CHAPTER 11 Cash Flow Estimation and Risk Analysis

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CHAPTER 11Cash Flow Estimation and Risk Analysis

• Relevant cash flows

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Principles of Cash Flow Estimation

• 1.The relevant cash flows are incremental cash
  flows that arise as a result of
• accepting the project
• ?CF CF with the project CF without the
  project

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Principles of Cash Flow Estimation

• 2. Cash flows are computed on an after-tax basis.
• Income tax payable are deducted and income tax
  savings are added to compute after-tax cash
  flows.
• Income taxes arise with respect to two major
  items.
• Operating profit or loss If profit, pay taxes
  (cash outflow) If loss, save taxes (cash
  inflow).

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• Salvage cash flows (at projects start or/and
  termination)
• Salvage cash flow estimated sale price of
  capital assets accumulated depreciation.
• If salvage cash flow is positive, then it is
  profit on sale, and taxes are payable.
• If salvage cash flow is negative, then it is a
  loss, and a tax savings arise.

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Principles of Cash Flow Estimation

• 3. Noncash charges must be added to net operating
  profit after taxes.
• Noncash charges include depreciaiton and
  amortization.
• They must be deducted in computing taxable
  operating income (because they are deductible for
  tax purposes and hence produce tax savings)
• Once tax savings have been accounted for, noncash
  charges must be added back to obtain the
  operating cash flow.

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Principles of Cash Flow Estimation

• 4. Interest expenses are not included in project
  cash flows.
• They represent cost of financing.
• The cost of financing is reflected in the
  discount rate (projects cost of capital) which
  is used for discounting future cash flows.
• Do not subtract interest expense in computing
  cash flows.

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Principles of Cash Flow Estimation

• 5. Sunk costs are not included in project cash
  flows.
• Sunk costs are outlays that have been already
  incurred
• They do not have an impact on future cash flows
  regardless of whether or not the project is
  accepted.

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Principles of Cash Flow Estimation

• 5. All opportunity costs arising from the
  acceptance of the project are included in project
  cash flows.
• These represent cash flows that could be
  generated by assets already in the firm if they
  are not used for the project.

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Principles of Cash Flow Estimation

• 6. Externalities arising from the acceptance of
  the project are included in project cash flows.
• These represent cash flow effects of the project
  on other parts of the firm.
• If the new project takes sales from existing
  products of the firm, such revenue should not be
  included in projects cash flows.

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Principles of Cash Flow Estimation

• 7. Change in Net Working Capital (NWC) must be
  included in projects cash flows.
• NWC current assets current liabilities.
• Increases in NWC represent cash outflows, while
  decreases represent inflows.

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• Changes in NWC can arise at three points in time
• Start of the project adjust the changes in NWC
  at the start of the project to initial investment
  cost.
• During the projects operation adjust the
  changes in NWC to annual operating cash flows.
• At project termination the investments in NWC
  are recovered.

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Estimating Initial Investment

• The initial investment (t0) consists of the
  following
• Cost of capital assets
• Cost of shipping and installation
• Changes in net operating working capital
• Proceeds from sale of existing assets
• Tax payments or savings associated with asset
  sales

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Estimating Initial Investment

• Step 1 Cost plus installation and shipping
• Plus
• Step 2 Increases in net working capital
• Minus
• Step 3 Net proceeds from sale of existing
  assets
• Plus or minus
• Step 4 Taxes associated with the above sale
• Equals
• Initial Investment

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Computing Net Cash Flows
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Computing Tax Depreciation

• Tax depreciation is based on the Modified
• Accelerated Cost Recovery System (MACRS).
• Class life and types of assets for MACRS
• Class Type of Property
• 3-year Certain special manufacturing tools
• 5-year Automobiles, light-duty trucks,
  computers, and certain special manufacturing
  equipment
• 7-year Most industrial equipment, office
  furniture and fixtures.
• 10-year Certain longer-lived types of equipment
• 27.5 year Residential rental real property such
  as apartment buildings
• 39-year All nonresidential real property,
  including commercial and industrial buildings

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Computing Tax Depreciation

• 3-, 5- , 7-, and 10-year property can be
  depreciated either by the MACRS given in Table
  below or by the straight-line method.

• 27.5- and 39-year properties (real estate) must
  be depreciated by the straight-line method.
• Depreciable Basis under MACRS
• Purchase cost shipping and installation.
• Salvage value is not deducted in computing the
  depreciable basis.

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Proposed Project

• Total depreciable cost
• Equipment 200,000
• Shipping 10,000
• Installation 30,000
• Changes in working capital
• Inventories will rise by 25,000
• Accounts payable will rise by 5,000
• Effect on operations
• New sales 100,000 units/year _at_ 2/unit
• Variable cost 60 of sales

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Proposed Project

• Life of the project
• Economic life 4 years
• Depreciable life MACRS 3-year class
• Salvage value 25,000
• Tax rate 40
• WACC 10

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Determining project value

• Estimate relevant cash flows
• Calculating annual operating cash flows.
• Identifying changes in working capital.
• Calculating terminal cash flows.

0 1 2
3 4
Initial OCF1 OCF2
OCF3 OCF4 Costs
Terminal CFs NCF0
NCF1 NCF2 NCF3
NCF4
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Initial year net cash flow

• Find ? NOWC.
• ? in inventories of 25,000
• Funded partly by an ? in A/P of 5,000
• ? NOWC 25,000 - 5,000 20,000
• Combine ? NOWC with initial costs.
• Equipment -200,000
• Installation -40,000
• ? NOWC -20,000
• Net CF0 -260,000

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Determining annual depreciation expense

• Year Rate x Basis Depr
• 1 0.33 x 240 79
• 2 0.45 x 240 108
• 3 0.15 x 240 36
• 4 0.07 x 240 17
• 1.00 240
• Due to the MACRS ½-year convention, a 3-year
  asset is depreciated over 4 years.

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Annual operating cash flows

• 1 2 3 4
• Revenues 200 200 200 200
• - Op. Costs (60) -120 -120 -120 -120
• - Deprn Expense -79 -108 -36 -17
• Oper. Income (BT) 1 -28 44 63
• - Tax (40) - -11 18 25
• Oper. Income (AT) 1 -17 26 38
• Deprn Expense 79 108 36 17
• Operating CF 80 91 62 55

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Terminal net cash flow

• Recovery of NOWC 20,000
• Salvage value 25,000
• Tax on SV (40) -10,000
• Terminal CF 35,000

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Proposed projects cash flow time line
0 1 2
3 4
-260 79.7 91.2 62.4
54.7 Terminal CF ? 35.0
89.7

• Enter CFs into calculator CFLO register, and
  enter I/YR 10.
• NPV -4.03 million
• IRR 9.3

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• What is the net investment for an extruder that
  costs 42,000, if shipping costs are 1,500 and
  installation is 4,800? Assume this efficient
  machine is replacing an older extruder with a
  book and market value of zero. The replacement
  investment will reduce operating costs by 6,600
  a year.

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• Jim Bo's currently has annual cash revenues of
  240,000 and annual operating expenses of
  185,000 including 35,000 in depreciation. The
  firm's marginal tax rate is 40 percent. A new
  cutting machine can be purchased for 120,000
  that that will increase revenues by 50,000 per
  year while operating expenses would increase to
  205,000, including 42,000 in depreciation.
  Compute Jim Bo's annual incremental after-tax net
  cash flows.

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• Baker Company is considering an investment in a
  new metal lathe. If the new lathe is purchased,
  revenues will increase by 5,000 per year and
  cash operating costs will decline by 10,000 per
  year. The lathe will cost 60,000 and will be
  depreciated on a straight-line basis over 10
  years to a zero estimated salvage value. Baker's
  marginal tax rate is 40. Determine the annual
  net cash flows generated by the lathe.