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Chapter 13

Capital Budgeting: Estimating Cash Flows and Analyzing Risk


Calculate Cash Flows for the new project.
Calculate the cost of capital.
Apply capital budgeting techniques: NPV, IRR, etc..
Project has positive NPV.
Done?
No
Analyze Risk:
Sensitivity Analysis
Scenario Analysis
Simulation Analysis
Decision Trees

Capital Budgeting: Estimating Cash Flows and Analyzing Risk
To get the cash flows:
Year 0, middle years, last year
Building -cost
Equipment -cost
Operating cash flows:
Units sold
Sales price

Revenue(=units*price)
-Variable cost
-Fixed costs
-Depreciation
=EBIT
-Taxes (=EBIT*tax)
=NOPAT
+depreciation
= Operating CF
1
Operating CF
(last)

NOWC full amount higher/lower/equal to last 0
CF from NOWC -full amount last current + last years NOWC

Salvage value + salvage value CF

Net CF building + equip.+ operating CF + Last year s CF
CF from NOWC + salvage value (do this for all years)

Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Things to be mindful about :

Sunk Costs
These costs were incurred in the past and your decision to accept or reject the project
cannot change them.
Ignore

Opportunity Costs
Costs of letting go of the opportunity to do other things with the assets you need to put to
use for this project.
Include

Externalities
The trickle down effects on other parts of your business, for example, helping sales of
related products, increasing brand loyalty or cannibalizing an existing product line.
Include

Keep track of timing of cash flows.
Be as precise as possible,

Use real and current tax rates and depreciation rates.
Take account of installation costs to calculate the depreciable basis for an asset.
Take account of salvage value.
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
A new project is being considered by RIC with an economic life of 4 years.

RICs marketing VP believes that the new sales from the project will be 20,000
units per year priced at 3,000 each. The price will increase by 2% each year but
the number of units sold will not grow.

The engineering department reports that the project will require new space and
new machinery. The building can be bought for $12 million and the machinery for
$8 million. Building falls in MACRS 39-year class and machinery in 5-year class.

The building can be sold for $7.5 million and machinery for $2 million at the end of
projects life.

The production department estimates that the variable cost per year will be
$2,100 per unit for the first year and the fixed cost (excluding depreciation) will be
$8 million per year.

Variable cost will increase by 2% and fixed cost by 1% per year.

They also estimate that the project will require 10% of next years total sales as
net working capital each year.

RICs marginal tax rate is 40% and its WACC is 12%
Capital Budgeting: Estimating Cash Flows and Analyzing Risk

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A B C D E F G H I
0 1 2 3 4
I nvestment Outlays: Long-Term Assets
Building
Equipment
Operating Cash Flows over the Project's Life
Units sold
Sales price
Sales revenue
Variable cost per unit
Total Variable costs
Fixed operating costs
Depreciation (building)
Depreciation (equipment)
Oper. income before taxes (EBIT)
Taxes on operating income (40%)
Net Operating Profit After Taxes (NOPAT)
Add back depreciation
Operating cash flow
Cash Flows Due to Net Operating Working Capital
Net Operating Working Capital (based on sales)
Cash flow due to investment in NOWC
Salvage Cash Flows: Long-Term Assets
Net salvage cash flow: Building
Net salvage cash flow: Equipment
Total salvage cash flows
Net Cash Flow (Time line of cash flows)
Years
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A B C D E F G H I
0 1 2 3 4
I nvestment Outlays: Long-Term Assets
Building ($12,000)
Equipment (8,000)
Operating Cash Flows over the Project's Life
Units sold 20,000 20,000 20,000 20,000
Sales price $3.00 $3.06 $3.12 $3.18
Sales revenue $60,000 $61,200 $62,424 $63,672
Variable costs 42,000 42,840 43,697 44,571
Fixed operating costs 8,000 8,080 8,161 8,242
Depreciation (building) 156 312 312 312
Depreciation (equipment) 1,600 2,560 1,520 960
Oper. income before taxes (EBIT) 8,244 7,408 8,734 9,587
Taxes on operating income (40%) 3,298 2,963 3,494 3,835
Net Operating Profit After Taxes (NOPAT) 4,946 4,445 5,241 5,752
Add back depreciation 1,756 2,872 1,832 1,272
Operating cash flow $6,702 $7,317 $7,073 $7,024
Cash Flows Due to Net Operating Working Capital
Net Operating Working Capital (based on sales) $6,000 $6,120 $6,242 $6,367 $0
Cash flow due to investment in NOWC ($6,000) ($120) ($122) ($125) $6,367
Salvage Cash Flows: Long-Term Assets
Net salvage cash flow: Building $8,863
Net salvage cash flow: Equipment 1,744
Total salvage cash flows $10,607
Net Cash Flow (Time line of cash flows) ($26,000) $6,582 $7,194 $6,948 $23,999
Years
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Once your cash flows are in place and you have calculated things like NPV and IRR,
you need to get some idea of the risk of the project.

