Cash Flow Estimation and Risk Analysis

Conceptual Issues in Cash Flow Estimation

Cash Flow versus Accounting Income
The firms value is based on cash flows because cash is what firms use to spend or reinvest. Any changes to working capital of a project directly affects cash flows but not net income.

Timing of Cash Flows

Deal with cash flows exactly when they occur. But for simplicity purposes, we assume year-end cash flows.

Incremental Cash Flows

A cash flow that will occur if and only if the firm takes on a project. They should be included in estimating cash flows.

Replacement Projects
Projects where the firm replaces existing assets to: a) Reduce costs and/or b) Increase operational efficiency.

Conceptual Issues in Cash Flow Estimation

Sunk Costs
A cash outlay that has already been incurred and that cant be recovered regardless of whether the project is accepted or rejected. They should not be included in estimating cash flows.

Opportunity Costs
The best returns that can be earned on assets the firm already own if those assets are not used for the new project. They should be included in estimating cash flows.

Externalities
They should be included in estimating cash flows. Negative Within-Firm Externalities (Cannibalization) for substitutable products Positive Within-Firm Externalities for complementary products Environment Externalities when a firms project can harm the environment (firm can boost up goodwill when spending for the environment)

Cash Flow Estimation and Risk Analysis

Estimating Cash Flows
Most important and most difficult step in Capital Budgeting If not reasonably accurate, no matter how sophisticated the analytical technique is, it can lead to poor decisions.

Financial staffs role in the forecasting process

Obtain information from various departments (engineering and marketing) Ensure the use of a consistent set of economic assumptions Make sure there are no biases inherent in the forecast

Identifying Relevant Cash Flows

Based on Cash Flows, not Accounting Income Only Include Incremental Cash Flows

1. Based on CFs
Free Cash Flow = EBIT(1-T) + Depreciation CAPEX Change in NOWC

1. Based on CFs
Free Cash Flow = EBIT(1-T) + Depreciation CAPEX Change in NOWC EBIT(1-T) = Interest expense is not subtracted because you still have to discount CF at the k or WACC wd(rd)(1-T) + wp(rp) + we(re). If you subtract interest, you double-count the cost of debt. Depreciation = Shields NI from tax but is not actually a cash expense, so must add back to get FCF CAPEX = Cost of fixed assets. You must use the full cost of the equipment, including shipping and installation charges. Depreciation basis = Cost + shipping + installation Change in NOWC Positive change additional funding is needed for inventories and receivables, therefore you have to deduct from FCF Negative change reduces cash needed to finance inventories and receivables, so you add back to FCF.

Answer the following: 13-1 : 12 million 13-2 : 2.6 million

2. Only include Incremental CFs

Incremental Cash Flows Change in CFs as a direct result of accepting the project Net Cash Flow attributable to an Investment Project Three Costs to take note of: Sunk Cost cost already incurred and is unrecoverable. Opportunity Cost return on the best alternative use of an asset Externalities effects of a project on cash flows in other parts of the firm. o Cannibalization when undertaking a project/introducing new product causes the sales of existing products to decline. Projects Incremental Cash Flow Corporate CF with the Project Corporate CF without the Project

3 problematic costs that may affect incremental CFs

Sunk Costs
Suppose P100,000 had been spent last year to improve the production line site. Should the cost be included in the analysis? Must not be reflected/included in the analysis

Opportunity Costs
Suppose the plant space could be leased out for P250,000 a year, and tax is 30% Would this affect the analysis? (P250,000 x (1-T)) = P175,000 (after tax OC) Must be reflected/included in the analysis

Externalities (e.g. Cannibalization)

Positive, if new projects are complements to existing assets, negative if substitutes. If the new product line would decrease sales of the firms other products by P50,000 per year, would this affect the analysis? Must be reflected/included in the analysis. Net CF loss per year on other lines would be a cost to this project.

Why is it important to include inflation when estimating cash flows?

Nominal r > real r. The cost of capital, r, includes a premium for inflation. Nominal CF > real CF. This is because nominal cash flows incorporate inflation. If you discount real CF with the higher nominal r, then your NPV estimate is too low.

Inflation (Continued)
Nominal CF should be discounted with nominal r, and real CF should be discounted with real r. It is more realistic to find the nominal CF (i.e., increase cash flow estimates with inflation) than it is to reduce the nominal r to a real r.

