Chapter 13

Cash Flow Estimation and

Risk Analysis

Relevant Cash Flows

Types of Risk
Risk Analysis
NPV Profiles for Project S and L
 Determining Project Value

• Estimate relevant cash flows

– Calculating annual operating cash
flows.
– Identifying changes in net operating
working capital.
– Calculating terminal cash flows: after-
tax salvage value and recovery of
NOWC.

0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
FCF0 FCF1 FCF2 FCF3 FCF4
 Conceptual Issues in Cash
Flow Estimation
Free Cash Flow
Timing of Cash Flows
Incremental Cash Flows
Expansion Projects and Replacement
Projects
Sunk Cost - 已經發生並且無論專案
項目被接受還是拒絕都無法收回的
現金支出。
Opportunity Costs - 如果某些資產
不用於新專案項目下，該資產可以
獲得的最佳回報(獲利)。
Externalities (公司/環境的外部成本)
Cannibalization (蠶食; IBM/PC)
Complementary (iPod/iTunes)
Environmental Externalities
(Government Regulations/Rules)
Analysis of an Expansion Project
• Project S will require Allied to purchase $900,000
of equipment in 2017(t=0)
• Inventory will increase by $175,000 and accounts
payable will rise by $75,000. All other working
capital components will stay the same, so the
change in net operating working capital (NOWC) is
$100,000 at t 0.
• The project will last for four years. The company
forecasts the following sales: 2,685,000 units in
2018; 2,600,000 units in 2019; 2,525,000 units
in 2020; and 2,450,000 units in 2021. Each unit
will sell for $2.
• The fixed cost of producing the product is $2
million each year, and the variable cost of
producing each unit will rise from $1.018 in 2018
to $1.221 in 2021.
• The company will use accelerated depreciation,
however, the CFO is also interested in seeing how
the project’s value would change if it instead used
straight-line depreciation.
• When the project is completed in 2021 t 4 , the
company expects that it will be able to salvage the
equipment for $50,000 and that it will fully
recover the NOWC of $100,000.
• The estimated tax rate is 40%.
• Based on the perceived risk, the project’s WACC is
estimated to be 10%.
 Cash Flow Estimation and
Analysis for Expansion Project S
 Replacement Analysis
• Evaluate a replacement decision on both
a new, highly efficient machine
(depreciated on an accelerated basis)
and the old machine (depreciated on a
straight-line basis).
• The key inputs used in the analysis. No
additional operating working capital is
needed.
• Data applicable to both machines:
Sales revenues, remain constant $ 2,500
Expected life of the new and old machines
4 years; WACC for the analysis 10%; Tax
rate 40%
• Data for old machine:
Market (salvage) value of the old machine
today $ 400; Old labor, materials, and
other costs per year $ 1,000; Old
machine’s annual depreciation $ 100
• Data for new machine:
Cost of new machine $ 2,000; New labor,
materials, and other costs per year $ 400
Replacement Project R
 Three Types of Project Risk
• Stand-alone Risk :
The project’s total risk, uncertainty about its
cash flows.
Usually measured by standard deviation (or
coefficient of variation).
However, it ignores the firm’s diversification
among projects and investors’ 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 firm
projects.
• Market Risk
the riskiness of the project as seen by a well
diversified stockholder who recognizes (a) that
the project is only one of the firm’s assets and
(b) that the firm’s stock is but one part of his
or her stock portfolio.
The project’s market risk is measured by its
effect on the firm’s beta coefficient.
 Stand-Alone Risk
Sensitivity Analysis
• Percentage change in NPV
resulting from a given percentage
change in an input variable, other
things held constant.
Sensitivity Graph for Project S
Scenario Analysis for
Project S

Monte Carlo simulation