Cash Flow Estimation and Risk Analysis

12 - 1
CHAPTER 12
Cash Flow Estimation and
Risk Analysis
Relevant cash flows

Incorporating inflation
Types of risk
Risk analysis
Real options
Copyright © 2002 by Harcourt, Inc. All rights reserved.
12 - 2
Proposed Project
Cost: $200,000 + $10,000 shipping

+ $30,000 installation. Depreciable
cost: $240,000.
Inventories will rise by $25,000 and
payables by $5,000.
Economic life = 4 years.
Salvage value = $25,000.
MACRS 3-year class.
12 - 3
Sales: 100,000 units/year @ $2.

Variable cost = 60% of sales.
Tax rate = 40%.
WACC = 10%.

12 - 4
Set up, without numbers, a time line

for the project’s cash flows.
0 1 2 3 4
Initial OCF1 OCF2 OCF3 OCF4

Costs
+
(CF0)
Terminal
CF
NCF0 NCF1 NCF2 NCF3 NCF4

12 - 5
Investment at t = 0:
Equipment -$200
Installation & Shipping -40
Increase in inventories -25
Increase in A/P 5
Net CF0 -$260
DNOWC = $25 – $5 = $20.

12 - 6
What’s the annual depreciation?
Year Rate x Basis Depreciation

1 0.33 $240 $ 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
1.00 $240
Due to 1/2-year convention, a 3-year
asset is depreciated over 4 years.
12 - 7
Operating cash flows:
1 2 3 4
Revenues 200 200 200 200
Op. Cost, 60% -120 -120 -120 -120
Depreciation -79 -108 -36 -17
Oper. inc. (BT) 1 -28 44 63
Tax, 40% -- -11 18 25
Oper. inc. (AT) 1 -17 26 38
Add. Depr’n 79 108 36 17
Op. CF 80 91 62 55
12 - 8
Net Terminal CF at t = 4:
Recovery of NOWC $20

Salvage Value 25
Tax on SV (40%) -10
Net termination CF $35
Q. Always a tax on SV? Ever a

positive tax number?
Q. How is NOWC recovered?
12 - 9
Should CFs include interest expense?

Dividends?
No. The cost of capital is

accounted for by discounting at
the 10% WACC, so deducting
interest and dividends would be
“double counting” financing
costs.

12 - 10
Suppose $50,000 had been spent last
year to improve the building. Should
this cost be included in the analysis?
No. This is a sunk cost.

Analyze incremental investment.

12 - 11
Suppose the plant could be leased out

for $25,000 a year. Would this affect
the analysis?
Yes. Accepting the project means

foregoing the $25,000. This is an
opportunity cost, and it should be
charged to the project.
A.T. opportunity cost = $25,000(1 – T)
= $25,000(0.6) = $15,000 annual cost.
12 - 12
If the new product line would decrease
sales of the firm’s other lines, would
this affect the analysis?
Yes. The effect on other projects’ CFs

is an “externality.”
Net CF loss per year on other lines
would be a cost to this project.
Externalities can be positive or
negative, i.e., complements or
substitutes.
12 - 13
Here are all the project’s net CFs (in
thousands) on a time line:
0 1 2 3 4
k = 10%
-260 79.7 91.2 62.4 54.7

Terminal CF 35.0
89.7
Enter CFs in CF register, and I = 10%.

NPV = -$4.03.
IRR = 9.3%.
12 - 14
What’s the project’s MIRR?
0 1 2 3 4
-260 79.7 91.2 62.4 89.7

10% 68.6
10%
110.4
10% 106.1
MIRR = ? 374.8
-260
Can we solve using a calculator?

12 - 15
Yes. CF0 = 0
CF1 = 79.7
CF2 = 91.2
CF3 = 62.4
CF4 = 89.7
I = 10
NPV = 255.97
INPUTS 4 10 -255.97 0
N I/YR PV PMT FV
OUTPUT TV = FV = 374.8
12 - 16
Use the FV = TV of inputs to find MIRR
INPUTS 4 -260 0 374.8

N I/YR PV PMT FV
OUTPUT 9.6
MIRR = 9.6%. Since MIRR < k = 10%,

reject the project.
12 - 17
What’s the payback period?
0 1 2 3 4
-260 79.7 91.2 62.4 89.7
Cumulative:
-260 -180.3 -89.1 -26.7 63.0
Payback = 3 + 26.7/89.7 = 3.3 years.