Where does risk come from?
Riskiness of project implies things will not be the same in reality as you
expected.
In other words, your cash flows might change from your projections.

What can make cash flows change?
Things can change for three broad reasons:
The project specific (and only those) factors (i.e. your decision variables)
change.
Stand-alone Risk
Company-wide factors change
Corporate Risk
Economy-wide conditions change and everyone is affected.
Market Risk (Systemic Risk)

Now rank these risks in the order of importance:
Market Risk
Corporate Risk
Stand alone Risk
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
How can we figure out how much stand alone risk is in a project?

We need to see what happens when the values of project variables
change.

Are we in trouble if the actual value of a variable is slightly different
from out base line scenario?

We can try to answer this question in three main ways:
Capital Budgeting: Estimating Cash Flows and Analyzing Risk

Sensitivity Analysis

The most straight forward thing to do would be to change our variables
within a broad (reasonable) range and see what happens.

We can do this by using Excel Table command and find out NPVs for
different values of a particular variable.

Which variables posses the most risk?

The ones for which a small change in the value brings about a relatively
large change in the final NPV.

The easiest way to figure it out is to make a graph of NPV values for each
range of values we gave to our variables in sensitivity analysis.

-30 -20 -10 Base 10 20 30
Value (%)
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NPV
(000s)
Unit Sales
Salvage
r
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
The variable posing the highest risk would have the steepest slope.

Once you have found your areas of concern, you need to sit down and
re-evaluate how confident you are in your projections of those
variables.

Suppose you are very confident.
For example, your NPV changes sharply if your variable cost changes
but you can enter a long term purchase agreement with your (very
reliable) supplier. So a change in that variable has maximum impact but
the likelihood of that happening is very low.

In this case, the risk of your project does not increase (at least because
of that one variable) and you may decide to go ahead with it.
Otherwise? What do you do otherwise?

You can subjectively increase your cost of capital (WACC) and run your
analysis one more time.

If it still comes out to be a winner, go for it.
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Previous discussion highlighted one point (or two if you are already
racing through all the what ifs in your mind).

1. The values of variables can change but what is the chance
(probability) of that happening.

2. In real life, not just one variable changes at a time, a
combination of them might change simultaneously.
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
We can handle that through what is called:

Scenario Analysis
Take a set of variables and change their values at the same time according to a possible
scenarios that you think might happen.

You can think of a lot of scenarios and in real life people do test for a multitude of
scenarios.

For the sake of simplicity in explaining, lets just go with three scenarios:

Base Case
The way things were when you originally did the analysis
Best Case
The most rosy picture of things
Worst Case
All hell breaks loose.
Well not really, but the worst it can reasonably go.

Find NPV for each scenario
Assign a probability to each scenario
Find the expected value, standard deviation and the coefficient of variation from those
NPVs.
Compare it with the CVs of firms regular projects.
If CV of NPVs is too high, what do you do?
Adjust the WACC and re-evaluate the project.
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Scenario Analysis
For the exercise we did in the lab, if we change our variable values for
different scenarios, we get the following NPVs:







Calculate the Expected NPV, standard deviation of NPV and the
coefficient of variation.

