Capital Budgeting Project Cash Flows and Risk

1
Capital BudgetingProject Cash Flows and Risk

• When evaluating a capital budgeting project, we
  must estimate the after-tax cash flows the asset
  is expected to generate in the future.

• When evaluating a capital budgeting project, we
  must estimate the after-tax cash flows the asset
  is expected to generate in the future.
• Future cash flows generally are uncertain to some
  degree, so the risk associated with a capital
  budgeting project should be considered

2
Capital BudgetingProject Cash Flows and Risk

• Cash Flow Estimation
• Expansion Project Evaluation
• Replacement Analysis
• Risk Analysis in Capital Budgeting
• Capital Rationing Multinational Capital
  Budgeting

3
Capital BudgetingRelevant Cash Flows

• Cash flow versus accounting income

4
Capital BudgetingRelevant Cash Flows
Incremental cash flowsmarginal cash flows
(positive and negative) generated by the asset

• Sunk cost
• Opportunity cost
• Externalities
• Shipping and installation
• Depreciable basis
  Purchase price (Shipping
  Installation)
• Inflation

5
Identifying Incremental Cash Flows

• Initial investment outlayincludes cash flows
  that occur only at the beginning of the projects
  life.
• Incremental operating cash flowschanges in cash
  flows that are sustained throughout the life of
  the assetthat is, the cash flow effects are
  ongoing.
• Terminal cash flowthe cash flows that occur only
  at the end of the life of the asset.

6
Initial Investment Outlay

• Purchase price
• Shipping and installation
• Cost/Benefit of disposing of old asset
• Taxes
• Change in net working capital
• Net working capital CA CL
• Other up-front inflows/outflows

7
Incremental Operating Cash Flows

• D Cash sales
• D Salaries
• D Costs of raw materials
• D Other cash operating revenues and expenses
• D Taxes
• ? revenues or expenses, ? tax liability
• Depreciationnon-cash expense that affects taxes

8
Terminal Cash Flow

• Salvage value of new asset
• Taxes
• Salvage value of old asset
• Taxes
• D Net working capital
• Other terminal inflows/outflows associated with
  both the new asset and the old asset

9
Capital Budgeting Project Evaluation

• Expansion projectsmarginal cash flows include
  all cash flows associated with adding a new asset
  to grow the firm.
• Replacement analysismarginal cash flows include
  changes ( or -) in the cash flows associated
  with the new asset that replace the cash flows
  associated with the old asset that is replaced
  (maintain existing operations by replacing an old
  asset).

10
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

11
MACRS Depreciation

• Life Class of Investment
• Year 3-year 5-year 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

12
Expansion ProjectInitial Investment Outlay

• Purchase Price (47,000)
• Installation ( 3,000)
• ? Net WC ( 1,500)

Purchase Price (47,000) Installation ( 3,000) ?
Net WC ( 1,500)
Initial invest outlay (51,500)
Depreciable basis 47,000 3,000 50,000

13
Expansion ProjectIncremental Operating CF
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500)
Depreciation1 50,000(0.33) 16,500
Depreciation1 50,000(0.33)
16,500 Depreciation2 50,000(0.45) 22,500
Depreciation1 50,000(0.33)
16,500 Depreciation2 50,000(0.45)
22,500 Depreciation3 50,000(0.15) 7,500
14
Expansion ProjectIncremental Operating CF
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)

Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) D net income
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) D net income 2,970
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 D net income 2,970
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 D net income 2,970 (
990)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990)
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910 Depreciation 16,5
00
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910 Depreciation 16,5
00 D operating CF 19,470
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910 Depreciation 16,5
00 22,500 D operating CF 19,470
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910 Depreciation 16,5
00 22,500 D operating CF 19,470 21,510
Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910 Depreciation 16,5
00 22,500 7,500 D operating CF 19,470 21,510

Year 1 Year 2 Year 3 D gross
profit 21,000 21,000 21,000 Depreciation (1
6,500) (22,500) ( 7,500) D taxable
income 4,500 ( 1,500) 13,500 D taxes (34)
(1,530) 510 ( 4,590) D net
income 2,970 ( 990) 8,910 Depreciation 16,5
00 22,500 7,500 D operating
CF 19,470 21,510 16,410
15
Expansion ProjectTerminal Cash Flow

• Salvage of asset 5,000
• Taxes on sale (510)

