Capital Budgeting
Project Cash Flows and Risk
^
CF1
^
CF2
^
CFn
Asset’s
+…+
= NPV = CF0 +
+
1
2
Net Value
(1 + r)
(1 + r)
(1 + r)n
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
1
Capital Budgeting
Project Cash Flows and Risk
Cash Flow Estimation
Expansion Project Evaluation
Replacement Analysis
Risk Analysis in Capital Budgeting
Capital Rationing & Multinational Capital
Budgeting
2
Capital Budgeting
Relevant Cash Flows
Cash flow versus accounting income
Net
Cash = Net income + Depreciation
Flow
Return
of
on
Return
=
+
capital
capital
3
Capital Budgeting—Relevant Cash Flows
Incremental cash flows—marginal cash flows
(positive and negative) generated by the asset
Sunk cost
Opportunity cost
Externalities
Shipping and installation
 Depreciable basis
= Purchase price + (Shipping & Installation)
Inflation
4
Identifying Incremental Cash Flows
Initial investment outlay—includes cash
flows that occur only at the beginning of the
project’s life.
Incremental operating cash flows—
changes in cash flows that are sustained
throughout the life of the asset—that is, the
cash flow effects are ongoing.
Terminal cash flow—the cash flows that
occur only at the end of the life of the asset.
5
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
6
Incremental Operating Cash Flows
D Cash sales
D Salaries
D Costs of raw materials
D Other cash operating revenues and expenses
D Taxes
 Δ revenues or expenses, Δ tax liability
 Depreciation—non-cash expense that affects taxes
7
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
8
Capital Budgeting Project Evaluation
Expansion projects—marginal cash flows include
all cash flows associated with adding a new asset to
grow the firm.
Replacement analysis—marginal 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).
9
Expansion Project—Example
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)
$(1,500)*
 Increase in gross profit
$21,000
 Marginal tax rate
34%
34%*
 Depreciation method
MACRS
10
MACRS Depreciation
Year
1
2
3
4
5
6
7
8
Life Class of Investment
3-year
5-year
7-year
33%
20%
14%
45
32
25
15
19
17
7
12
13
11
9
6
9
9
4
100%
100%
100%
11
Expansion Project
Initial Investment Outlay
Purchase Price
Installation
Δ Net WC
Initial invest outlay
$(47,000)
( 3,000)
( 1,500)
$(51,500)
Depreciable basis = $47,000 + $3,000
= $50,000
12
Expansion Project
Incremental Operating CF
D gross profit
Depreciation
Year 1
$21,000
(16,500)
Year 2
$21,000
(22,500)
Year 3
$21,000
( 7,500)
Depreciation1 = $50,000(0.33) = $16,500
Depreciation2 = $50,000(0.45) = $22,500
Depreciation3 = $50,000(0.15) = $ 7,500
13
Expansion Project
Incremental Operating CF
Year 1
D gross profit
$21,000
Depreciation
(16,500)
D taxable income
4,500
D taxes (34%)
(1,530)
D net income
2,970
Depreciation
16,500
D operating CF
19,470
Year 2
$21,000
(22,500)
( 1,500)
510
( 990)
22,500
21,510
Year 3
$21,000
( 7,500)
13,500
( 4,590)
8,910
7,500
16,410
14
Expansion Project
Terminal Cash Flow
Salvage of asset
Taxes on sale
Δ net working capital
Terminal cash flow
$5,000
(510)
1,500
5,990
% of asset depreciated = 33% + 45% + 15% = 93%
Book Value = (0.07)$50,000 = $3,500
Gain on sale = Sale
$5,000
price – Book
$3,500
value
= $1,500
Tax on gain = 0.34 x $1,500 = $510
15
Expansion Project
Cash Flow Time Line
0
1
2
3
19,470
21,510
16,410
5,990
22,400
12%
(51,500.00)
17,383.93
17,147.64
15,943.88
(1,024.55)
IRR = 10.9%
16
Replacement Decision—Example
Old machine
Purchase price
$(34,000)
Original life
6 years
Remaining life
4 years
Current salvage value
$16,000
Book value in four years
$4,000
Salvage in four years
$1,000
Depreciation
$5,000
Operating expense savings
-Δ Net WC
-Marginal tax rate
40%
New Machine
$(40,000)
4 years
4 years
-$0
$2,000
MACRS: 3-yr
$8,000
$1,000*
$1,000
40%
40%*
17
Replacement Decision
Initial Investment Outlay
Purchase price of new machine
Salvage value of old machine
Tax on sale of old machine
D working capital
Initial investment outlay
$(40,000)
$16,000
$3,200
$1,000
$(19,800)
Σ 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)
18
Replacement Decision
Incremental Operating CF
Savings
D depreciation
D taxable income
D taxes (40%)
D net income
Depreciation
D Operating CF
D
D
D
D
Depreciation1