Sample Problem (Expansion Project v1):

Summit Inc. is planning an expansion project and has the following estimates relating to that particular project for the next four years (in thousands): Year 1 Year 2 Year 3 Year 4 Units 1,250 1,250 1,250 1,250 Unit price 200 206 212.18 218.55 Unit cost 100 103 106.09 109.27 Summit decides to buy an equipment costing $200,000. Shipping costs and installations are $20,000 and $20,000 respectively. Summit uses a 3-year MACRS class life method to compute for depreciation. The equipment can be sold after 4 years for $25,000. Taxes are 40%. Summit estimates that it needs net operating working capital of 12.36% of sales. Requirement 1: Calculate Summits: a) Operating Cash Flows for Years 1 to 4, and b) Free Cash Flows for Years 1 to 4. Requirement 2: Compute the Payback Period, Discounted Payback Period, NPV, IRR, and MIRR, if WACC is 10%. Should this project be undertaken?

Sample Problem (Expansion Project v2):

Summit Inc. has the following estimates for the next four years (in thousands): Year 1 Year 2 Year 3 Year 4 Units 1,250 1,250 1,250 1,250 Unit price 200 206 212.18 218.55 Unit cost 100 103 106.09 109.27 Summit decides to buy an equipment costing $200,000. Shipping costs and installations are $20,000 and $20,000 respectively. Summit uses a 3-year MACRS class life method to compute for depreciation. The equipment can be sold after 4 years for $25,000. Taxes are 40%. Summit estimates that it needs net operating working capital of 12.36% of sales. Summit intends to sell the equipment after 3 years. Requirement 1: Calculate Summits: a) Operating Cash Flows for Years 1 to 3, and b) Free Cash Flows for Years 1 to 3. Requirement 2: Compute the Payback Period, Discounted Payback Period, NPV, IRR, and MIRR, if WACC is 10%. Should this project be undertaken?

Sample Problem (Replacement Project):

Austen Inc. is considering whether it should replace its old machinery. The firm has gathered data below: Data applicable to both machines: Sales revenues, which would remain constant Expected life of the new and old machines WACC Tax rate Data for old machine: Market (salvage) value of the old machine today Old labor, materials, and other costs per year Old machines annual depreciation Data for new machine: Cost of new machine New labor, materials, and other costs per year $2,500 4 years 10% 40% $400 $1,000 $100 $2,000 $400

Should Austen replace its old machinery?

RISK ANALYSIS

What does risk mean in capital budgeting?

Uncertainty about a projects future profitability.
Measured by NPV, IRR, beta. Will taking on the project increase the firms and stockholders risk?

Is risk analysis based on historical data or subjective judgment?

Can sometimes use historical data, but generally cannot.
So risk analysis in capital budgeting is usually based on subjective judgments.

3 types of risk that are relevant in capital budgeting:

Stand-alone risk
Corporate risk

Market (or beta) risk

How is each type of risk measured, and how do they relate to one another?
1. Stand-Alone Risk:
The projects risk if it were the firms only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the or CV of NPV, IRR, or MIRR.

Advantages of Stand-alone Risk:

Easier to estimate than corporate risk and far easier to measure than market risk In general, all 3 types of risk are highly correlated, so if the general economy does well, so will the firm, and if the firm does well, so will most of its projects. It is a good proxy for hard to measure corporate and market risk.

Probability Density

Flatter distribution, larger , larger stand-alone risk.

E(NPV)

NPV

Such graphics are increasingly used by corporations.

2. Corporate Risk:
Reflects the projects effect on corporate earnings stability. Considers firms other assets (diversification within firm). Usually is of concern to small business and undiversified shareholders. Depends on:

projects , and its correlation, r, with returns on firms other assets.

Measured by the projects corporate beta.

What is a corporate beta?

A quantitative measure of corporate risk. Measures the volatility of returns on the project relative to the firm as a whole.

Profitability Project X

Total Firm
Rest of Firm

Years

1. Project X is negatively correlated to firms other assets. 2. If r < 1.0, some diversification benefits. 3. If r = 1.0, no diversification effects.

3. Market Risk:
Reflects the projects effect on a well-diversified stock portfolio. Takes account of stockholders other assets.

Depends on projects and correlation with the stock market. Measured by the projects market beta.

How does a corporate beta differ from a market beta?

A projects market beta is a similar quantitative measure of a projects market risk, but it measures the volatility of project returns relative to market returns.

How is each type of risk used?

Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk. Therefore, corporate risk is also relevant.

 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.

Techniques in measuring standalone risk:

Sensitivity Analysis Scenario Analysis Monte-Carlo Simulation

What is sensitivity analysis?

Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant. Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. Answers what if questions, e.g. What if sales decline by 30%?