Salvage of asset 5,000 Taxes on sale (510) ? net
working capital 1,500
Salvage of asset 5,000 Taxes on sale (510) ? net
working capital 1,500 Terminal cash flow 5,990
of asset depreciated 33 45 15 93
Book Value (0.07)50,000 3,500 Gain on sale
Sale price Book value
of asset depreciated 33 45 15 93
Book Value (0.07)50,000 3,500 Gain on sale
5,000 Book value
of asset depreciated 33 45 15 93
Book Value (0.07)50,000 3,500 Gain on sale
5,000 3,500 1,500 Tax on gain
0.34 x 1,500 510
of asset depreciated 33 45 15 93
Book Value (0.07)50,000 3,500 Gain on sale
5,000 3,500
of asset depreciated 33 45 15 93
Book Value (0.07)50,000 3,500 Gain on sale
5,000 3,500 1,500
16
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
IRR 10.9
(1,024.55)
17
Replacement DecisionExample
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40
Old machine New Machine Purchase
price (34,000) (40,000) Original life 6
years 4 years Remaining life 4 years
4 years Current salvage value 16,000 -- Bo
ok value in four years 4,000 0 Salvage in
four years 1,000 2,000 Depreciation 5,000 MA
CRS 3-yr Operating expense savings -- 8,000 ?
Net WC -- 1,000 Marginal tax rate
40 40

18
Replacement DecisionInitial Investment Outlay
Purchase price of new machine (40,000) Salvage
value of old machine 16,000 Tax on sale of old
machine 3,200
Purchase price of new machine (40,000) Salvage
value of old machine 16,000 Tax on sale of old
machine 3,200 D working capital 1,000
Purchase price of new machine (40,000) Salvage
value of old machine 16,000 Tax on sale of old
machine 3,200 D working capital
1,000 Initial investment outlay (19,800)
S depreciation of old machine 5,000 x 2
10,000 Book value of old machine 34,000
10,000 24,000 Loss on sale of old machine
16,000 24,000 (8,000) Tax on sale
(8,000) x 0.40 (3,200)

19
Replacement DecisionIncremental Operating CF

• Year 1 Year 2 Year 3 Year 4
• Savings 8,000 8,000 8,000 8,000

Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000) 2,200

Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000) 2,200 D
taxable income (200)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000) 2,200 D
taxable income (200) (5,000)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000) 2,200 D
taxable income (200) (5,000) 7,000
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,080)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000)
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 D Operating CF 8,080
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 13,000 D Operating
CF 8,080
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 13,000 D Operating
CF 8,080 10,000
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 13,000 1,000 D Operating
CF 8,080 10,000
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 13,000 1,000 D Operating
CF 8,080 10,000 5,200
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 13,000 1,000 (2,200) D
Operating CF 8,080 10,000 5,200
Year 1 Year 2 Year 3 Year
4 Savings 8,000 8,000 8,000 8,000 D
depreciation (8,200) (13,000) (1,000)
2,200 D taxable income (200) (5,000) 7,000 10,
200 D taxes (40) 80 2,000 (2,800) (4,08
0) D net income (120) (3,000) 4,200 6,120 Depr
eciation 8,200 13,000 1,000 (2,200) D
Operating CF 8,080 10,000 5,200 3,920

D Depreciation1 New depreciation Old
depreciation 40,000(0.33) 5,000 8,200

D Depreciation1 40,000(0.33) 5,000
8,200 D Depreciation2 40,000(0.45) 5,000
13,000
D Depreciation1 40,000(0.33) 5,000
8,200 D Depreciation2 40,000(0.45) 5,000
13,000 D Depreciation3 40,000(0.15)
5,000 1,000
D Depreciation1 40,000(0.33) 5,000
8,200 D Depreciation2 40,000(0.45) 5,000
13,000 D Depreciation3 40,000(0.15)
5,000 1,000 D Depreciation4 40,000(0.07)
5,000 (2,200)
20
Replacement DecisionTerminal Cash Flow

• Salvage value of new machine 2,000
• Tax on sale of new machine (800)

Salvage value of new machine 2,000 Tax on sale
of new machine (800) D working capital (1,000)
Salvage value of new machine 2,000 Tax on sale
of new machine (800) D working
capital (1,000) Loss of salvage value of old
machine (1,000)
Salvage value of new machine 2,000 Tax on sale
of new machine (800) D working
capital (1,000) Loss of salvage value of old
machine (1,000) Loss of tax effect on sale of
old machine (1,200)
Salvage value of new machine 2,000 Tax on sale
of new machine (800) D working
capital (1,000) Loss of salvage value of old
machine (1,000) Loss of tax effect on sale of
old machine (1,200) Terminal cash flow (2,000)
Book value of new machine 0 Gain on sale
2,000 0 2,000 Tax on sale 2,000(0.40)
800
Book value of old machine in four years
4,000 Gain on potential sale 1,000 4,000
(3,000) Tax on potential sale (3,000) x
0.40 (1,200)

21
Replacement DecisionCash Flow Time Line
12
8,080
10,000
5,200
3,920
(19,800.00)
(2,000)
7,214.29
1,920
7,971.94
3,701.26
1,220.19
IRR 12.9
307.68
22
Incorporating Risk In Capital Budgeting Analysis

• Project risk should be evaluated to determine if
  the appropriate required rate of return is used
  to compute the projects NPV (or to compare to
  its IRR).
• If a firm is considering a project that is much
  riskier than the existing assets, then it makes
  sense that the firm should expect to earn a
  higher return on the project than on its existing
  assets (and vice versa).