12 - 18
If this were a replacement rather than a

new project, would the analysis change?
Yes. The old equipment would be

sold, and the incremental CFs would
be the changes from the old to the
new situation.

12 - 19
The relevant depreciation would be

the change with the new equipment.
Also, if the firm sold the old machine
now, it would not receive the SV at
the end of the machine’s life. This is
an opportunity cost for the
replacement project.

12 - 20
Q. If E(INFL) = 5%, is NPV biased?

CFt Re v t  Cost t
n
A. YES. NPV    .
t  0 1  k  1  k 
t t
k = k* + IP + DRP + LP + MRP.
Inflation is in denominator but not in

numerator, so downward bias to NPV.
Should build inflation into CF forecasts.
12 - 21
Consider project with 5% inflation.
Investment remains same, $260.
Terminal CF remains same, $35.
Operating cash flows:
1 2 3 4
Revenues 210 220 232 243
Op. cost 60% -126 -132 -139 -146
Depr’n -79 -108 -36 -17
Oper. inc. (BT) 5 -20 57 80
Tax, 40% 2 -8 23 32
Oper. inc. (AT) 3 -12 34 48
Add Depr’n 79 108 36 17
Op. CF 82 96 70 65
12 - 22
Here are all the project’s net CFs (in

thousands) when inflation is considered.
0 1 2 3 4
k = 10%
-260 82.1 96.1 70.0 65.1

Terminal CF 35.0
100.1
Enter CFs in CF register, and I = 10%.
NPV = $15.0. Project should be accepted.
IRR = 12.6%.
12 - 23
What are the 3 types of project risk?
Stand-alone risk
Corporate risk
Market risk

12 - 24
What is stand-alone risk?
The project’s total risk if it were

operated independently.
Usually measured by standard
deviation (or coefficient of
variation).
However, it ignores the firm’s
diversification among projects
and investor’s diversification
among firms.
12 - 25
What is corporate risk?
The project’s risk giving

consideration to 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 projects in
the firm.
12 - 26
What is market risk?
The project’s risk to a well-

diversified investor.
Theoretically, it is measured by
the project’s beta and it
considers both corporate and
stockholder diversification.

12 - 27
Which type of risk is most relevant?
Market risk is the most relevant

risk for capital projects, because
management’s primary goal is
shareholder wealth maximization.
However, since total risk affects
creditors, customers, suppliers,
and employees, it should not be
completely ignored.
12 - 28
Which risk is the easiest to measure?
Stand-alone risk is the easiest to

measure. Firms often focus on
stand-alone risk when making
capital budgeting decisions.
Focusing on stand-alone risk is
not theoretically correct, but it
does not necessarily lead to poor
decisions.
12 - 29
Are the three types of risk generally

highly correlated?
Yes. Since most projects the firm

undertakes are in its core business,
stand-alone risk is likely to be highly
correlated with its corporate risk,
which in turn is likely to be highly
correlated with its market risk.

12 - 30
What is sensitivity analysis?
 Sensitivity analysis measures the

effect of changes in a variable on the
project’s NPV.
 To perform a sensitivity analysis, all
variables are fixed at their expected
values, except for the variable in
question which is allowed to fluctuate.
 Resulting changes in NPV are noted.
12 - 31
What are the primary advantages and

disadvantages of sensitivity analysis?
ADVANTAGE:
Sensitivity analysis identifies variables
that may have the greatest potential
impact on profitability. This allows
management to focus on those
variables that are most important.

12 - 32
DISADVANTAGES:
Sensitivity analysis does not reflect
the effects of diversification.
Sensitivity analysis does not
incorporate any information about
the possible magnitudes of the
forecast errors.

