Capital Budgeting: Estimating Cash Flows and Analyzing Risk

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Capital Budgeting Estimating Cash Flows and
Analyzing Risk

• Chapter 13

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Estimating Cash Flows

• Most important and most difficult step in capital
  budgeting
• Consider relevant CFs
• Use CF not accounting income
• Only incremental CFs are relevant
• CFs with project minus CFs without project
• _____ costs are NOT relevant
• ___________ costs are relevant
• Externalities
• effects of a project on other parts of firm
  (e.g., cannibalization)
• difficult to quantify but are relevant

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Tax Effects

• Higher depreciation
• increases CF because it lowers taxes
• MACRS
• depreciation method used for tax purposes
• shortens the depreciable lives
• depreciation expense is determined by multiplying
  the depreciable basis by the applicable recovery
  percentage
• depreciable basis is price plus shipping and
  installation
• For capital budgeting, use ________

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Mini Case Chapter 13

• Shrieves Casting is considering adding a new line
  to its product mix. New line will be set up in
  unused space at main plant. Machinery costs
  200,000 plus 10,000 in shipping and 30,000 to
  install. Machinery has economic life of 4 years
  but for tax purposes it is in the MACRS 3-year
  class. Expected salvage value is 25,000 after 4
  years of use.
• The new line will generate incremental sales of
  1250 units per year for 4 years at an incremental
  cost of 100 per unit in the first year,
  excluding depreciation. Each unit can be sold
  for 200 in the first year. The sales price and
  costs are both expected to increase 3 per year
  due to inflation.
• To handle the new line, the firms net operating
  working capital would have to increase by an
  amount equal to 12 of next years sales
  revenues.
• Tax rate is 40 and WACC is 10.

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Interest expense and dividends

• Do we need to worry about subtracting interest
  expense and dividends when calculating cash
  flows?
• We discount project CFs with a cost of capital
  that is the rate of return required by ALL
  investors, so we should discount the total amount
  of CF available to all investors
• Essentially, dividends and interest are part of
  the costs of capital. If we subtract them, we
  are double counting the costs of capital.

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Mini Case Chapter 13

• If the firm spent 100,000 last year to
  rehabilitate the production line, do we include
  this cost?
• If the plant space could be leased to another
  firm for 25,000, do we include this?
• If the new line is expected to decrease sales of
  other lines by 50,000, do we include this?

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Mini Case Cash Flows

• Net Investment (at t0) or Initial cost

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Mini Case Cash Flows

• Depreciation
• Depreciable basis
• Using MACRSYear Basis Depr1 33 2 45
  3 15 4 7

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Mini Case Cash Flows

• Annual sales and costs Year 1 Year
  2 Year 3 Year 4Units 1250Unit
  price 200Unit cost 100 Sales 250,000 C
  osts 125,000

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Inflation

• Why?
• Nominal r gt real r.
• Cost of capital includes premium for inflation.
• Nominal CF gt real CF
• Nominal CFs incorporate inflation
• Discounting a real CF with a nominal r will
  _________ your NPV
• So, be consistent
• More realistic to find nominal CFs (i.e.,
  increase CFs to include inflation effects) than
  to reduce nominal r to real r.

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Mini Case Cash Flows

• Operating CFs

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Mini Case Cash Flows

• Formula to estimate CFsFCF NOPAT
  Depreciation Gross Fixed Asset
  Expenditures - ?NOWCFCF EBIT(1-T)
  Depreciation Gross Fixed Asset
  Expenditures (?Operating Current
  Assets - ?Operating Current Liabilities)

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Mini Case Cash Flows

• Investments in NOWCYear Sales NOWC CF
  01 250,0002 257,5003 265,2254
  273,188 Remember that you recover (sell)
  NOWC in last year

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Mini Case Cash Flows

• Salvage CF at t4
• What if terminated before fully depreciated?
• CF from Sale Sale proceeds Taxes paid
• Taxes are based on basis
• Basis Original basis - accumulated depreciation

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Mini Case Cash Flows

• Example
• Suppose you sell after 3 years
• Basis 240-223.2 16.8where 223.2 79.2 108.0
  36.0 or depr left to take from table
• Taxes .4(25-16.8) 3.28

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Mini Case Cash Flow Summary

• Find NPV, IRR, MIRR. Accept or reject?

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Risk and capital budgeting

• Risk
• Uncertainty about a projects future
  profitability
• Measured by ?NPV, ?IRR, beta
• Will taking on project increase the firms and
  stockholders risk?
• Often based on subjective judgments
• Types
• Stand-alone
• Corporate risk
• Market risk

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Stand-alone risk

• Projects risk if it were the firms ONLY asset
  and there were no shareholders
• Ignores firm and s/h diversification
• Measured by ? or CV of NPV, IRR, or MIRR

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Stand-alone risk
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Estimating stand-alone risk

• Goal Assess the variability of projects
  expected returns
• 3 techniques
• Sensitivity Analysis
• Scenario Analysis
• Simulation Analysis

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Sensitivity Analysis

• Indicates how much the NPV (or IRR or MIRR) will
  change in response to a given change in an input
  variable
• change one variable at a time
• answers what if questions
• start with base-case which uses expected values

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Sensitivity Analysis Example
Change from Resulting NPV (000s)
Base Level Unit Sales Salvage r
-30 17 85 113 -15 52 86 100
0 88 88 88 15 124 90 76 30 159 91 65
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Sensitivity Analysis Example
NPV (000s)
Project is most sensitive to which
factor? Suppose each line was a different
project, which would be riskiest?
Unit Sales
Salvage
88
r
BaseValue
-30
30
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Sensitivity Analysis

• Strengths
• intuitive
• identifies ___________ variables
• gives breakeven information
• Weaknesses
• ignores ____________
• ignores likelihood of change in variables
• ignores relationships among variables

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Scenario Analysis

• Examines several possible outcomes (worst, most
  likely, best)
• provides a range of possible outcomes
• Use results of scenario analysis to obtain
  E(NPV), snpv, CVnpv

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Scenario Analysis Example

• 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
What if firms average project has cv of 0.4?
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Scenario Analysis

• Difficult to estimate probabilities
• ballparks may provide some insight into risk
• Only considers a few discrete outcomes
• Assumes that inputs are perfectly correlated
• All bad values occur together and all good
  values occur together
• Measures stand-alone risk, so ignores
  diversification

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Simulation Analysis

• Computerized version of ______ analysis
  whichuses continuous probability distributions
• Steps
• Computer program selects values for each variable
  based on its assumed distribution
• NPV/IRR are calculated
• Process is repeated many (1000) times
• End result is a probability distribution of NPV
  based on the simulated values

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Simulation Example

• Assumptions
• Normal distribution for unit sales (mean1250,
  std dev200)
• Triangular distribution for unit price (lower
  bound160, most likely200, upper bound250)
• Process
• Pick random variable for unit sales and price.
  Calculate NPV. Repeat.

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Simulation Example Results
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Simulation Example
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Simulation Analysis

• Strengths
• Reflects probability distributions of each input
• Gives intuitive graph with ranges
• Weaknesses
• Still measures stand-alone risk only
• Difficult to specify distributions and
  correlations
• Garbage in, garbage out
• Looks accurate but may be a SWAG

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Sensitivity, Scenario, and Simulation

• Do not provide _______________
• Need to know if expected return is sufficient to
  compensate for risk
• Only measure stand-alone risk
• could be uncorrelated with firms other assets or
  stocks in general
• Still requires qualitative judgment
• Example With a 3 risk adjustment, is NPV
  positive?

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Corporate Risk

• Measured by projects impact on uncertainty about
  firms future earnings
• Depends on project s and its correlation with
  returns on firms other assets
• if s is high, corporate risk is high unless
  diversification benefits
• Diversification within the firm
• if project is highly correlated with other
  assets, stand-alone reflects corporate risk

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Corporate Risk
Profitability
Project X
Total Firm
Rest of Firm
Years
0
1. Project X is negatively correlated to firms
other assets. 2. If r lt 1.0, some diversification
benefits. 3. If r 1.0, no diversification
effects.
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Market Risk

• Reflects projects effect on a well-diversified
  stock portfolio
• Considers stockholders other assets
• Depends on s and correlation with the stock
  market
• Measured by the projects market beta (CAPM)
• High correlation with economy increases market
  risk

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How is each type of risk used?

• Market
• Best in most situations
• However, creditors, customers, suppliers, and
  employees are more affected by corporate risk
• Stand-alone
• Easiest to measure, more intuitive
• May be correlated so may reflect corporate risk
  and market risk

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Qualitative Adjustments

• Some firms assign projects to a risk category
  based on its risk relative to average risk
• Example Add 2 to high risk projects and
  subtract 1 for low risk projects from average
  project within the division
• Ultimately, must use mix of objective
  subjective analysis