback: 1.00 1.00 1.00 0.22
115 Payback = 3.22
116
117 Years
118 0 1 2 3 4
119 Discounted cash flow for payback: 5,877 5,735 4,945 15,252
120 Cumulative cash flow for payback (20,123) (14,388) (9,442) 5,809
121 Part of year required for payback: 1.00 1.00 1.00 0.39
122 Payback = 3.39
123
124
125
126
127 Based on the firm's 12% weighted average cost of capital, this project has a NPV of $5,809. Since the NPV is
128 positive,'we tentatively conclude that the project should be accepted. The IRR and MIRR confirm this decision because
129 both exceed the cost of capital. Note, though, that no risk analysis has been conducted. It is possible that the firm's
130 managers, after appraising the project's risk, might conclude that its projected return is insufficient to compensate for
131 its risk, and reject it.
132
133 PROJECT RISK ANALYSIS: TECHNIQUES FOR MEASURING STAND-ALONE RISK (Section 12.6)
134
135 Sensitivity Analysis
136
137
138 Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome.
139 For example, if there were a high probability that the $5,166 expected NPV as calculated above will actually turn out to
140 be negative, then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is,
141 typically, because sales were lower than expected, costs were higher than expected, or the project turned out to have a
higher than expected initial cost. In other words, if the assumed inputs turn out to be worse than expected, then the
142
output will likewise be worse than expected. We use data tables below to examine the project's sensitivity to changes in
143
the input variables.
144
145
146 Here we use an Excel "Data Table" to find NPV different unit sales, holding other thing constant.
147
148 % Deviation WACC % Deviation 1st YEAR UNIT SALES
149 from NPV from Units NPV
150 Base Case WACC 5,809 Base Case Sold $5,809
151 -30% 8.4% $9,030 -30% 14,000 -$3,628
152 -15% 10.2% $7,362 -15% 17,000 $1,091
153 0% 12.0% $5,809 Base Case 0% 20,000 $5,809
154 15% 13.8% $4,363 15% 23,000 $10,528
155 30% 15.6% $3,014 30% 26,000 $15,247
156
157
158 % Deviation VARIABLE COSTS % Deviation GROWTH RATE, UNITS
159 from Variable NPV from Growth NPV
160 Base Case Cost $5,809 Base Case Rate % $5,809
161 -30% $1.47 $29,404 -30% -30% -$4,923
162 -15% $1.79 $17,607 -15% -15% -$115
163 0% $2.10 $5,809 Base Case 0% 0% $5,809
164 15% $2.42 -$5,988 15% 15% $12,987
165 30% $2.73 -$17,785 30% 30% $21,556
166
167
168 % Deviation SALES PRICE % Deviation FIXED COSTS
169 from Sales NPV from Fixed NPV
170 Base Case Price $5,809 Base Case Costs $5,809
171 -30% $2.10 -$27,223 -30% $5,600 $10,243
172 -15% $2.55 -$10,707 -15% $6,800 $8,026
173 0% $3.00 $5,809 Base Case 0% $8,000 $5,809
174 15% $3.45 $22,326 15% $9,200 $3,593
175 30% $3.90 $38,842 30% $10,400 $1,376
176
177 We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:
178
179
180 Figure 12-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)
181
182
183 NPV ($)
$40,000 Sales price
184
Variable
185 $30,000 cost
186
Growth
187 $20,000 rate
188
Units sold
189 $10,000 Fixed cost
190
191 $0 WACC
192
193 ($10,000)
194
195 ($20,000)
196
197 ($30,000)
198 -30% -15% 0% 15% 30%
199
Deviation from Base-Case Value (%)
200
201
202
203 Deviation NPV at Different Deviations from Base
204 from Sales Variable Growth Year 1 Fixed
205 Base Case Price Cost/Unit Rate Units Sold Cost WACC
206 -30% ($27,223) $29,404 ($4,923) ($3,628) $10,243 $9,030
207 -15% ($10,707) $17,607 ($115) $1,091 $8,026 $7,362
208 0% $5,809 $5,809 $5,809 $5,809 $5,809 $5,809
209 15% $22,326 ($5,988) $12,987 $10,528 $3,593 $4,363
210 30% $38,842 ($17,785) $21,556 $15,247 $1,376 $3,014
211
212 Range $66,064 $47,189 $26,479 $18,875 $8,867 $6,016
213
214 We see from the tables and graph that NPV is most sensitive to changes in the sales price and variable
215 costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not very sensitive to
216 changes in WACC and fixed costs. Thus, the real issue is our confidence in the forecasts of the sales price
217 and variable costs, as well as the first-year sales and the growth rate in units sold.
218
219 NPV Breakeven Analysis
220
221 In breakeven analysis, we find the value of the input variable that produes a zero NPV. It is easiest to do
222 this with Goal Seek. For example, the screen shot below shows the Goal Seek inputs we used to set the cell
223 for NPV to a value of zero by changing the cell for the sales price. We repeated this for the other inputs.
224
225
226
227
228
229
230
231
232
233
234
235
236
237 Table 12-4. NPV Breakeven Analysis (Dollars in Thousands)
238
239 Input Input Value that Produces Zero NPV
240 Sales price $2.84
241 Variable cost/unit $2.26
242 Growth rate -14.7%
243 Year 1 units sold 16,307
244 Fixed cost $11,145
245 WACC 20.1%
246
247
248 Scenario Analysis
249
250 Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a
251 time, hence to see the combined effects of changes in several variables on NPV, and (2) It allows us to
bring in the probabilities of changes in the key variables. Part 7 provides a scenario analysis of the
252
computer project.
253
254 We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales, and the
255 unit growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base case levels
256 and then examine the situation when the key variables change. We assume that the company regards the
