Brigham & Ehrhardt

Financial
Management:
Theory and Practice
14e
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1
CHAPTER 11

Cash Flow Estimation and

Risk Analysis

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2
Topics
 Estimating cash flows:
 Relevant cash flows
 Working capital treatment
 Risk analysis:
 Sensitivity analysis
 Scenario analysis
 Simulation analysis
 Real options
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 The Big Picture:
Project Risk Analysis

Project’s Cash
Flows (CFt)

CF CF CF
NPV = + + ··· + N −
(1 1+ r )1 (1 2+ r)2 (1 + r)N
Initial cost

Market Project’s
interest debt/equity
Project’s risk-
rates capacity
adjusted
cost of capital
Market (r)
risk
aversion Project’s
business
risk
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Proposed Project Data
 $200,000 cost + $10,000 shipping
+ $30,000 installation.
 Economic life = 4 years.
 Salvage value = $25,000.
 MACRS 3-year class.

Continued…
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Project Data (Continued)
 Annual unit sales = 1,250.
 Unit sales price = $200.
 Unit costs = $100.
 Net working capital:

NWCt = 12%(Salest+1)
 Tax rate = 40%.
 Project cost of capital = 10%.
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Incremental Cash Flow for
a Project
 Project’s incremental cash flow is:

Corporate cash flow with the project

Minus
Corporate cash flow without the
project.

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Treatment of Financing
Costs
 Should you subtract interest expense or
dividends when calculating CF?
 NO.
 We discount project cash flows with a cost
of capital that is the rate of return required
by all investors (not just debtholders or
stockholders), and so we should discount
the total amount of cash flow available to all
investors.
 They are part of the costs of capital. If we
subtracted them from cash flows, we would
be double counting capital costs. 8
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Sunk Costs
 Suppose $100,000 had been spent last
year to improve the production line site.
Should this cost be included in the
analysis?

 NO. This is a sunk cost. Focus on

incremental investment and operating
cash flows.

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Incremental Costs
 Suppose the plant space could be
leased out for $25,000 a year. Would
this affect the analysis?
 Yes. Accepting the project means we will
not receive the $25,000. This is an
opportunity cost and it should be
charged to the project.
 A.T. opportunity cost = $25,000 (1 – T)
= $15,000 annual cost.

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Externalities
 If the new product line would decrease
sales of the firm’s other products by
$50,000 per year, would this affect the
analysis?
 Yes. The effects on the other projects’
CFs are “externalities.”
 Net CF loss per year on other lines
would be a cost to this project.
 Externalities will be positive if new
projects are complements to existing
assets, negative if substitutes.
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What is an asset’s
depreciable basis?

Basis = Cost
+ Shipping
+ Installation
$240,000

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Annual Depreciation
Expense (Thousands of
Dollars)
(Initial =
Year % X
Basis) Deprec.
1 0.3333 $240 $80.0

2 0.4445 106.7

3 0.1481 35.5

4 0.0741 17.8

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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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14
Why is it important to include
inflation when estimating cash
flows?
 Nominal r > real r. The cost of
capital, r, includes a premium for
inflation.
 Nominal CF > real CF. This is
because nominal cash flows
incorporate inflation.
 If you discount real CF with the
higher nominal r, then your NPV
estimate is too low. Continued…
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Inflation (Continued)

 Nominal CF should be discounted

with nominal r, and real CF should
be discounted with real r.
 It is more realistic to find the
nominal CF (i.e., increase cash flow
estimates with inflation) than it is
to reduce the nominal r to a real r.

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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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Cash Flows Due to Investments in
Net Working Capital (NWC)

CF Due to
Sales NWC Investment
(% of sales) in NWC
Year 0 $30,000 -$30,000
Year 1 $250,000 30,900 -900
Year 2 257,500 31,827 -927
Year 3 265,225 32,783 -956
Year 4 273,188 0 32,783

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Salvage Cash Flow at t = 4
(000s)
Salvage Value $25
Book Value 0
Gain or loss $25
Tax on SV 10
Net Terminal CF $15

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What if you terminate a project
before the asset is fully
depreciated?
 Basis = Original basis – Accum.
deprec.
 Taxes are based on difference

between sales price and tax basis.

