Chapter 7:
Cash Flow Estimation
and Risk Analysis
Financial management
Free cash flow
OCF (Operating Cash Flow)
Assume that the firm invests in fixed assets and net operating working
capital only at t=0
After the initial investments, the project will hopefully produce positive
cash flows over its operating life.
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Salvage value
Once the project is completed, the company sells the project’s fixed assets
and NOWC and receives cash.
The price received for selling fixed asset is salvage value.
The company will also have to pay taxes if the asset’s salvage value
exceeds its book value.
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Timing of cash flows
We generally assume that all cash flows occur at the end of the year.
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Incremental cash flows
Incremental cash flows will occur if and only if the firm takes on a project.
You should always ask yourself “Will this cash flow occur ONLY if we accept the
project?”
➢ If the answer is “yes”, it should be included in the analysis because it is
incremental
➢ If the answer is “no”, it should not be included in the analysis because it will
occur anyway
➢ If the answer is “part of it”, then we should include the part that occurs
because of the project
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Sunk costs & Opportunity costs
Sunk costs - A cash outlay that has already been incurred and that cannot
be recovered regardless of whether the project is accepted or rejected.
→ Sunk costs are not relevant in the capital budgeting analysis.
Opportunity costs - The best return that could be earned on assets the
firm already owns if those assets are not used for the new project.
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Externalities
Externalities are effects on the firm or the environment that are not reflected in
the project’s cash flows
▪ Negative within-firm externalities (Cannibalization) - The situation when a
new project reduces cash flows that the firm would otherwise have had
▪ Positive within-firm externalities - A new project can be complementary to
an old one, in which cash flows in the old one will be increased
▪ Environmental externalities
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Analysis of an Expansion Project
Allied is considering introducing a new health-food product with
summarized information:
Initial investment
▪ Equipment: $900,000
▪ Changes in NOWC
Inventory will increase by $175,000
Accounts payable will rise by 75,00
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Analysis of an Expansion Project
Effect on operations
▪ Sales: 2,685,000; 2,600,000; 2,525,000 and 2,450,000 units in 4 years
@ $2 each
▪ Fixed cost: $2,000,000 each year
▪ Variable cost: $1.018; $1.078; $1.046 and $1.221 per unit in 4 years
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Analysis of an Expansion Project
▪ Depreciation method: accelerated
▪ Salvage value: $50,000
▪ Recover NOWC: $100,000
▪ Tax rate: 40%
▪ WACC: 10%
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Analysis of an Expansion Project
Cash flows are divided into three components
1. The initial investments required at t = 0
2. The operating cash flows received over the life of the project
3. The terminal cash flows realized when the project is completed
0 1 2 3 4
Initial OCF1 OCF2 OCF3 OCF4
Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
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Analysis of an Expansion Project
Initial year net cash flow
Find Δ NOWC
◼ ⇧ in inventories of $175
◼ Funded partly by an ⇧ in A/P of $75
→ Δ NOWC = $175 - $75 = $100
Combine Δ NOWC with initial costs
Capex -$900
Δ NOWC -100
→ Net CF0 -$1,000
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Analysis of an Expansion Project
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Analysis of an Expansion Project
Annual operating cash flows (thousands of dollars)
1 2 3 4
Sales 5,370 5,200 5,050 4,900
- Variable Costs 2,735 2,803 2,640 2,992
- Fixed Costs 2,000 2,000 2,000 2,000
- Depreciation 297 405 135 63
EBIT 338 -8 275 -155
- Tax (40%) 135 -3 110 -62
Operating Income (AT) 203 -5 165 -93
+ Depreciation 297 405 135 63
OCF 500 400 300 -30
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Analysis of an Expansion Project
Terminal net cash flow
Recovery of NOWC $100
Salvage value (SV) 50
Tax on SV (40%) -20
Terminal CF 130
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Analysis of an Expansion Project
Terminal net cash flow
0 1 2 3 4
-1000 500 400 300 -30
Terminal CF → 130
CF4 100
◼ NPV = $78.82
◼ IRR = 14.489%
◼ MIRR = 12.106%
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◼ Payback = 2.33 years
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Analysis of an Expansion Project
Effect of different depreciation rates
Accelerated vs straight-line method
CFs in the early years from straight-line method would be lower
and in the later years would be higher => lower NPV
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Analysis of an Expansion Project
Cannibalization
If the project reduces the after-tax cash flows of another division
by $50 per year, would this affect the analysis?