12 - 33
Perform a scenario analysis of the
project, based on changes in the
sales forecast.
Assume that we are confident of all the
variables that affect the cash flows,
except unit sales. We expect unit sales
to adhere to the following profile:
Case Probability Unit sales
Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000
12 - 34
If cash costs are to remain 60% of

revenues, and all other factors are
constant, we can solve for project
NPV under each scenario.
Case Probability NPV

Worst 0.25 ($27.8)
Base 0.50 $15.0
Best 0.25 $57.8

12 - 35
Use these scenarios, with their given
probabilities, to find the project’s
expected NPV, NPV, and CVNPV.
E(NPV)=.25(-$27.8)+.5($15.0)+.25($57.8)
E(NPV)= $15.0.
NPV = [.25(-$27.8-$15.0)2 + .5($15.0-$15.0)2
+ .25($57.8-$15.0)2]1/2
NPV = $30.3.
CVNPV = $30.3 /$15.0 = 2.0.
12 - 36
The firm’s average projects have

coefficients of variation ranging from
1.25 to 1.75. Would this project be of
high, average, or low risk?
The project’s CV of 2.0 would

suggest that it would be
classified as high risk.

12 - 37
Is this project likely to be correlated
with the firm’s business? How would it
contribute to the firm’s overall risk?
We would expect a positive

correlation with the firm’s aggregate
cash flows.
As long as correlation is not
perfectly positive (i.e., r  1), we
would expect it to contribute to the
lowering of the firm’s total risk.
12 - 38
If the project had a high correlation
with the economy, how would
corporate and market risk be affected?
The project’s corporate risk would

not be directly affected. However,
when combined with the project’s
high stand-alone risk, correlation
with the economy would suggest
that market risk (beta) is high.

12 - 39
If the firm uses a +/-3% risk adjustment
for the cost of capital, should the
project be accepted?
Reevaluating this project at a 13%

cost of capital (due to high stand-
alone risk), the NPV of the project is
-$2.2 .
If, however, it were a low-risk
project, we would use a 7% cost of
capital and the project NPV is $34.1.
12 - 40
What subjective risk factors should be

considered before a decision is made?
Numerical analysis sometimes fails

to capture all sources of risk for a
project.
If the project has the potential for a
lawsuit, it is more risky than
previously thought.
If assets can be redeployed or sold
easily, the project may be less risky.
12 - 41
What is real option analysis?
Real options exist when managers

can influence the size and riskiness
of a project’s cash flows by taking
different actions during the project’s
life.
Real option analysis incorporates
typical NPV budgeting analysis with
an analysis for opportunities
resulting from managers’ decisions.
12 - 42
What are some examples of

real options?
Investment timing options

Abandonment/shutdown options
Growth/expansion options
Flexibility options

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12 - 1

Relevant cash flows

Cost: $200,000 + $10,000 shipping

Sales: 100,000 units/year @ $2.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Set up, without numbers, a time line

Initial OCF1 OCF2 OCF3 OCF4

NCF0 NCF1 NCF2 NCF3 NCF4

Copyright © 2002 by Harcourt, Inc. All rights reserved.

DNOWC = $25 – $5 = $20.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s the annual depreciation?

Year Rate x Basis Depreciation

Operating cash flows:

Recovery of NOWC $20

Q. Always a tax on SV? Ever a

Should CFs include interest expense?

No. The cost of capital is

Copyright © 2002 by Harcourt, Inc. All rights reserved.

No. This is a sunk cost.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Suppose the plant could be leased out

Yes. Accepting the project means

Yes. The effect on other projects’ CFs

-260 79.7 91.2 62.4 54.7

Enter CFs in CF register, and I = 10%.

What’s the project’s MIRR?

-260 79.7 91.2 62.4 89.7

Can we solve using a calculator?

Use the FV = TV of inputs to find MIRR

INPUTS 4 -260 0 374.8

MIRR = 9.6%. Since MIRR < k = 10%,

What’s the payback period?

-260 79.7 91.2 62.4 89.7

Payback = 3 + 26.7/89.7 = 3.3 years.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

If this were a replacement rather than a

Yes. The old equipment would be

Copyright © 2002 by Harcourt, Inc. All rights reserved.

The relevant depreciation would be

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Q. If E(INFL) = 5%, is NPV biased?

Inflation is in denominator but not in

Here are all the project’s net CFs (in

-260 82.1 96.1 70.0 65.1

What are the 3 types of project risk?

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What is stand-alone risk?

The project’s total risk if it were

What is corporate risk?

The project’s risk giving

What is market risk?

The project’s risk to a well-

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Which type of risk is most relevant?

Market risk is the most relevant

Which risk is the easiest to measure?

Stand-alone risk is the easiest to