Essentials of Managerial Finance

1
Chapter 7 Project Cash Flows and Risk
2
The cash flow estimation
3
Cash Flow from Assets

• Cash Flow From Assets (CFFA) Cash Flow to
  Creditors Cash Flow to Stockholders
• Cash Flow From Assets Operating Cash Flow Net
  Capital Spending Changes in NWC

4
Basic Terminology
Conventional Versus Nonconventional Cash Flows
5
The Relevant Cash Flows

• Incremental cash flows
• are cash flows specifically associated with the
  investment, and
• their effect on the firms other investments (both
  positive and negative) must also be considered.

For example, if a day-care center decides to open
another facility, the impact of customers who
decide to move from one facility to the new
facility must be considered.
6
Relevant Cash Flows
Major Cash Flow Components


7
Relevant Cash Flows

• Categories of Cash Flows
• Initial Cash Flows are cash flows resulting
  initially from the project. These are typically
  net negative outflows.
• Operating Cash Flows are the cash flows generated
  by the project during its operation. These cash
  flows typically net positive cash flows.
• Terminal Cash Flows result from the disposition
  of the project. These are typically positive net
  cash flows.

8
Relevant Cash Flows
Expansion Versus Replacement Cash Flows

• Estimating incremental cash flows is relatively
  straightforward in the case of expansion
  projects, but not so in the case of replacement
  projects.
• With replacement projects, incremental cash flows
  must be computed by subtracting existing project
  cash flows from those expected from the new
  project.

9
Relevant Cash Flows
Expansion Versus Replacement Cash Flows
10
Relevant Cash Flows
Sunk Costs Versus Opportunity Costs

• Note that cash outlays already made (sunk costs)
  are irrelevant to the decision process.
• However, opportunity costs, which are cash flows
  that could be realized from the best alternative
  use of the asset, are relevant.

11
Finding the Initial Investment
12
Expansion ProjectExample

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

• Increase production by adding a machine
• Purchase price (47,000)
• Installation (3,000)
• Life 3 years
• Salvage 5,000
• Increase in net WC (1,500)
• Increase in gross profit 21,000
• Marginal tax rate 34
• Depreciation method MACRS

13
MACRS Depreciation
Life Class of Investment Year 3-year 5-ye
ar 7-year 1 33 20 14 2 45 32 25 3 15
19 17 4 7 12 13 5 11 9 6 6 9 7
9 8 4 100 100 100


14
Expansion ProjectInitial Investment Outlay
Purchase Price (47,000) Installation ( 3,000) ?
Net WC ( 1,500)
Initial invest outlay (51,500)
Depreciable basis 47,000 3,000 50,000
15
Expansion ProjectIncremental Operating Cash Flows

• Year 1 Year 2 Year 3
• D gross profit 21,000 21,000 21,000
• Depreciation (16,500) (22,500) ( 7,500)
• ? taxable income 4,500 ( 1,500) 13,500
• ? taxes (34) (1,530) 510 ( 4,590)
• ? net income 2,970 ( 990) 8,910
• Depreciation 16,500 22,500 7,500
• ? operating CF 19,470 21,510 16,410

Depreciation1 50,000(0.33)
16,500 Depreciation2 50,000(0.45)
22,500 Depreciation3 50,000(0.15) 7,500



16
Expansion ProjectTerminal Cash Flow

• Salvage of asset 5,000
• Taxes on sale (510)
• ? net working capital 1,500
• Terminal cash flow 5,990

17
Expansion ProjectCash Flow Time Line
12
19,470
21,510
16,410
(51,500.00)
5,990
17,383.93
22,400
17,147.64
15,943.88
(1,024.55)
IRR 10.9
18
Capital Budgeting Project Evaluation

• Expansion projectsmarginal cash flows include
  all cash flows associated with adding a new asset
  to grow the firm.

19
Corporate (Within-Firm) Risk

• Determine how a capital budgeting project is
  related to the existing assets of the firm.
• If the firm wants to diversify its risk, it will
  try to invest in projects that are negatively
  related (or have little relationship) to the
  existing assets.
• If a firm can reduce its overall risk, then it
  generally becomes more stable and its required
  rate of return decreases.

20
Beta (Market) Risk

• Theoretically any asset has a beta, ?, or some
  way to measure its systematic risk
• If we can determine the beta of an asset, then we
  can use the capital asset pricing model, CAPM, to
  compute its required rate of return as follows
• kproj kRF (kM - kRF)?proj
• Measuring beta risk for a projectit is difficult
  to determine the beta for a project.
• pure play method

21
Beta (Market) RiskExample

• Capital Budgeting Project Characteristics
• Cost 100,000
• bproject 1.5
• kRF 3.0
• kM 9.0
• kproject 3.0 (9.0 - 3.0)1.5 12.0

• Firms Characteristics Before Purchasing the
  Project
• Total assets 400,000
• bfirm 1.0

• Firms Beta Coefficient After Purchasing the
  Project
• Total assets 400,000 100,000 500,000

22
Capital BudgetingRisk Analysis

• The firm generally uses its average required rate
  of return to evaluate projects with average risk.
• The average required rate of return is adjusted
  to evaluate projects with above-average or
  below-average risks.

Project Required Risk Category Rate of Return
Above-average 16 Average 12 Below-average 10

• If risk is not considered, high-risk projects
  might be accepted when they should be rejected
  and low-risk projects might be rejected when they
  should be accepted.