→ Yes. The effect on other projects’ CFs is an “externality”
(cannibalization / negative within-firm externality).
→ It must be calculated.
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Analysis of an Expansion Project
Opportunity costs
If the project uses some equipment the company now owns and
that equipment would be sold for $100, after taxes, would this
affect the analysis?
→ Yes. $100 is an opportunity cost → it should be reflected in our
calculations
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Analysis of an Expansion Project
Sunk costs
Suppose the firm had spent $150 on a marketing study to estimate
potential sales. Should the $150 be charged to the project when
determining its NPV for capital budgeting purpose?
→ No. This cost could not be recovered regardless of whether the
project is accepted or rejected.
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Risk Analysis
Three separate and distinct types of risk
1. Stand-Alone Risk - The risk an asset would have if it were a firm’s
only asset and if investors owned only one stock. It is measured by
the variability of the asset’s expected returns.
2. Corporate (Within-Firm) Risk - Risk considering the firm’s
diversification, but not stockholder diversification. It is measured by a
project’s effect on uncertainty about the firm’s expected future
returns.
3. Market (Beta) Risk - Considers both firm and stockholder
diversification. It is measured by the project’s beta coefficient.
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Risk Analysis
What type of risk is most relevant?
Market risk is theoretically the most relevant because
management’s primary goal is shareholder wealth
maximization but it is also the most difficult to estimate.
Usually calculate stand-alone risk and then consider the
other two risk measures in a qualitative manner.
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Risk Analysis
Are the three types of risk 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.
In addition, corporate risk is likely to be highly
correlated with its market risk.
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Risk Analysis
Risk-Adjusted Cost of Capital - The cost of capital
appropriate for a given project, given the riskiness of that
project. The greater the risk, the higher the cost of capital.
▪ Average-risk projects - WACC
▪ Higher-risk projects - WACC + % risk adjustment
▪ Lower-risk projects - WACC - % risk adjustment
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Stand-alone Risk
Three techniques to assess stand-alone risk
1. Sensitivity analysis
2. Scenario analysis
3. Monte Carlo simulation
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Stand-alone Risk
Sensitivity analysis - Percentage change in NPV resulting from a
given percentage change in an input variable, other things held
constant.
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.
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Stand-alone Risk
Advantage
Identifies variables that may have the greatest potential impact on
profitability and allows management to focus on these variables
Disadvantages
Does not reflect the effects of diversification
Does not incorporate any information about the possible magnitudes of
the forecast errors
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Stand-alone Risk
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Stand-alone Risk
Scenario analysis - A risk analysis technique in which “bad” and
“good” sets of financial circumstances are compared with a most
likely, or base-case, situation
• Base-Case Scenario - An analysis in which all inputs are set at their
most likely values
• Worst-Case Scenario - An analysis in which all inputs are set at their
worst reasonably forecasted values
• Best-Case Scenario - An analysis in which all inputs are set at their
best reasonably forecasted values
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Stand-alone Risk
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Stand-alone Risk
Scenario analysis
If the firm’s average projects have CVNPV about 2, would this
project be of high, average, or low risk?
→ CV of 6.19 indicates that this project is much riskier than most
of other projects => higher discount rate should be used to find the
project’s NPV (For example, WACC = 12.5% instead of 10%)
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Stand-alone Risk
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
Monte Carlo simulation, so named because this type of
analysis grew out of work on the mathematics of casino
gambling, is a sophisticated version of scenario analysis
Here the project is analyzed under a large number of
scenarios, or “runs.”
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Stand-alone Risk
Sensitivity analysis, scenario analysis, and Monte Carlo simulation dealt
with stand-alone risk
In theory, we should be more concerned with within-firm and beta risk
than with stand-alone risk
It is very difficult, if not impossible, to quantitatively measure projects’
within-firm and beta risks
Because stand-alone risk is correlated with within-firm and market risk,
not much is lost by focusing just on stand-alone risk
Experienced managers make many judgmental assessments, including
those related to risk. They consider quantitative NPVs, but they also
bring subjective judgment into the decision process
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End of Chapter 7
Financial management
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