Base-Case NPV the NPV when sales and other input variables are set equal to the most likely (or base-case) values.

Sensitivity Analysis
NPV with Variables at different deviations from base Deviation from Base Sales Price VC/Unit Units Sold Fixed Costs Equipment WACC 25% 2,256.86 -1,245.67 1202.37 -872.14 -71.26 33.62 0% 78.82 78.82 78.82 78.82 78.82 78.82 -25% -2,369.22 1,403.31 -1,044.73 1,029.78 228.90 127.62 Range 4,626.08 2,648.98 2,247.10 1,901.92 300.16 94.00

NPV (000s)

Unit Sales

88 r

Salvage

-30

-20

-10 Base 10 Value

20

30 (%)

Results of Sensitivity Analysis

Steeper sensitivity lines show greater risk. Small changes result in 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.

What are the weaknesses of sensitivity analysis?

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 wont fall. Ignores relationships among variables.

Why is sensitivity analysis useful?

Gives some idea of stand-alone risk.

Identifies dangerous variables.

Gives some breakeven information.

What is scenario analysis?

It is a risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely, or basecase, situation. Examines several possible situations, usually worst case, most likely case, and best case. Provides a range of possible outcomes. Base-Case Scenario
An analysis in which all of the input variables are set at their most likely values.

Worst-Case Scenario
An analysis in which all of the input variables are set at their worst reasonably forecasted values.

Best-Case Scenario
An analysis in which all of the input variables are set at their best reasonably forecasted values.

Best scenario: 1,600 units @ 240 Worst scenario: 900 units @ 160
Scenario Best Base Worst Probability 0.25 0.50 0.25 NPV(000) 279 88 -49

E(NPV) = 101.5 (NPV) = 116.75 CV(NPV) = (NPV)/E(NPV) = 1.15

Are there any 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, although subjective adjustments can be made.

What is a simulation analysis?

A computerized version of scenario analysis which uses continuous probability distributions. Computer selects values for each variable based on given probability distributions.
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.

 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.

Histogram of Results
Probability

-$60,000

$45,000

$150,000

$255,000

$360,000

NPV ($)

What are the advantages of simulation analysis?

Reflects the probability distributions of each input.

Shows range of NPVs, the expected NPV, NPV, and CVNPV. Gives an intuitive graph of the risk situation.

What are the disadvantages of simulation?

Difficult to specify probability distributions and correlations. If inputs are bad, output will be bad: Garbage in, garbage out.

 Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a projects expected return is sufficient to compensate for its risk. Sensitivity, scenario, and simulation analyses all ignore diversification. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting.

If the firms average project has a CV of 0.2 to 0.4, is this a high-risk project? What type of risk is being measured?
CV from scenarios = 0.74, CV from simulation = 0.62. Both are > 0.4, this project has high risk. CV measures a projects stand-alone risk. High stand-alone risk usually indicates high corporate and market risks.

With a 3% risk adjustment, should our project be accepted?

Project r = 10% + 3% = 13%.
Thats 30% above base r. NPV = 65,371. Project remains acceptable after accounting for differential (higher) risk.

Should subjective risk factors be considered?

Yes. A numerical analysis may not capture all of the risk factors inherent in the project.

For example, if the project has the potential for bringing on harmful lawsuits, then it might be riskier than a standard analysis would indicate.

UNEQUAL PROJECT LIVES

Analysis needed when a company is choosing between two projects that are:
Have significantly different lives Are mutually exclusive Can be repeated

UNEQUAL PROJECT LIVES

Two methods to evaluate these kinds of projects:
Replacement Chain (Common Life) Approach
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 Annuity Approach

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 the higher EAA should be chosen.

UNEQUAL PROJECT LIVES

The two approaches will always result to the same decision. Advantages of using the Replacement Chain Approach:
Easier to explain to senior managers. Easier to make modifications to the replacement chain data to deal with anticipated productivity improvements and asset price changes. Used when working with both engineers and non-engineers.

Advantages of using the Equivalent Annual Annuity Approach:

Easier to implement, especially when the longer project does not have exactly twice the life of the shorter one and hence more than two cycles are needed to find a common life. Used when working with engineers, but rarely with nonengineers.

S and L are mutually exclusive and will be repeated. r = 10%. Which is better?
Expected Net CFs Year Project S Project L ($100,000) 33,500 33,500 33,500 33,500

0
1 2 3 4

($100,000)
59,000 59,000 ---

Using Replacement Chain Analysis:

Using Equivalent Annual Annuity Approach: