Finance management cengage 2013 chapter 012

Chapter 12 Cash Flow Estimation and Risk Analysis Relevant Cash Flows Incorporating Inflation Types of Risk Risk Analysis 12-1 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Proposed Project • Total depreciable cost • Changes in operating working capital • – Equipment: $200,000 – Shipping and installation: $40,000 – Inventories will rise by $25,000 – Accounts payable will rise by $5,000 Effect on operations – New sales: 100,000 units/year @ $2/unit – Variable cost: 60% of sales 12-2 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Proposed Project • Life of the project • • Tax rate: 40% – Economic life: years – Depreciable life: MACRS 3-year class – Salvage value: $25,000 WACC: 10% 12-3 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Determining Project Value • Estimate relevant cash flows – Calculating annual operating cash flows – Identifying changes in net operating working capital – Calculating terminal cash flows: after-tax salvage value and return of NOWC Initial Costs OCF1 OCF2 OCF3 FCF0 FCF1 FCF2 FCF3 OCF4 + Terminal CFs FCF4 12-4 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Initial Year Investment Outlays • • Find ∆NOWC –  in inventories of $25,000 – Funded partly by an  in A/P of $5,000 – ∆NOWC = $25,000 – $5,000 = $20,000 Initial year outlays: Equipment cost -$200,000 Installation -40,000 CAPEX -240,000 ∆NOWC -20,000 FCF0 -$260,000 12-5 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Determining Annual Depreciation Expense Year Rate 0.33 0.45 0.15 0.07 1.00 x x x x x Basis $240 240 240 240 Deprec $ 79 108 36 17 $240 Due to the MACRS ½-year convention, a 3-year asset is depreciated over years 12-6 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Project Operating Cash Flows (Thousands of dollars) Revenues 200.0 – Op costs -120.0 – Depreciation 200.0 200.0 200.0 -120.0 -120.0 -120.0 -79.2 -108.0 -36.0 -16.8 EBIT 0.8 -28.0 44.0 63.2 – Taxes (40%) 0.3 -11.2 17.6 25.3 EBIT(1 – T) 0.5 -16.8 26.4 37.9 + Depreciation 79.2 108.0 36.0 16.8 EBIT(1 – T) + DEP 79.7 91.2 62.4 54.7 12-7 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Terminal Cash Flows (Thousands of dollars) Salvage value – Tax on SV (40%) AT salvage value + ∆NOWC Terminal CF FCF4 $25 10 $15 20 $35 = EBIT(1 – T) + DEP – CAPEX – ∆NOWC = $54.7 + $35 = $89.7 12-8 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Terminal Cash Flows Q How is NOWC recovered? Q Is there always a tax on SV? Q Is the tax on SV ever a positive cash flow? 12-9 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Should financing effects be included in cash flows? • No, dividends and interest expense should not be included in the analysis • Financing effects have already been taken into account by discounting cash flows at the WACC of 10% • Deducting interest expense and dividends would be “double counting” financing costs 12-10 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Evaluating Projects with Unequal Lives • Machines A and B are mutually exclusive, and will be repurchased If WACC = 10%, which is better? Year Expected Net CFs Machine A Machine B ($50,000) ($50,000) 17,500 34,000 17,500 27,500 12-25 – © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 17,500 Solving for NPV with No Repetition • Enter CFs into calculator CFLO register for both projects, and enter I/YR = 10% – NPV = $5,472.65 – NPV = $3,636.36 A B • Is Machine A better? – Need replacement chain and/or equivalent annual annuity analysis 12-26 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Replacement Chain • Use the replacement chain to calculate an extended NPVB to a common life • Since Machine B has a 2-year life and Machine A has a 4-year life, the common life is years 10% -50,000 34,000 27,500 -50,000 27,500 -22,500 NPVB = $6,641.62 (on extended basis) 34,000 12-27 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Equivalent Annual Annuity • Using the previously solved project NPVs, the EAA is the annual payment that the project would provide if it were an annuity • Machine A – Enter N = 4, I/YR = 10, PV = -5472.65, FV = 0; solve for PMT = EAAA = $1,726.46 • Machine B – Enter N = 2, I/YR = 10, PV = -3636.36, FV = 0; solve for PMT = EAAB = $2,095.24 • Machine B is better! 12-28 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part If expected inflation equals 5% is NPV biased? • Yes, inflation causes the discount rate to be upwardly revised • Therefore, inflation creates a downward bias on NPV • Inflation should be built into CF forecasts 12-29 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Project Operating Cash Flows, If Expected Inflation = 5% (Thousands of dollars) Revenues Op costs (60%) – Depreciation EBIT – Taxes (40%) EBIT(1 – T) + Depreciation EBIT(1 – T) + DEP 210 220 232 -126 -132 -139 -79 -108 -36 -20 57 -8 23 -12 34 79 108 36 82 96 70 243 -146 -17 80 32 48 17 65 12-30 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Considering Inflation: Project CFs, NPV, and IRR (Thousands of dollars) FCFs • -260 82.1 96.1 70.0 -260 82.1 96.1 70.0 65.1 35.0 100.1 Enter CFs into calculator CFLO register, and enter I/YR = 10% NPV = $15.0 MIRR = 11.6% IRR = 12.6% Payback = 3.1 years 12-31 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Perform a Scenario Analysis of the Project, Based on Changes in the Sales Forecast • Suppose we are confident of all the variable estimates, except unit sales The actual unit sales are expected to follow the following probability distribution: Case Worst Base Best Probability 0.25 0.50 