257 worst case as one where each of the three variables is 30% worse than the base level, and the best case has
258 each variable 30% better than base. We also assume that there is a 25% chance of the best and worst
259 cases, and a 50% chance of base case levels.
260
261 We used Tools-Scenarios to define the three different scenarios in the Scenario Manager dialog box. We
262 then used the Scenario Manager's Summary feature to creat a summary, shown in the worksheet "Scenario
263 Summary." We then copied the values from the Scenario Summary into the table below.
264
265 Table 12-5. Scenario Analysis (Dollars in Thousands) Squared
266 Deviation
267 Sales Unit Variable Growth Times
268 Scenario Probability Price Sales Costs Rate NPV Probability
269
270 Best Case 25% $3.90 26,000 $1.47 30% $146,180 3,366,596,001
271 Base Case 50% $3.00 20,000 $2.10 0% $5,809 ###
272 Worst Case 25% $2.10 14,000 $2.73 -30% ($37,257) ###
273 4797908060
274 Expected NPV = sum, prob times NPV $30,135
275 Standard Deviation = Sq Root of column I sum $69,267
276 Coefficient of Variation = Std Dev / Expected NPV 2.30
277 a. Probability Graph
278 Probability
279
280 50%
281
282
283 25%
284
285
286 (37,257) 0 30,135 146,180
287 5,809 NPV ($)
288 Most Likely Mean of distribution
289
290
291 b. Continuous Approximation
292
293 Probability Density
294
295
296
297
298 (37,257) 0 30,135 146,180
299 NPV ($)
300 5,809
301
302
303
304 An even easier way to do scenario analysis is with the Scenario Manager. To use this, click on Tools, then Scenarios. You
305 will get the dialog box shown below.
306
307 scenarios. See below for
308 instructions on how to create your
309 own.
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 To show one of the existing scenarios, simply highlight that scenario, click Show, and Excel will replace all the variables
328 in that scenario with the desired numbers. To create a new scenario, select the Add button shown above and you will get
329 the dialog box that guides you through the steps (the same steps apply if you want to edit a scenario).
330
331 The Scenario Manager also has another powerful feature. Suppose you have already defined several scenarios, as we
332 have, and you would like to see the inputs and selected outputs for the various scenarios. To do this, click on Tool,
333 Scenarios, and you will get the box shown above.
334
335
336 If you click on Summary, you will get the dialog box shown below.
337 In our case, we would like to see the NPV for each scenario. To do this,
338 enter the appropriate references in the results cells (such as the cell for
339 NPV), then click OK. You will get a new worksheet, called Scenario
340 Summary, with the results. To see our result, click on the Tab Scenario
341 Summary.
342
343
344 For those who want to use even more Excel features, you can give names to
345 the input and output cells before doing the Summary. To do this, select a
346 particular cell, such as the one with NPV, then put your cursor at the top left
347 of the sheet on the Name box which is to the left of the formula bar and type
348 in a new name, such as NPV. Then when you run the summary, the summary
349 table will have the name for the variable, and not its cell reference.
350
351 Monte Carlo Simulation
352
353 Monte Carlo simulation is similar to scenario analysis in that different values of key inputs are input. Unlike scenario
354 analysis, Monte Carlo simulation draws the input values from a specified probability distribution and then computes the
355 NPV. It repeats this process hundred, or even thousands, of times. It then averages the NPVs from each repetition. See
356 the file IFM9 Ch 13 Tool Kit Simulation.xls for a detailed example. To use this spreadsheet, you will need to install the
357 Excel Add-In Simtools.xla. See the file Explanation of Simulation.doc for an explanation of how to install the Add-In.
358
359 MANAGING RISK THROUGH PHASED DECISIONS: DECISION TREES (Section 12.9)
360
361 Stage 1: At t=0, the firm has the opportunity to spend $500,000 on a feasibility study.
362
363 Stage 2: At t=1 the firm will learn whether the project appears feasible (there is an 80% chance that the project will be
364 feasible). If it is feasible, the firm can spend $1,000,000 on a prototype.
365
366 Stage 3: At t=2 the firm will learn whether the prototype is successful (there is a 60% chance the prototype will be
367 successful). If it is successful, the firm can spend $10,000,000 to launch the project.
368
369 Stage 4: At t=3 the firm will learn how well the market accepts the project. There is a 30% chance the project will have
370 cash flows of $10,000,000 per year for 4 years, a 40% chance the project will have cash flows of $4,000,000 per year for
371 four years, and a 30% chance the project will have cash flows of -$2,000,000 per year for four years. If the project is not
372 successful, the firm can abandon the project after t=3.
373
374
375 Cost of capital = 11.5%
376
377 Join
378 t=0 t=1 t=2 t=3 t=4 t=5 Probability NPV Prob.xNPV
379
380 $18,000 $18,000 $18,000 0.144 $25,635 $3,691
381
0.3
($10,000) $8,000 $8,000 $8,000 0.192 $6,149 $1,181
382 0.4
383
384 0.6
($1,000) ($2,000) Stop 0.144 ($10,883) ($1,567)
0.3
385
386 ($500)
0.8 0.4 Stop 0.320 ($1,397) ($447)
387
388 0.2 Stop 0.200 ($500) ($100)
389
390 1.000 Expected NPV= $2,758
391
392 s= $10,584
393
Base Case

