CASH FLOW ESTIMATION

AND RISK ANALYSIS

Chapter 13

Nadya Khairunnisa (23/511774/NEK/27529)

Ario Guntara (23/524322/NEK/27853)
CONSEPTUAL ISSUES
IN CASH FLOW
ESTIMATION
The statement of Cash Flow is part of
company’s financial statements that show how
much cash the firm is generating.
FREE CASH FLOW VERSUS ACCOUNTING INCOME
In the last chapter, we showed that a project’s NPV is equal to the
present value of its discounted free cash flows.

Once the project is completed, the compancy sells the project’s

fixed assets and inventory and receives cash.

Taxes paid on salvaged assets = Tax Rate X (Salvaged value - Book Value
TIMING OF CASH FLOWS
In theory, capital budgeting analyses should deal with cash
flows exactly when they occure: therefore daily cash flows
theoritically would be better than annual flows. However, it
would be costly to estimate and analyze daily cash flows, and
they would probably be no more accurate than annual estimate
because simply cannot accurately forcast at daily level out 10
year or so into the future. Therefore, assume that all cash flows
occure at the end of the year.

INCREMENTAL CASH FLOWS

Incremental cash floes are flows that will occure if
and only if some specific event occures.
REPLACEMENT PROJECT
1. Expansion Projects
2. Replacement Projects

SUNK COST
A sunk cost is an outlay that was incurred in
the past and cannot be recovered in the future
regradless of whether the project under
consideration is accepted.
OPPORTUNITY COST
ASSOCIATED WITH ASSETS THE FIRM
OWNS
Oppoertunity Cost is the best return
that could be earned on assets the firm
already owns if those assets are not
used for the new project.

Example:
Home Depot owns land with MV of $2
milion and that land will be used for the
new store and only $15 million will be
required if HD decides to build it.
EXTERNALITIES
Negative Within-Firm Externalities

Positive Whitin-Firm Externalities

Enviromental Externalities
ANALYSIS
OF AN EXPANSION
PROJECT
DEPRECIATION
BASICS
1. Straight Line
2. MACRS (Accelerated Rate Depreciations)
EFFECT OF DIFFERENT DEPRECIATION RATES
If we replaced the accelerated depreciation numbers in Table 13.1
with the constant values that would exist under the straight-line
method, the result would be a free cash flow time line on row 28.

CANNIBALIZATION
Project S does not involve any cannibalization effects. Suppose,
that Project S would reduce the after-tax cash flows of another
division by $50 per year. No other firm would take on this project
if our firm turns it down.
OPPORTUNITY COST
Suppose that the project would save money by using some
equipment the company owns and that equipment would be sold for
$100 after-tax, if the project is rejected. The $100 is an opportunity
cost, and should add $100 to the project’s cost. The result would be
an NPV of $78.82 - $100 = -$21.18, so the project would now be
rejected.

SUNK COST
Suppose the firm had spent $150 on a marketing study to
estimate potential sales. This $150 could not be recovered
regardless of whether the project is accepted or rejected.
OTHER CHANGE
TO THE INPUTS
Variables other than depreciation also could
be varied, and these changes would alter the
calculated cash flows and thus NPV and IRR.
REPLACEMENT
ANALYSIS
To find incremental cash flow by find cash flow differentials
between the new and old projects. (Excel formula needed)

Elements that should be need to look at when doing

replacement analysis:
Depreciation rate
Cannibalisation
Opportunity cost
Salvage value
and other elements that influence cash flow
Example: evaluate a replacement decision with
data on both new, highly efficient machine
(accelerated basis) and old machine (straight-
line basis).

Data application to both machines:

Sales revenues, which would 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 cost 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 cost per year $400
RISK ANALYSIS
IN CAPITAL
BUDGETING
RISK ANALYSIS
IN CAPITAL BUDGETING
1. Stand-alone risk
The risk an asset would have if it were a firm’s
only asset and if investors owned only one stock.
It is measured by the variability of the asset’s
expected returns.
RISK ANALYSIS
IN CAPITAL BUDGETING
2. Corporate or within-firm risk
Risk considering the firm’s diversification, but
now stockholder diversification. It is measured by
a project’s effect on uncertainty about the firm’s
expected future returns.
RISK ANALYSIS
IN CAPITAL BUDGETING
3. Market (beta) risk
Considers both firm and stockholder
diversification. It is measured by the project’s
beta coefficient.
MEASURING
STAND-ALONE RISK
There are three techniques are used to
assess stand-alone risk:

1. Sensitivity analysis
2. Scenario analysis
3. Monte Carlo simulation
SENSITIVITY
ANALYSIS
Percentage change in NPV resulting from
a given percentage change in an input
variable, other things held constant.
SENSITIVITY
List of key inputs for Project S:
Equipment cost
Change in NOWC
Unit sales
Sales price

ANALYSIS Variable cost per unit

Fixed operating cost
Tax rate
WACC
SENSITIVITY
ANALYSIS
Strengths: Weaknesses:
Provides indication of stand- Does not reflect diversification
alone risk Says nothing about the likelihood
Identifies dangerous variables change in a variable
Gives some breakeven Ignores relationships among
information variables
SCENARIO
ANALYSIS
A risk analysis technique in which “bad”
and “good” sets of financial circumstances
are compared with a most likely, or base-
case situation.
SCENARIO
ANALYSIS
Base-Case Scenario (50%)

Worst-Case Scenario (25%)

Best-Case Scenario (25%)

SCENARIO
ANALYSIS
Problems:
Only considers a few possible outcomes
Assumes that inputs are perfectly
correlated (all “bad” values occur together
and all “good” values occur together)
Focuses on stand-alone risk
MONTE CARLO
SIMULATION
A risk analysis technique in which probable
future events are simulated on a computer,
generating estimated rates of return and
risk indexes
WITHIN-FIRM
AND BETA RISK
Measure diversification’s effects on risk, we need the
correlation coefficient between a project’s returns
and returns on the firm’s other assets (which need
historical data for new project that obviously do not
exist).
WITHIN-FIRM
AND BETA RISK
Conclusions:
1. It is very difficult to quantitatively measure projects’ within-
firm and beta risks
2. Most projects’ returns are positively correlated with returns
on the firm’s other assets and with returns on the stock
market
3. Experienced managers make many judgmental
assessments and also they bring subjective judgment into
the decision process
4. Good managers applied the analysis based on judgement
that used in finance theory
UNEQUAL
PROJECT LIVES
If a company is choosing between two projects
and those projects;
1. Have significantly different lives
2. Mutually exclusive
3. Can be repeated
the regular NPV method may not indicate the
better project
REPLACEMENT
CHAINS
A method of comparing projects with unequal lives that
assumes that each project can be repeated as many times as
necessary to reach a common life.

The NPVs over this life are then compared, and the project
with the higher common-life NPV is chosen.
EQUIVALENT
ANNUAL ANNUITIES (EAA)

A method that calculates the annual payments

that a project will provide if it is an annuity.

When comparing projects with unequal lives, the one with

higher equivalent annual annuity (EAA) should be chosen.
CONCLUSIONS
ABOUT UNEQUAL LIVES
The replacement chain and EAA methods
always result in the same decision

The EAA is a bit easier to implement for a

longer project

The replacement chain method is often

easier to explain to senior managers
THANK YOU
FOR LISTENING!
Don't Hesitate to Ask Any Questions to
Mrs. Wuri Handayani, S.E., Ak., M.Si.,
M.A., Ph.D. :)