Week 5

Cash Flow Estimation and

Risk Analysis

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1
Topics
 Risk analysis:
 Sensitivity analysis
 Scenario analysis
 Simulation analysis

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Project Data
 Annual unit sales = 1,250.
 Unit sales price = $200.
 Unit costs = $100.
 Tax rate = 40%.
 Project cost of capital = 10%.

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 Annual Sales and Costs

Year 1 Year 2 Year 3 Year 4

Units 1,250 1,250 1,250 1,250

Unit $200 $206 $212.18 $218.55

Price
Unit $100 $103 $106.09 $109.27
Cost
Sales $250,00 $257,50 $265,22 $273,18
0 0 5 8
Costs $125,00 $128,75 $132,61 $136,58
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Operating Cash Flows
(Years 1 and 2)
Year 1 Year 2
Sales $250,000 $257,500
Costs 125,000 128,750
Deprec. 79,992 106,680
EBIT $ 45,008 $ 22,070
Taxes (40%) 18,003 8,828
EBIT(1 – T) $ 27,005 $ 13,242
+ Deprec. 79,992 106,680
Net Op. CF $106,997 $119,922

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Operating Cash Flows
(Years 3 and 4)
Year 3 Year 4
Sales $265,225 $273,188
Costs 132,613 136,591
Deprec. 35,544 17,784
EBIT $ 97,069 $118,807
Taxes (40%) 38,827 47,523
EBIT(1 – T) $ 58,241 $ 71,284
+ Deprec. 35,544 17,784
Net Op. CF $ 93,785 $ 89,068
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Measuring stand-alone risk
 Sensitivity analysis
 Scenario analysis
 Simulation

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 Project evaluation
techniques
Popularity of project evaluation techniques
0% 10% 20% 30% 40% 50% 60% 70% 80%

IRR

NPV

Payback

Sensitivity
analysis

Real options

Australia US
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What is sensitivity
analysis?
 Shows how changes in a variable
such as unit sales affect NPV or
IRR.
 Each variable is fixed except one.
Change this one variable to see
the effect on NPV or IRR.
 Answers “what if” questions, e.g.
“What if sales decline by 30%?”
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 Sensitivity Analysis
Change From Resulting NPV
(000s)
Base level r Unit Salvage
sales
-30% $113 $17 $85
-15% $100 $52 $86
0% $88 $88 $88
15% $76 $124 $90
30% $65 $159 $91
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Sensitivity Graph
NPV
($ 000s)
Unit Sales

88 Salvage

-30 -20 -10 Base 10 20 30

(%)
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Results of Sensitivity
Analysis
 Steeper sensitivity lines show
greater risk. Small changes result
in large declines in NPV.
 Unit sales line is steeper than
salvage value or r, so for this
project, should worry most about
accuracy of sales forecast.

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What are the weaknesses
of
sensitivity analysis?
 Says nothing about the likelihood
of change in a variable, i.e. a steep
sales line is not a problem if sales
won’t fall.
 Ignores relationships among
variables.

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Why is sensitivity analysis
useful?
 Gives some idea of stand-alone
risk.
 Identifies dangerous variables.
 Gives some breakeven information.

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Example
 Given the following information, by
how much would the NPV change
(3 years) if the number of cars
washed declined by 40%?
WACC 10.0%
Net investment cost $60,000
Number of cars washed 2,800
Price per car $25.00
Fixed cost $10,000
Variable op. cost/unit (i.e., VC per car $5.375
washed)
Annual depreciation $20,000
Tax Learning.
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as
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Example
 Base case cash flows:
t=0 t=1 t=2 t=3
- $36,218 $36,218 $36,218
$60,000
 NPV = $30,068
 40% decline cash flows:
t=0 t=1 t=2 t=3
- $21,931 $21,931 $21,931
$60,000
 NPV = -$5,462
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What is scenario analysis?
 Examines several possible
situations, usually worst case,
most likely case, and best case.
 Provides a range of possible
outcomes.

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$240
Worst scenario: 900 units @
$160
Scenario Probability NPV(000)
Best 0.25 $279
Base 0.50 88
Worst 0.25 -49
E(NPV) = $101.6
σ(NPV) = 116.6
CV(NPV) = σ(NPV)/E(NPV) =
1.15
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Are there any problems
with
scenario analysis?
 Only considers a few possible out-
comes.
 Assumes that inputs are perfectly
correlated—all “bad” values occur
together and all “good” values
occur together.
 Focuses on stand-alone risk,
although subjective adjustments
can be made.
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 Example
 An investment requires Rs
8.5million up-front and will last 3
years. Assume the cash-flows
occur at the year end and the
discount rate is 10%.

