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Chapter 7 Project Cash Flows and Risk

Chapter 7 Project Cash Flows and Risk. © 2005 Thomson/South-Western. Cash Flow Estimation. Most important and most difficult step in the analysis of a capital project Financial staff’s role includes: Coordinating other departments’ efforts

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Chapter 7 Project Cash Flows and Risk

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  1. Chapter 7 Project Cash Flows and Risk © 2005 Thomson/South-Western

  2. Cash Flow Estimation • Most important and most difficult step in the analysis of a capital project • Financial staff’s role includes: • Coordinating other departments’ efforts • Ensuring that everyone uses the same set of economic assumptions • Making sure that no biases are inherent in forecasts

  3. Relevant Cash Flows • Cash Flow Versus Accounting Income • Incremental Cash Flows

  4. 2010 Situation Accounting Profits Cash Flows Sales $50,000 $50,000 Costs except depreciation (25,000) (25,000) Depreciation (15,000) -- Net operating income or cash flow $10,000 $25,000 Taxes based on operating income (30%) (3,000)(3,000) Net income or net cash flow $7,000$22,000 Net cash flow = Net income plus depreciation = $7,000 + $15,000 = $22,000 Cash Flow Versus Accounting Income

  5. 2011 Situation Accounting Profits Cash Flows Sales $50,000 $50,000 Costs except depreciation (25,000) (25,000) Depreciation (5,000) -- Net operating income or cash flow $20,000 $25,000 Taxes based on operating income (30%) (6,000)(6,000) Net income or net cash flow $14,000$19,000 Net cash flow = Net income plus depreciation = $14,000 + $5,000 = $19,000 Cash Flow Versus Accounting Income

  6. Incremental Cash Flows An Incremental Cash Flow is the change in a firm’s net cash flow attributable to an investment project.

  7. Problems in Determining Incremental Cash Flows • Sunk Cost: A cash outlay that already has been incurred and cannot be recovered • Opportunity Cost: The return on the best alternative use of an asset • Externalities: The effect of accepting a project on the cash flows in other parts of the firm • Shipping and Installation Costs • Inflation

  8. Identifying Incremental Cash Flows • Initial Investment Outlay: the incremental cash flows associated with a project that will occur only at the start of a project’s life • Incremental Operating Cash Flow: the changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset • Terminal Cash Flow: the net cash flows that occur only at the end of a project’s life

  9. Incremental Operating Cash Flow Incrementaloperatingcash flowt = D Cash revenuest- DCash expensest- DTaxest = DNOIt x (1 - T) + DDeprt = (DSt - DOCt -DDeprt)x (1 - T) + DDeprt = (DSt - DOCt) x (1 - T) + T(DDeprt)

  10. Capital Budgeting Project Evaluation • Expansion Project: A project that is intended to increase sales; provides growth to the firm • Replacement Analysis: An analysis involving the decision of whether to replace an existing, still productive asset with a new asset

  11. Classwork 3 and 4

  12. Year 2010 $5,000 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $2,000(0.40) 2011 $5,480 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $3,200(0.40) 2012 $4,960 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $1,900(0.40) - - – 2013 $4,680 = ($30,000 $18,000 $5,000) (1 0.40) + $1,200(0.40) Expansion Project Analysis of the Cash Flows Incremental Operating Cash Flow Computation

  13. 0 1 2 3 4 2012 2013 2014 2010 2011 k = 15% (14,000) 4,384 4,143 3,261 6,038 $3,790 5,480 4,960 10,560 5,000 Net cashflows NPV= 26.3% IRR = Expansion Project Cash Flow Time Line Payback period = 2.7 years

  14. 2012 2013 2014 2010 2011 2015 0 1 2 3 4 5 k = 15% Net cashflows (11,400) 3,030 3,070 1,723 1,278 2,038 $(261) 4,060 2,620 2,236 4,100 3,484 NPV= 14.0% IRR = Replacement Project Cash Flow Time Line Payback period = 3.6 years

  15. Introduction to Project Risk Analysis • Stand-Alone Risk: the risk an asset would have if it were a firm’s only risk • Measured by the variability of the asset’s expected returns • Corporate (Within-Firm) Risk: risk not considering the effects of stockholder’s diversification • Measured by a project’s effect on the firm’s earnings variability • Beta (Market) Risk: partof a project’s risk that cannot be eliminated by diversification • Measured by the project’s beta coefficient

  16. Techniques for Measuring Stand-Alone Risk • Sensitivity Analysis: Key variables are changed and the resulting changes in the NPV and the IRR are observed. • Scenario Analysis: “Bad” and “good” sets of financial circumstances are compared with the most likely situation. • Monte Carlo Simulation: Probable future events are simulated on a computer.

  17. 80 Unit sales NPV (000s) 60 40 20 SV 0 k -20 -40 -30 -20 -10 0 10 20 30 % change from base -60 Base Sensitivity Analysis Graph

  18. E(NPV) = $15.0 (NPV) = $30.3 Scenario Analysis Assume we know all variables except unit sales, which could range from 75,000 to 125,000 (or 75 to 125). Here are the scenario NPVs:

  19. Standard Deviation: σNPV = $30.3 Coefficient of Variation: Scenario Analysis

  20. Advantages / Disadvantages of Simulation Analysis Advantages • Reflects probability of each input • Shows range of NPVs, expected NPV, σNPV, and CVNPV Disadvantages • Difficult to specify probability distributions and correlation • If inputs are bad, output will be bad: GIGO = Garbage In, Garbage Out!

  21. Beta (or Market) Risk and Required Rate of Return for a Project Security Market Line equation: kS = kRF + (kM - kRF)βs Erie Steel is all equity financed, so cost of equity is also its averaged required rate of return, or cost of capital. Erie’s β = 1.1; kRF = 8%; and kM = 12% kS = 8% + (12% - 8%)1.1 = 12.4% = Erie’s cost of equity Investors should be willing to give Erie money to invest in average-risk projects.

  22. Required Rate of Return for a Project kproj = the risk-adjusted required rate of return for an individual project kproj = kRF + (kM - kRF)bproj

  23. Measuring Beta Risk for a Project Pure Play Method: 1. Identify companies whose only business is the project in question. 2. Determine the beta for each company. 3. Average the betas to find an approximation of proposed project’s beta.

  24. How Project Risk Is Considered in Capital Budgeting Decisions Most firms use: Risk-Adjusted Discount Rate • Discount rate that applies to particularly risky stream of income • It is equal to the risk-free rate of interest plus a risk premium.

  25. Capital Rationing A situation in which a constraint is placed on the total size of the firm’s capital investment.

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