0.25 Unit Sales 75,000 100,000 125,000 12-32 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Scenario Analysis • All other factors shall remain constant and the NPV under each scenario can be determined Case Worst Base Best Probability 0.25 0.50 0.25 NPV ($27.8) 15.0 57.8 12-33 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Determining Expected NPV, σNPV, and CVNPV from the Scenario Analysis E(NPV) = 0.25(-$27.8) + 0.5($15.0) + 0.25($57.8) = $15.0 σNPV = [0.25(-$27.8 − $15.0)2 + 0.5($15.0 − $15.0)2 + 0.25($57.8 − $15.0)2 ]1/2 = $30.3 CVNPV = $30.3/$15.0 = 2.0 12-34 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part If firm’s average projects’ CVNPV range is 1.25-1.75, would this project have high, average, or low risk? • With a CVNPV of 2.0, this project would be classified as a high-risk project • Perhaps, some sort of risk correction is required for proper analysis 12-35 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Is this project likely to be correlated with the firm’s business? How would it contribute to the firm’s overall risk? • We would expect a positive correlation with the firm’s aggregate cash flows • As long as correlation is not perfectly positive (i.e., ρ ≠ 1), we would expect it to contribute to the lowering of the firm’s overall risk 12-36 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part If the project had a high correlation with the economy, how would corporate and market risk be affected? • The project’s corporate risk would not be directly affected However, when combined with the project’s high stand-alone risk, correlation with the economy would suggest that market risk (beta) is high 12-37 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part If the firm uses a +/-3% risk adjustment for the cost of capital, should the project be accepted? • Reevaluating this project at a 13% cost of capital (due to high stand-alone risk), the NPV of the project is -$2.2 • If, however, it were a low-risk project, we would use a 7% cost of capital and the project NPV is $34.1 12-38 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What subjective risk factors should be considered before a decision is made? • Numerical analysis sometimes fails to capture all sources of risk for a project • If the project has the potential for a lawsuit, it is more risky than previously thought • If assets can be redeployed or sold easily, the project may be less risky than otherwise thought 12-39 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part [...]... (substitutes) 12-13 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Proposed Project’s Cash Flow Time Line (Thousands of dollars) 0 1 -260 • 79.7 2 3 4 91.2 62.4 89.7 Enter CFs into calculator CFLO register, and enter I/YR = 10% NPV = -$4.03 IRR = 9.3% MIRR = 9.6% Payback = 3.3 years 12-14 © 2013 Cengage Learning... machine’s life This is the opportunity cost for the replacement project 12-15 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What are the 3 types of project risk? • • • Stand-alone risk Corporate risk Market risk 12-16 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated,... other firm projects 12-18 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is market risk? • • The project’s risk to a well-diversified investor Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder diversification 12-19 © 2013 Cengage Learning All Rights... better! 12-28 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part If expected inflation equals 5% is NPV biased? • Yes, inflation causes the discount rate to be upwardly revised • Therefore, inflation creates a downward bias on NPV • Inflation should be built into CF forecasts 12-29 © 2013 Cengage Learning... 75,000 100,000 125,000 12-32 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Scenario Analysis • All other factors shall remain constant and the NPV under each scenario can be determined Case Worst Base Best Probability 0.25 0.50 0.25 NPV ($27.8) 15.0 57.8 12-33 © 2013 Cengage Learning All Rights Reserved... © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Evaluating Projects with Unequal Lives • Machines A and B are mutually exclusive, and will be repurchased If WACC = 10%, which is better? Year 0 1 2 Expected Net CFs Machine A Machine B ($50,000) ($50,000) 17,500 34,000 17,500 27,500 12-25 3 – © 2013. .. type of risk is most relevant? • Market risk is the most relevant risk for capital projects, because management s primary goal is shareholder wealth maximization • However, since corporate risk affects creditors, customers, suppliers, and employees, it should not be completely ignored 12-20 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly... Resulting changes in NPV are noted 12-23 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What are the advantages and disadvantages of sensitivity analysis? • Advantage – Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables... undertakes are in its core business, stand-alone risk is likely to be highly correlated with its corporate risk • In addition, corporate risk is likely to be highly correlated with its market risk 12-22 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is sensitivity analysis? • Sensitivity analysis... independently • Usually measured by standard deviation (or coefficient of variation) • However, it ignores the firm’s diversification among projects and investors’ diversification among firms 12-17 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is corporate risk? • The project’s risk when considering