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A B C D E F G H
Sales Unit Variable Growth
Probability Price Sales Costs Rate NPV
25% $3.90 26,000 $1.47 30% $146,180
50% $3.00 20,000 $2.10 0% $5,809
25% $2.10 14,000 $2.73 -30% ($37,257)
Scenario
Worst Case
Base Case
Best Case
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
You would get the following values:










Now compare the CV to companys normal CV. If this value it higher than that, the project is
riskier than what the firm normally does.

What would you do then?


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D E F G H
Expected NPV = sum, prob times NPV $30,135
Standard Deviation = Sq Root of column I sum $69,267
Coefficient of Variation = Std Dev / Expected NPV 2.30
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
The companys normal WACC is 12%.
Suppose the firm adds 3% to WACC for projects that are as riskier as the
current one.
So, we recalculate the NPV using 15% WACC and we get the NPV of
$3454.
Will you accept this project?
Why?
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Well, why stop at 3 scenarios or 30 scenarios? Why not have a 1000 or 10,000
scenarios.
We can do that by using, what is called Monte-Carlo Simulation or just
Simulation Analysis
How can you think of so many values for so many variables?
You should not. If you think of the numbers yourself, you are violating the rules
of simulation analysis.
Those values should be random. You need to generate random values for each
of your variables.
But those random values should follow the overall behavior of the variables you
are simulating.
That is, they should be from the same probability as what you think your original
variable comes from.
If you think that your sales cost behaves like a normal random variable with a
mean (expected value) of $3.00 and 68% of the time will stay within $3 + or -
$0.35 then you would generate a normal random variable with mean 3 and
standard deviation 0.35.
Excel can do that for you.
And since, Excel does all the work, you can generate a very large number (in
fact, the larger the better) say, 10,000 values of your potential sales cost figure.
You do this for all the important variables (the one that can change) in your
analysis.
Find NPVs for all the 10,000 sets of numbers you have generated.
Find out the mean, standard deviation and the number of times your NPV goes
negative relative to total NPV figures
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Depending on how confident you want to be in statistical sense, if you see your
NPV crossing the negative line say more than 10% of the time, you will
categorize your project as risky. Or you can base your decision on the expected
value and standard deviation of the resulting NPVs.
The easiest way to see the results of simulation analysis is to make a histogram
of your NPV values. Like this:















Probability in this chart is the percentage of times, NPV was in that particular
range relative to total number of NPVs calculated (sample size).

-$60,000 $45,000 $150,000 $255,000 $360,000
NPV ($)
Probability
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Final what if for this section.
What if you had the choice to change tracks
mid-way? What if you had the choice to make
a different decision based on the outcome in
the future periods.

In this case, you can make a decision tree
and find out the possible NPVs and calculate
statistics like expected NPV, standard
deviation and coefficient of variation.
Lets take the example in the book.
Capital Budgeting: Estimating Cash Flows and Analyzing Risk

Stage 1: At t=0, the firm has the opportunity to spend $500,000 on a
feasibility study.

Stage 2: At t=1 the firm will learn whether the project appears feasible
(there is an 80% chance that the project will be feasible). If it is feasible,
the firm can spend $1,000,000 on a prototype.

Stage 3: At t=2 the firm will learn whether the prototype is successful
(there is a 60% chance the prototype will be successful). If it is
successful, the firm can spend $10,000,000 to launch the project.

Stage 4: At t=3 the firm will learn how well the market accepts the
project. There is a 30% chance the project will have cash flows of
$18,000,000 per year for 3 years, a 40% chance the project will have
cash flows of $8,000,000 per year for three years, and a 30% chance the
project will have cash flows of -$2,000,000 per year for three years. If
the project is not successful, the firm can abandon the project after t=3.
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
t0 t1 t2 t3 t4 t5












-500
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
t0 t1 t2 t3 t4 t5










-1,000

-500
Stop
0.8
0.2
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
t0 t1 t2 t3 t4 t5









-10,000
-1,000

Stop
-500

Stop
0.8
0.2
0.6
0.4
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
t0 t1 t2 t3 t4 t5








18,000 18,000 18,000
-10,000 8,000 8,000 8,000
-2,000 Stop
-1,000

Stop
-500

Stop


How many ways to travel through this tree to a different end node?
As many as the end nodes.
How many different scenarios?
As many as the end nodes.