 Sales volume per year: 25,500

 Sales price per unit: 347
VC per unit: 193
 permitted
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 Example (cont’d)
Pessimistic Base case Optimistic
Sales volume 22,000 25,500 29,000
Price/unit 290 347 380
VC/unit 230 193 175

 NPV (base) = Rs 1,265,868

 NPV (pessimistic) = Rs -5,217,355
 NPV (optimistic) = Rs 6,284,335
 Range = Rs 11,501,690

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Example (scenario +
sensitivity)

SALES VOL VC
NPV(base) 1,265,868 NPV(base) 1,265,868
NPV(pess) (74,545) NPV(pess) (1,080,477)
NPV(opt) 2,606,281 NPV(opt) 2,407,333
Range = 2,680,826 Range = 3,487,810

PRICE
NPV(base) 1,265,868
NPV(pess) (2,348,772)
NPV(opt) 3,358,554
Range = 5,707,325
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Example (cont’d)

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What is a simulation
analysis?
 A computerized version of scenario
analysis that uses continuous
probability distributions.
 Computer selects values for each
variable based on given probability
distributions.

(More...)
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What is a simulation
analysis?
 NPV and IRR are calculated.
 Process is repeated many times
(1,000 or more).
 End result: Probability distribution
of NPV and IRR based on sample of
simulated values.
 Generally shown graphically.

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Simulation Example
Assumptions
 Normal distribution for unit sales:
 Mean = 1,250
 Standard deviation = 200
 Normal distribution for unit price:
 Mean = $200
 Standard deviation = $30

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Simulation Process
 Pick a random variable for unit
sales and sale price.
 Substitute these values in the
spreadsheet and calculate NPV.
 Repeat the process many times,
saving the input variables (units
and price) and the output (NPV).

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 Simulation Results (2,000
trials)
Units Price NPV
Mean 1,252 $200 $88,808
Std deviation 199 30 $82,519
Maximum 1,927 294 $475,145
Minimum 454 94 -$166,208
Median 685 $163 $84,551
Prob NPV > 0 86.9%
CV 0.93
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Interpreting the Results
 Inputs are consistent with
specified distributions.
 Units: Mean = 1,252; St. Dev. = 199.
 Price: Mean = $200; St. Dev. = $30.
 Mean NPV = $88,808. Low
probability of negative NPV (100%
– 87% = 13%).

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Histogram of Results
18%

16%

14%

12%

10%

8%

6%

4%

2%

0% NPV
($475,145) ($339,389) ($203,634) ($67,878) $67,878 $203,634 $339,389 $475,145
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What are the advantages
of simulation analysis?
 Reflects the probability
distributions of each input.
 Shows range of NPVs, the
expected NPV, σNPV, and CVNPV.
 Gives an intuitive graph of the risk
situation.

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What are the
disadvantages
of simulation?
 Difficult to specify probability
distributions and correlations.
 If inputs are bad, output will be
bad:
“Garbage in, garbage out.”

(More...)
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What are the
disadvantages
of simulation?
 Sensitivity, scenario, and simulation
analyses do not provide a decision rule.
They do not indicate whether a project’s
expected return is sufficient to
compensate for its risk.
 Sensitivity, scenario, and simulation
analyses all ignore diversification. Thus
they measure only stand-alone risk,
which may not be the most relevant risk
in capital budgeting.
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If the firm’s average project has a CV
of 0.2 to 0.4, is this a high-risk
project? What type of risk is being
measured?
 CV from scenarios = 1.15, CV from
simulation = 0.93. Both are > 0.4,
this project has high risk.
 CV measures a project’s stand-
alone risk.
 High stand-alone risk usually
indicates high corporate and
market risks.
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Should subjective risk
factors be considered?
 Yes. A numerical analysis may not
capture all of the risk factors
inherent in the project.
 For example, if the project has the
potential for bringing on harmful
lawsuits, then it might be riskier
than a standard analysis would
indicate.

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Example
 A simple business model is defined by the
equation:
Profit (P) = Revenues (R) – Expenses (E)
 The variables R and E are normally distributed, such
that
R ~ N(15, 5): mean = 15; var = 5; sd = 5
E ~ N(10, 2): mean = 10; var = 2; sd = 2

 You want to know the probability that your profits

exceed 8 million. You run a monte carlo simulation
which shows profits exceeding 8 million appear only
4.1% of the time. Is this result consistent with the actual
probability?
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Solution
 z= = = 1.73
From the z-table
 P(x > 1.67) = 4.18% ~ the same as the monte

carlo estimate

[note: we relaxed the principle of ‘adding’

standard deviations]

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Example
 You find out that the returns of your
holdings are normally distributed
around a mean of 15% with a standard
deviation of 10% (per annum). What is
the probability of getting positive
returns if the returns are calculated:
 annually (n=1)
 quarterly (n=2)

Verify using monte carlo simulation

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