23
Capital Budgeting Project Risk

• Types of risk associated with projects
• Stand-alone riskrisk of the asset when it is
  held in isolationthat is, when it stands alone
• Corporate, or within-firm, riskmeasured by the
  impact an asset is expected to have on the
  operations of the firmthat is, how an asset will
  affect the firms total risk if it is purchased
  and added to existing assets
• Beta, or market, riskthe portion of an assets
  risk that cannot be eliminated through
  diversificationthat is, how an asset will affect
  the firms market risk, or beta, if it is
  purchased and added to existing assets.

24
Stand-Alone Risk of a Project

• Sensitivity analysisdetermine by how much the
  final result of a computation, such as NPV,
  changes when the values (inputs) needed for the
  computation are changed.
• Examplereplacement decision illustration

Operating Expense Required Rate Deviation
from Savings per Year of Return (k)
Base Case () NPV D NPV
D -10 (421.29) (237) 519.27 69 0 307
.68 0 307.68 0 10 1,036.64 237 99.85 (68
)
Operating Expense Required Rate Deviation
from Savings per Year of Return (k)
Base Case () NPV D NPV
D -10 (421.29) (237) 519.27 69 0 307
.68 0 307.68 0 10 1,036.64 237 99.85 (68
)
Operating Expense Required Rate Deviation
from Savings per Year of Return (k)
Base Case () NPV D NPV
D -10 (421.29) (237) 519.27 69 0 307
.68 0 307.68 0 10 1,036.64 237 99.85 (68
)
Operating Expense Required Rate Deviation
from Savings per Year of Return (k)
Base Case () NPV D NPV
D -10 (421.29) (237) 519.27 69 0 307
.68 0 307.68 0 10 1,036.64 237 99.85 (68
)

25
Stand-Alone Risk of a Project

• Scenario analysiscompute outcomes using various
  circumstances, or scenarios.

Scenario Savings NPV Probability Best
case 10,000 3,953 0.2 Most likely
case 8,000 308 0.7 Worst case 6,000 (3,337)
0.1
Scenario Savings NPV Probability NPV x
Pr Best case 10,000 3,953 0.2 790.60 Most
likely case 8,000 308 0.7 215.60 Worst
case 6,000 (3,337) 0.1 (333.70)
(333.70) Expected NPV 672.50
(333.70) Expected NPV 672.50
sNPV 1,962.89
(333.70) Expected NPV 672.50
sNPV 1,962.89 CVNPV 2.92
26
Stand-Alone Risk of a Project

• Monte Carlo simulationtry to simulate the real
  world by identifying all the possible outcomes
  for all the situations, or variables, that are
  associated with a capital budgeting project.

27
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.

28
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
• rproj rRF (rM - rRF)?proj
• Measuring beta risk for a projectit is difficult
  to determine the beta for a project.
• pure play method

29
Beta (Market) RiskExample

• Capital Budgeting Project Characteristics
• Cost 100,000
• bproject 1.5
• rRF 3.0
• rM 9.0
• rproject 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

30
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.

31
Capital Rationing

• If the amount of funds that is invested in
  capital budgeting projects is constrained, then
  capital rationing exists.
• The firm should invest in the combination of
  projects that provides the highest combined
  NPVthat is, that increases the firms value by
  the greatest total amount.

32
Multinational Capital Budgeting

• For the most part, the capital budgeting projects
  of multinational firms should be evaluated the
  same as for domestic firms.
• Repatriation of cash (earnings) might be
  restricted
• Projects associated with foreign operations
  generally are considered riskier than domestic
  projects because
• Movements in exchange ratesthat is, exchange
  rate riskaffect the translation of foreign
  currency into domestic currency
• Risk that foreign governments will takeover or
  severely restrict operations of foreign
  subsidiariesthat is, political risk exists

33
Project Cash Flows and RiskThe Answers

• What are the relevant cash flows associated with
  a capital budgeting project?
• Initial investment outlay
• Incremental operating cash flows
• Terminal cash flow
• What is depreciation and how does it affect a
  projects relevant cash flows?
• The means by which a long-term asset is expensed
  over time.

34
Project Cash Flows and RiskThe Answers

• How is risk incorporated in capital budgeting
  analysis?
• Projects that are riskier than average are
  evaluated with higher required rates of return
• How do capital budgeting analyses/decisions
  differ for multinational firms?
• Because risk is greater the required rate of
  return used to evaluate a foreign investment is
  higher than the required rate of return for
  similar domestic investments