14 - 1

Cash Flow Estimation and Risk

Analysis

 Relevant cash flows

 Working capital treatment
 Inflation
 Risk Analysis: Sensitivity
Analysis, Scenario Analysis, and
Simulation Analysis
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Proposed Project

 Cost: $240,000.
 Inventories will rise by $25,000 and
payables will rise by $5,000.
 Economic life = 4 years.
 Salvage value = $25,000.
 MACRS 3-year class.
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 Incremental gross sales = $250,000.

 Incremental cash operating costs =
$125,000.
 Tax rate = 40%.
 Overall cost of capital = 10%.
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Set up without numbers a time line for

the project CFs.

0 1 2 3 4
Initial OCF1 OCF2 OCF3 OCF4
Outlay + Terminal
CF
NCF0 NCF1 NCF2 NCF3 NCF4
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Incremental Cash Flow

= Corporate cash flow

with project
minus
Corporate cash flow
without project
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Should CFs include interest expense?

Dividends?

 NO. The costs of capital are already

incorporated in the analysis since
we use them in discounting.
 If we included them as cash flows,
we would be double counting capital
costs.
 14 - 7

Suppose $100,000 had been spent last

year to improve the production line
site. Should this cost be included in
the analysis?

 NO. This is a sunk cost. Focus on

incremental investment and
operating cash flows.
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Suppose the plant space could be

leased out for $25,000 a year. Would
this affect the analysis?

 Yes. Accepting the project means we

will not receive the $25,000. This is an
opportunity cost and it should be
charged to the project.
 A.T. opportunity cost = $25,000 (1 - T) =
$15,000 annual cost.
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If the new product line would decrease

sales of the firm’s other products by
$50,000 per year, would this affect the
analysis?

 Yes. The effects on the other

projects’ CFs are “externalities”.
 Net CF loss per year on other lines
would be a cost to this project.
 Externalities will be positive if new
projects are complements to existing
assets, negative if substitutes.
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Net Investment Outlay at t = 0 (000s)

Equipment ($240)
Change in NWC (20)
Net CF0 ($260)

NWC = $25,000 - $5,000

= $20,000.
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Annual Depreciation Expense (000s)

Year % x Basis = Depr.

1 0.33 $240 $ 79
2 0.45 108
3 0.15 36
4 0.07 17
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Year 1 Operating Cash Flows (000s)

Year 1
Net revenue $125
Depreciation (79)
Before-tax income $ 46
Taxes (40%) (18)
Net income $ 28
Depreciation 79
Net operating CF $107
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Year 4 Operating Cash Flows (000s)

Year 1 Year 4
Net revenue $125 $125
Depreciation (79) (17)
Before-tax income $ 46 $108
Taxes (40%) (18) (43)
Net income $ 28 $ 65
Depreciation 79 17
Net operating CF $107 $ 82
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Net Terminal Cash Flow at t = 4 (000s)

Salvage value $25

Tax on SV (10)
Recovery on NWC 20
Net terminal CF $35
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What if you terminate a project before

the asset is fully depreciated?

Cash flow from sale = Sale proceeds

- taxes paid.

Taxes are based on difference between

sales price and tax basis, where:

Basis = Original basis - Accum. deprec.

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Example: If Sold After 3 Years (000s)

 Original basis = $240.

 After 3 years = $17 remaining.
 Sales price = $25.
 Tax on sale = 0.4($25-$17)
= $3.2.
 Cash flow = $25-$3.2=$21.7.
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Project Net CFs on a Time Line

0 1 2 3 4

(260)* 107 118 89 117

Enter CFs in CFLO register and I = 10.

NPV = $81,573.
IRR = 23.8%.
*In thousands.
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What is the project’s MIRR? (000s)

0 1 2 3 4

(260)* 107 118 89 117.0

97.9
142.8
142.4
(260) 500.1
MIRR = ?
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Calculator Solution

1. Enter positive CFs in CFLO:

I = 10; Solve for NPV = $341.60.
2. Use TVM keys: PV = 341.60, N = 4
I = 10; PMT = 0; Solve for FV = 500.10.
(TV of inflows)
3. Use TVM keys: N = 4; FV = 500.10;
PV = -260; PMT= 0; Solve for I = 17.8.

MIRR = 17.8%.
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What is the project’s payback? (000s)

0 1 2 3 4

(260)* 107 118 89 117

Cumulative:
(260) (153) (35) 54 171

Payback = 2 + 35/89 = 2.4 years.

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If 5% inflation is expected over the

next 5 years, are the firm’s cash flow
estimates accurate?

