CHAPTER 13

1. CHAPTER 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk

2. Chapter Topics • Estimating cash flows: • Issues in Project Analysis • Depreciation & Tax Effects on Salvage Value • Inflation • Risk Analysis: • Sensitivity Analysis • Scenario Analysis • Simulation Analysis • Decision Trees • Real Options

3. Relevant Cash Flows:Incremental Cash Flow for a Project • Project’s incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project.

4. Free Cash Flow Capital Expenditures = FA + Deprec ΔNOWC = Current Operating Assets – Current Operating Liabilities Current Operating Assets excludes Marketable Securities Current Operating Liabilities excludes Notes Payable

5. Free Cash Flow “Investment outlay CF = CF0 “Operating CF” = Net Income + Non-cash items (deprec) each year “NOWC CF” = Net working capital requirements each year “Salvage CF” = After-tax salvage value of assets and NOWC recovery

6. Issues in Project Analysis • Purchase of Fixed Assets …………… Y • Non-cash charges …………………….. Y • Changes in Net Working Capital……Y • Interest/Dividends …………..……….. N • “Sunk” Costs …………………………….. N • Opportunity Costs …………………….. Y • Externalities/Cannibalism …………… Y • Tax Effects ………………………..…….. Y

7. Depreciation Basics • Straight Line  Salvage Value • MACRS  0 • Recovery Period = Class Life • 1/2 Year Convention

8. MACRS Depreciation Classes TABLE 13.1

9. MACRS Depreciation TABLE 13.2

10. Annual Depreciation Expense (000s) SCC (Minicase): Equipment cost $200 Shipping 10 Installation 30  Book Depr Value 79.2 160.8 187.2 52.8 223.2 16.8 240.0 0 % 0.33 0.45 0.15 0.07 x Basis = Year 1 2 3 4 Depr $ 79.2 108.0 36.0 16.8 $240

11. Tax Effect on Salvage • Net Cash flow from sale = Sale proceeds • - taxes paid • Tax basis = difference between sales price • and book value, where: • Book value = Original basis • - Accumulated depreciation

12. Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling Price BV = Book Value T = Corporate tax rate

13. Example: If Asset Sold After 3 Years • BV (EOY 3) = $17 • IF: Selling price = $20 • TCF = $20 - (20-17)(.4) = $18.8 • IF: Selling price = $10 • TCF = $10 - (10-17)(.4) = $12.8

14. Adjusting for Inflation • Nominal r > real r • The cost of capital, r, includes a premium for inflation • Nominal CF > real CF • Nominal cash flows incorporate inflation • If you discount real CF with the higher nominal r, then your NPV estimate is biased downward.

15. INFLATION Real vs. Nominal Cash flows Real Nominal

16. INFLATION Real vs. Nominal Cash flows • 2 Ways to adjust • Adjust WACC • Cash Flows = Real • Adjust WACC to remove inflation • Adjust Cash Flows for Inflation • Use Nominal WACC

17. Regency Integrated Chips

18. RIC – Depreciation & Salvage Value

19. RIC – Sales, Costs and NWC

20. RIC – Cash Flow Estimation

21. RIC: Cash Flow Analysis

22. Excel Functions

23. RIC Background Data Salvage Value Key Basic Calculations Cash Flow Estimation Cash Flow Analysis

24. “Risk” in Capital Budgeting • Uncertainty about a project’s future profitability • Measured by σNPV, σIRR, beta • Will taking on the project increase the firm’s and stockholders’ risk?

25. Three types of relevant risk • Stand-alone risk • Corporate risk • Market (or beta) risk

26. Stand-Alone Risk • The project’s risk if it were the firm’s only asset and there were no shareholders. • Ignores both firm and shareholder diversification. • Measured by the σ or CV of NPV, IRR, or MIRR.

27. Flatter distribution, larger , larger stand-alone risk. NPV 0 E(NPV) Probability Density

28. Corporate Risk • Reflects the project’s effect on corporate earnings stability. • Considers firm’s other assets (diversification within firm). • Depends on project’s σ, and its correlation, ρ, with returns on firm’s other assets. • Measured by the project’s corporate beta.

29. Project X is negatively correlated to firm’s other assets → big diversification benefits If r = 1.0, no diversification benefits. If r < 1.0, some diversification benefits Profitability Project X Total Firm Rest of Firm 0 Years

30. Market Risk • Reflects the project’s effect on a well-diversified stock portfolio. • Takes account of stockholders’ other assets. • Depends on project’s σ and correlation with the stock market. • Measured by the project’s market beta.

31. Conclusions on Risk • Stand-alone risk is easiest to measure, more intuitive. • Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. • If the project is highly correlated with the economy, stand-alone risk also reflects market risk.

32. Sensitivity Analysis • Shows how changes in an input variable affect NPV or IRR • Each variable is fixed except one • Change one variable to measure the effect on NPV or IRR • Answers “what if” questions

33. RIC: Sensitivity Analysis

34. RIC: Sensitivity Graph

35. Results of Sensitivity Analysis • Steeper sensitivity lines = greater risk • Small changes → large declines in NPV • Unit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast

36. RIC: Sensitivity Analysis

37. 14-37 Sensitivity Ratio • %NPV = (New NPV - Base NPV)/Base NPV • %VAR = (New VAR - Base VAR)/Base VAR • If SR>0  Direct relationship • If SR<0  Inverse relationship

38. RIC: Sensitivity Ratios

39. RIC: Sensitivity Ratios & Graph

40. Sensitivity Analysis:Weaknesses • Does not reflect diversification • Says nothing about the likelihood of change in a variable • i.e. a steep sales line is not a problem if sales won’t fall • Ignores relationships among variables

41. Sensitivity Analysis:Strengths • Provides indication of stand-alone risk • Identifies dangerous variables • Gives some breakeven information

42. Scenario Analysis • Examines several possible situations, usually: • Worst case • Base case or most likely case, and • Best case • Provides a range of possible outcomes

43. RIC: Scenario Analysis

44. RIC: Scenario Analysis

45. Problems with Scenario Analysis • Only considers a few possible out-comes • Assumes that inputs are perfectly correlated • All “bad” values occur together and all “good” values occur together • Focuses on stand-alone risk

46. Monte Carlo Simulation Analysis • A computerized version of scenario analysis which uses continuous probability distributions • Computer selects values for each variable based on given probability distributions

47. Monte Carlo Simulation Analysis • NPV and IRR are calculated • Process is repeated many times (1,000 or more) • End result: Probability distribution of NPV and IRR based on sample of simulated values • Generally shown graphically

48. Histogram of Results

49. Advantages of Simulation Analysis • Reflects the probability distributions of each input • Shows range of NPVs, the expected NPV, σNPV, and CVNPV • Gives an intuitive graph of the risk situation

50. Disadvantages of Simulation Analysis • Difficult to specify probability distributions and correlations • If inputs are bad, output will be bad:“Garbage in, garbage out”