Cash flow = Sale – Taxe
from sale proceed s
s paid

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Example: If Sold After 3
Years for $25 ($
thousands)
 Original basis = $240.
 After 3 years, basis = $17.8
remaining.
 Sales price = $25.
 Gain or loss = $25 – $17.8 = $7.2.
 Tax on sale = 0.4($7.2) = $2.88.
 Cash flow = $25 – $2.88 =
$22.12.
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Example: If Sold After 3
Years for $10 ($
thousands)
 Original basis = $240.
 After 3 years, basis = $17.8 remaining.
 Sales price = $10.
 Gain or loss = $10 – $17.8 = -$7.8.
 Tax on sale = 0.4(-$7.8) = -$3.12.
 Cash flow = $10 – (-$3.12) = $13.12.
 Sale at a loss provides a tax credit, so
cash flow is larger than sales price!
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 Net Cash Flows for Years
1-2
Year 0 Year 1 Year 2
Init. Cost - 0 0
$240,000
Op. CF 0 $106,997 $119,922
NWC CF -$30,000 -$900 -$927

Salvage 0 0 0
CF
Net CF - $106,097 $118,995
$270,000 24
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Net Cash Flows for Years
3-4
Year 3 Year 4
Init. Cost 0 0
Op. CF $93,785 $89,068
NWC CF -$955 $32,782
Salvage CF 0 $15,000
Net CF $92,830 $136,850

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 Project Net CFs Time Line

0 1 2 3 4

(270,000)106,097 118,995 92,830 136,850

Enter CFs in CFLO register and I/YR =

10.
NPV = $88,010.
IRR = 23.9%.
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 What is the project’s
MIRR?

0 10%
1 2 3 4

(270,000)106,097 118,995 92,830 136,850

102,113
143,984
141,215
(270,000) 524,162
MIRR = ?
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Calculator Solution
 Enter positive CFs in CFLO. Enter I/YR
= 10. Solve for NPV = $358,009.72.
 Now use TVM keys: PV = -358,009.72,

N = 4, I/YR = 10; PMT = 0; Solve for

FV = 524,162.03. (This is TV of
inflows)
 Use TVM keys: N = 4; FV =
524,162.03;
PV = -270,000; PMT= 0; Solve for I/YR
= 18.0%.
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 What is the project’s
payback? ($ thousands)

0 1 2 3 4

(270) 106 119 93 137

Cumulative:
(270) (164) (45) 48 185

Payback = 2 + $45/$93 = 2.5 years.

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What does “risk” mean in
capital budgeting?
 Uncertainty about a project’s
future profitability.
 Measured by σNPV, σIRR, beta.
 Will taking on the project increase
the firm’s and stockholders’ risk?

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Is risk analysis based on
historical data or subjective
judgment?
 Can sometimes use historical data,
but generally cannot.
 So risk analysis in capital
budgeting is usually based on
subjective judgments.

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What three types of risk
are relevant in capital
budgeting?
 Stand-alone risk
 Corporate risk
 Market (or beta) risk

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Stand-Alone Risk
 The project’s risk if it were the
firm’s only asset and there were no
shareholders.
 Ignores both firm and shareholder
diversification.
 Measured by the σ or CV of NPV,
IRR, or MIRR.

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Probability Density

Flatter distribution,
larger , larger
stand-alone risk.

0 E(NPV) NPV
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Corporate Risk
 Reflects the project’s effect on
corporate earnings stability.
 Considers firm’s other assets
(diversification within firm).
 Depends on project’s σ, and its
correlation, ρ, with returns on firm’s
other assets.
 Measured by the project’s corporate
beta.
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 Project X is negatively
correlated to firm’s other assets,
so has big diversification
benefits

If r = 1.0, no diversification
Profitability benefits. If r < 1.0, some
diversification benefits.
Project X

Total Firm
Rest of Firm

0 Years
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Market Risk
 Reflects the project’s effect on a
well-diversified stock portfolio.
 Takes account of stockholders’
other assets.
 Depends on project’s σ and
correlation with the stock market.
 Measured by the project’s market
beta.
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How is each type of risk
used?
 Market risk is theoretically best in
most situations.
 However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
 Therefore, corporate risk is also
relevant.
Continued…
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How is each type of risk
used?
 Stand-alone risk is easiest to
measure, more intuitive.
 Core projects are highly correlated
with other assets, so stand-alone
risk generally reflects corporate
risk.
 If the project is highly correlated
with the economy, stand-alone risk
also reflects market risk.
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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 $91
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41
Sensitivity Graph
NPV
($ 000s)
Unit Sales

88 Salvage

-30 -20 -10 Base 10 20 30

(%)
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42
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?
 Does not reflect diversification.
 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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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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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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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
With a 3% risk adjustment,
should our project be
accepted?
 Project r = 10% + 3% = 13%.
 That’s 30% above base r.
 NPV = $65,350.
 Project remains acceptable after
accounting for differential (higher)
risk.

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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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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What is a real option?
 Real options exist when managers can
influence the size and risk of a project’s
cash flows by taking different actions
during the project’s life in response to
changing market conditions.
 Alert managers always look for real
options in projects.
 Smarter managers try to create real
options.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are some types of
real options?
 Investment timing options
 Growth options
 Expansion of existing product line
 New products
 New geographic markets

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Types of real options
(Continued)
 Abandonment options
 Contraction
 Temporary suspension
 Flexibility options

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.