 No. Net revenues are assumed to

be constant over the 4-year project
life, so inflation effects have not
been incorporated into the cash
flows.
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Real vs. Nominal Cash flows

 In DCF analysis, k includes an

estimate of inflation.
 If cash flow estimates are not
adjusted for inflation (i.e., are in
today’s dollars), this will bias the
NPV downward.
 This bias may offset the optimistic
bias of management.
 14 - 23

What does “risk” mean in

capital budgeting?

 Uncertainty about a project’s future

profitability.
 Measured by NPV, IRR, beta.
 Will taking on the project increase
the firm’s and stockholders’ risk?
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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.
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What three types of risk are relevant in

capital budgeting?

 Stand-alone risk
 Corporate risk
 Market (or beta) risk
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How is each type of risk measured, and

how do they relate to one another?
1. 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  or CV of NPV, IRR,
or MIRR.
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Probability Density
Flatter distribution,
larger , larger
stand-alone risk.

0 E(NPV) NPV
Such graphics are increasingly used
by corporations.
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2. Corporate Risk:
Reflects the project’s effect on
corporate earnings stability.
Considers firm’s other assets
(diversification within firm).
Depends on:
project’s , and
its correlation with returns on
firm’s other assets.
Measured by the project’s
corporate beta.
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Profitability
Project X

Total Firm
Rest of Firm

0 Years
1. Project X is negatively correlated to
firm’s other assets.
2. If r < 1.0, some diversification benefits.
3. If r = 1.0, no diversification effects.
 14 - 30

3. Market Risk:
Reflects the project’s effect on a
well-diversified stock portfolio.
Takes account of stockholders’
other assets.
Depends on project’s  and
correlation with the stock market.
Measured by the project’s market
beta.
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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.
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 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.
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What is sensitivity analysis?

 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%?”
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Illustration
Change from Resulting NPV (000s)
Base Level Unit Sales Salvage k

-30% $ 10 $78 $105

-20 35 80 97
-10 58 81 89
0 82 82 82
+10 105 83 74
+20 129 84 67
+30 153 85 61
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NPV
(000s)
Unit Sales

82 Salvage

-30 -20 -10 Base 10 20 30

Value
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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 k, so for this
project, should worry most about
accuracy of sales forecast.
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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
won’t fall.
 Ignores relationships among
variables.
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Why is sensitivity analysis useful?

 Gives some idea of stand-alone

risk.
 Identifies dangerous variables.
 Gives some breakeven information.
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What is scenario analysis?

 Examines several possible

situations, usually worst case,
most likely case, and best case.
 Provides a range of possible
outcomes.
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Assume we know with certainty all

variables except unit sales, which
could range from 900 to 1,600.
Scenario Probability NPV(000)
Worst 0.25 $ 15
Base 0.50 82
Best 0.25 148
E(NPV) = $ 82
(NPV) = 47
CV(NPV) = (NPV)/E(NPV) = 0.57
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If the firm’s average project has a CV of

0.2 to 0.4, is this a high-risk project?
What type of risk is being measured?

 Since CV = 0.57 > 0.4, this project

has high risk.
 CV measures a project’s stand-
alone risk. It does not reflect firm
or stockholder diversification.
 14 - 42

Would a project in a firm’s core

business likely be highly correlated
with the firm’s other assets?

 Yes. Economy and customer demand

would affect all core products.
 But each product would be more or
less successful, so correlation < +1.0.
 Core projects probably have corre-
lations within a range of +0.5 to +0.9.
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How do correlation and  affect

a project’s contribution to
corporate risk?
 If P is relatively high, then project’s
corporate risk will be high unless
diversification benefits are significant.
 If project cash flows are highly cor-
related with the firm’s aggregate cash
flows, then the project’s corporate risk
will be high if P is high.
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Would a core project in the furniture

business be highly correlated with the
general economy and thus with the
“market”?

 Probably. Furniture is a deferrable

luxury good, so sales are probably
correlated with but more volatile
than the general economy.
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Would correlation with the

economy affect market risk?

 Yes.
High correlation increases
market risk (beta).
Low correlation lowers it.
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With a 3% risk adjustment, should

our project be accepted?

 Project k = 10% + 3% = 13%.

 That’s 30% above base k.
 NPV = $60,541.
 Project remains acceptable after
accounting for differential (higher) risk.
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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.
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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.
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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.

(More...)
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 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.
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Probability Density

xxxx
xxxxxxx
xx xxxxxxx
xxx xxxxxxxx
xxxxxxxxxxxxxxx
xxxxxxxxxxxxxxxxxxxxxxxxx
0 E(NPV) NPV
Also gives NPV, CVNPV, probability
of NPV > 0.
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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.
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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.”

(More...)
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 Sensitivity, scenario, and simulation

analyses do not provide a decision
rule. They do not indicate whether a
project’s 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.
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Problem1
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Problem 2
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Problem 3
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Problem 4
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Problem 5
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Problem 6