20000
0
3
2.1

Page 2
Best case

26000
0.3
3.9
1.47

Page 3
Worst case

14000
-0.3
2.1
2.73

Page 4
DEPRECIATION TABLES

Recovery Allowance Percentage for Personal Property

Class of Investment
Ownership Year 3-Year 5-Year 7-Year 10-Year

1 33% 20% 14% 10%

2 45% 32% 25% 18%
3 15% 19% 17% 14%
4 7% 12% 13% 12%
5 11% 9% 9%
6 6% 9% 7%
7 9% 7%
8 4% 7%
9 7%
10 6%
11 3%
100% 100% 100% 100%

MACRS for Residential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8
1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364%
2-27 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
28 1.970% 2.273% 2.576% 2.879% 3.182% 3.458% 3.636% 3.636%
29 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.152% 0.455%
99.99% 99.99% 99.99% 99.99% 99.99% 99.96% 99.99% 99.99%

MACRS for Nonresidential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8
1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963%
2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564%
40 0.107% 0.321% 0.535% 0.749% 0.963% 1.177% 1.391% 1.605%
100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Rounded Percentages Used in Analysis

Property Life (in years): 39
Depreciation in Year 1 (assuming half-year convention): 1.30%
Rounded Depreciation in Years 2-39: 2.60%
Depreciation in Year 40: 1.30%
 9 10 11 12
1.061% 0.758% 0.455% 0.152%
3.636% 3.636% 3.636% 3.636%
3.636% 3.636% 3.636% 3.636%
0.758% 1.061% 1.364% 1.667%
99.99% 99.99% 99.99% 99.99%