0.8
0.2
0.6
0.4
0.3
0.4
0.3
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
t0 t1 t2 t3 t4 t5 Joint
Probability







18,000 18,000 18,000 0.144
-10,000 8,000 8,000 8,000 0.192
-2,000 Stop 0.144
-1,000

Stop 0.320
-500

Stop 0.200

Find the probability and the NPV for each scenario and then find the expected NPV,Standard deviation and
the CV.
WACC is 11.5%
0.8
0.2
0.6
0.4
0.3
0.4
0.3
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Time 0 1 2 3 4 5 NPV P
Cash Flows
Scenario:
1 -500 -1,000 -10,000 18,000 18,000 18,000 25,635 .144
2 -500 -1,000 -10,000 8,000 8,000 8,000 6,149 .192
3 -500 -1,000 -10,000 -2,000 -10,883 .144
4 -500 -1,000 -1,397 .320
5 -500 - 500 .200

`
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Expected NPV = 2,758
St dev = 10,584
CV = 3.84
Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Parker Products manufactures a variety of household products. The company is considering
introducing a new detergent. The company's CFO has collected the following information about the
proposed product. (Note: You may or may not need to use all of this information, use only the
information that is relevant.)
The project has an anticipated economic life of 4 years.
The company will have to purchase a new machine to produce the detergent. The machine has
an up-front cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4
years (that is, the company's depreciation expense will be $500,000 in each of the first four years (t =
1, 2, 3, and 4). The company anticipates that the machine will last for four years, and that after four
years, its salvage value will equal zero.
If the company goes ahead with the proposed product, it will have an effect on the company's
net operating working capital. At the outset, t = 0, inventory will increase by $140,000 and accounts
payable will increase by $40,000. At t = 4, the net operating working capital will be recovered after the
project is completed.
The detergent is expected to generate sales revenue of $1 million the first year (t = 1), $2
million the second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t = 4). Each
year the operating costs (not including depreciation) are expected to equal 50 percent of sales
revenue.
The company's interest expense each year will be $100,000.
The new detergent is expected to reduce the after-tax cash flows of the company's existing
products by $250,000 a year (t = 1, 2, 3, and 4).
The company's overall WACC is 10 percent. However, the proposed project is riskier than the
average project for Parker; the project's WACC is estimated to be 12 percent.
The company's tax rate is 40 percent.
What is the net present value of the proposed project?

Capital Budgeting: Estimating Cash Flows and Analyzing Risk
(In Thousands of Dollars)
t = 0 t = 1 t = 2 t = 3 t = 4
Initial cost
Change in NWC

Sales
Op. Costs
Depr.
Op. Inc. bef. taxes
Taxes (40%)
Oper. Inc. from project
Depr.
Change in other products

Net cash flow (NCF)

Capital Budgeting: Estimating Cash Flows and Analyzing Risk
(In Thousands of Dollars)
t = 0 t = 1 t = 2 t = 3 t = 4
Initial cost -2,000
Change in NWC -100 + 100

Sales $1,000 $2,000 $2,000 $1,000
Op. Costs 500 1,000 1,000 500
Depr. 500 500 500 500
Op. Inc. bef. taxes $ 0 $ 500 $ 500 $ 0
Taxes (40%) 0 200 200 0
Oper. Inc. from project $ 0 $ 300 $ 300 $ 0
Depr. 500 500 500 500
Change in other products - 250 - 250 - 250 - 250

Net cash flow (NCF) -2,100 $ 250 $ 550 $ 550 $ 350


NPV @ 12% = -$824,418.62

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