Depreciation2
Depreciation3
Depreciation4
=
=
=
=
Year 1
$8,000
(8,200)
(200)
80
(120)
8,200
8,080
Year 2
Year 3
Year 4
$8,000 $8,000 $8,000
(13,000) (1,000) 2,200
(5,000)
7,000 10,200
2,000
(2,800) (4,080)
(3,000)
4,200
6,120
13,000
1,000 (2,200)
10,000
5,200
3,920
New depreciation
$40,000(0.33)
– $5,000
– Old depreciation
= $8,200
$40,000(0.45)
$40,000(0.33) – $5,000 = $13,000
$8,200
$40,000(0.15) – $5,000 = $1,000
$40,000(0.07) – $5,000 = $(2,200)
19
Replacement Decision
Terminal Cash Flow
Salvage value of new machine
Tax on
Tax
on sale
sale of
of new
new machine
machine
D working capital
Loss of salvage value of old machine
Loss
tax of
effect
sale of=old machine
Bookof
value
new on
machine
$0
Terminal
cash
flow – $0 = $2,000
Gain
on sale
= $2,000
Tax on sale = $2,000(0.40) =
$2,000
(800)
(1,000)
(1,000)
(1,200)
(2,000)
$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)
20
Replacement Decision
Cash Flow Time Line
0
1
2
3
4
8,080
10,000
5,200
3,920
(2,000)
1,920
12%
(19,800.00)
7,214.29
7,971.94
3,701.26
1,220.19
307.68
IRR = 12.9%
21
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 project’s 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).
22
Capital Budgeting Project Risk
Types of risk associated with projects:
Stand-alone risk—risk of the asset when it is held in
isolation—that is, when it stands alone
Corporate, or within-firm, risk—measured by the
impact an asset is expected to have on the operations
of the firm—that is, how an asset will affect the firm’s
total risk if it is purchased and added to existing assets
Beta, or market, risk—the portion of an asset’s risk
that cannot be eliminated through diversification—that
is, how an asset will affect the firm’s market risk, or
beta, if it is purchased and added to existing assets.
23
Stand-Alone Risk of a Project
Sensitivity analysis—determine by how much the final
result of a computation, such as NPV, changes when
the values (inputs) needed for the computation are
changed.
Example—replacement decision illustration:
Deviation from
Base Case (%)
-10
0
10
Operating Expense
Savings per Year
NPV
%D
$(421.29) (237%)
307.68
0
1,036.64
237
Required Rate
of Return (k)
NPV
%D
$519.27
69%
307.68
0
99.85
(68)
24
Stand-Alone Risk of a Project
Scenario analysis—compute outcomes using
various circumstances, or scenarios.
Scenario
Savings
Best case
$10,000
Most likely case
8,000
Worst case
6,000
NPV Probability NPV x Pr
$3,953
0.2
$790.60
308
0.7
215.60
(333.70)
(3,337)
0.1
Expected NPV = 672.50
sNPV = 1,962.89
CVNPV =
2.92
25
Stand-Alone Risk of a Project
Monte Carlo simulation—try 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.
26
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.
27
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 project—it is difficult to
determine the beta for a project.
 pure play method
28
Beta (Market) Risk—Example
 Capital Budgeting Project Characteristics:
Cost = $100,000
project = 1.5
rRF
= 3.0%
rM
= 9.0%
rproject = 3.0% + (9.0% - 3.0%)1.5 = 12.0%
 Firm’s Characteristics Before Purchasing the Project:
Total assets = $400,000
firm
= 1.0
 Firm’s Beta Coefficient After Purchasing the Project:
Total assets = $400,000 + $100,000 = $500,000
 400,000 
 100,000 
β F irm-new = 1.0
 + 1.5
 = 1.1
 500,000 
 500,000 
29
Capital Budgeting—Risk 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.
Risk Category
Above-average
Average
Below-average
Project Required
Rate of Return
16%
12
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.
30
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
NPV—that is, that increases the firm’s value by
the greatest total amount.
31
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 rates—that is, exchange rate
risk—affect the translation of foreign currency into
domestic currency
 Risk that foreign governments will takeover or severely
restrict operations of foreign subsidiaries—that is,
political risk exists
32
Project Cash Flows and Risk
The 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
project’s relevant cash flows?
 The means by which a long-term asset is
expensed over time.
33
Project Cash Flows and Risk
The 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
34