9 10 11 12
0.749% 0.535% 0.321% 0.107%
2.564% 2.564% 2.564% 2.564%
1.819% 2.033% 2.247% 2.461%
100.00% 100.00% 100.00% 100.00%
Scenario Summary
Current Values: Base Case Best case Worst case
Changing Cells:
$D$80 20,000 20,000 26,000 14,000
$D$81 0.0% 0.0% 30.0% -30.0%
$D$82 $3.00 $3.00 $3.90 $2.10
$D$83 $2.10 $2.10 $1.47 $2.73
Result Cells:
$D$153 $5,809 $5,809 $146,180 ($37,257)
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
 A B C D E F G H I J
1 REPLACEMENT ANALYSIS
2
3
In this model, we analyze the issue of whether a piece of equipment should be replaced. While the mechanics
4 of the analysis are somewhat different from the analysis for a new project, the process is similar in that we
5 are concerned with incremental cash flows. In this instance, we will be looking at a case that consists of net
6 salvage value being an intial benefit of the project. This replacement project is deemed by the firm to be of
7 relatively low risk, and is evaluated with a cost of capital of 11.5%
8
9 Input Data
10
11 Cost of the new machine $12,000
12 Reduction in operating costs $5,000
13 New machine's salvage value at end of Year 5 $2,000
14 Old machine's current market value $1,000
15 Old machine's current book value $2,500
16 Increase in Net Operating WC $1,000
17 Tax rate 40%
18 WACC 11.5%
19
20 MACRS 3-year Depreciation Schedule
21
22 Year 1 2 3 4
23 Depr. Rate 33% 45% 15% 7%
24 Depr. Exp. $3,960 $5,400 $1,800 $840
25
26 New depr. $3,960 $5,400 $1,800 $840 0
27 Old depr. $500 $500 $500 $500 $500
28 Net depr. $3,460 $4,900 $1,300 $340 -$500
29
30 Replacement Project Net Cash Flow Schedule
31 Year: 0 1 2 3 4 5
32 Section I. Investment Outlay
33 Cost of new equipment ($12,000)
34 Market value of old equipment 1,000
35 Tax savings on old equipment sale 600
36 Increase in net operating WC (1,000)
37
38
39 Section II. Operating Inflows over the Project's Life
40 Decrease in operating costs $5,000 $5,000 $5,000 $5,000 $5,000
41 Net change in depreciation 3,460 4,900 1,300 340 (500)
42 Net earnings before taxes 1,540 100 3,700 4,660 5,500
43 Taxes 616 40 1,480 1,864 2,200
44 Net operating profit after taxes 924 60 2,220 2,796 3,300
45 Add back depreciation 3,460 4,900 1,300 340 (500)
46 Net operating cash flows $4,384 $4,960 $3,520 $3,136 $2,800
47
48 Section III. Terminal Year Cash Flows
49 Estimated salvage value of new machine $2,000
50 Tax on salvage value (40%) (800)
51 Return of net operating WC 1,000
52 Total termination cash flows $2,200
53
54 Section IV. Net Cash Flow ($11,400) $4,384 $4,960 $3,520 $3,136 $5,000
55 Cumulative cash flows (for payback) ($11,400) ($7,016) ($2,056) $1,464 $4,600 $9,600
56 Part of year required for payback: 1.00 1.00 0.58 - -
57
58 Section V. Capital Budgeting Analysis
59 Net Present Value (11.5%) $3,991.08
60 IRR 25.03%
61 MIRR 18.40%
62 Payback (in years) 2.58
63
64
This project carries much less risk than the firm's average project, hence it was only evaluated at 11.5%. The project's
NPV is positive; therefore, it should be accepted. A review of the IRR and MIRR also indicate that this project should be
accepted because their values are greater than the 11.5% cost of capital. In addition, the payback period for this project
is not very long, so if the required payback for this project were 3 years then according to the payback criterion this
project would also be accepted.
SECTION 12.2
SOLUTION TO SELF-TEST

1a a. If the WACC is 15%, what is the new NPV?

WACC 15%
Years
0 1 2 3 4
CFs -$26,000 $6,582 $7,194 $6,948 $23,999

NPV = $3,454