Cash Flow Estimation
Risk Analysis
CHAPTER 12
Conceptual Considerations
Analytical Methodology
Decision Metrics
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Dr. David P. Echevarria
1
Conceptual Considerations
A.
B.
Free Cash Flow = EBIT*(1-Tax Rate) – (CapEx
+ Changes in WC)
Accounting Income = Revenues – Expenses*
• Operating and Non-Operating
C. Incremental Cash Flows: change in total cash
flows as the result of an investment decision
D. Sunk Costs: costs incurred in the past which
cannot be recovered in the future regardless of
the investment decision
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Dr. David P. Echevarria
2
ANALYTICAL METHODOLOGY
A. Tax Considerations When Replacing Old
Plant and Equipment.
1. Replacement projects are undertaken to reduce
costs.
2. May involve the disposition of the old asset being
replaced.
3. Three possible situations when disposing (selling)
old assets (continued on next slide)
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Dr. David P. Echevarria
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ANALYTICAL METHODOLOGY
3. Three possible situations when disposing (selling)
old assets
a. If salvage value is less than book = tax credit.
The credit is a positive cash flow.
a. If salvage value is equal to book = it's a wash.
b. If salvage value is more than book = tax liability.
The liability is a negative cash flow.
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Dr. David P. Echevarria
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ANALYTICAL METHODOLOGY
B.
Determining Initial Investment (Io)
1.
The initial investment (or outlay) is the amount of
new cash we must provide to launch the venture.
The initial outlay (Io) is assumed to occur on day
zero. Io = CFo [-] in the BA II Plus
2.
C.
Typical Investment Objectives
1.
2.
3.
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Support additional sales.
Lower operating costs.
All projects must produce additional ATCF.
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5
ANALYTICAL METHODOLOGY
D. Learning Strategy
1. I will provide the change in operating income before
depreciation and taxes.
2. Depreciation Schedule according to M-ACRS
3. The Net Present Value of a Project (NPV);
NPV = S [ATCFn / (1+ka)n] - Io
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Dr. David P. Echevarria
6
Risk Analysis
A.
The riskiness of a potential investment can best
be approximated by sensitivity analysis
1.
2.
3.
4.
5.
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Changes in the cost of equipment or construction
Changes on Production Costs: Fixed, Variable
Changes in Expected Sales
Changes in the Cost of Capital
Changes in Tax Rates
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7
B.
Sensitivity can best be gauged using an NPV
profile
1.
2.
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A steep curve is implies less sensitivity
A shallow curve suggest more sensitivity
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8
CAPITAL BUDGETING
CLASS EXERCISE
FIN 335
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Dr. David P. Echevarria
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CAPITAL BUDGETING EXERCISE
A. Background Information: New Project Analysis
1.
2.
3.
4.
New machine [installed] cost = $ 250,000
Benefit: increases EBDT by $ 90,000 per year
Economic Expected Project Life = 5 years
Machine in 3 year ACRS category (ADC % rates = 33,
45, 15, 7 for years 1,2,3,4)
5. Expected Salvage Value at end of 5th year = $ 23,000
6. Startup Working Capital required = $ 25,000 (to be
recouped at end of 5th year)
7. Tax rate = 40%, WACC = 10%
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Computing Depreciation Schedule
DEPRECIATION SCHEDULE FOR NEW MACHINE
YEAR
ACRS
COST
1
0.33
250000
2
0.45
250000
3
0.15
250000
4
0.07
250000
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ADC
Dr. David P. Echevarria
ACDEP
BV
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Compute After Tax Cash Flows
YEAR
EBDT
1
90000
2
90000
3
90000
4
90000
5
90000
DEPR
EBT
TAX
EAT
DEPR
ATCF
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Dr. David P. Echevarria
12
After Tax Cash Flows
YEAR
ATCF
1
87000
2
99000
3
69000
4
61000
5
92800
Recoup
WC
25000
Sale
23000
Taxes
Net
ATCF
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Dr. David P. Echevarria
13
Compute NPV Using BA II PLUS
Press CF key: Use [ENTER] key to save values. Note CFo is a negative value.
CFo = -275000 ($250,000 cost of new machine + $25,000 WC needs)
↓
C01 = 87000
↓
F01 = 1
↓
C02 = 99000
↓
F02 = 1
↓
C03 = 69000
↓
F03 = 1
↓
C04 = 61000
↓
F04 = 1
↓
C05 = 92800
↓
F05 = 1
2ND QUIT
Press NPV key
I = 10
Press IRR key
Press [CPT]
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[↓]
Press [CPT]: NPV = 37,035.13
IRR = 15.30 [%]
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14
MIRR: Compute FV of ATCF using the
WACC (10%)
FVIF = (1 + Ka)(5-n)
Table 3
Year
ATCF
FVIF
FV
1
87000
1.4641
127376.7
2
99000
1.3310
131769
3
69000
1.2100
83490
4
61000
1.10
67100
5
92800
1.000
92800
FVIF(1) = (1.10)(5-1) = 1.4641, FVIF(2) = (1.10)3 = 1.3310, etc.
Terminal Value = S FVn from Table 3 = $ 502,535.70
2nd CLR TVM
FV = 502535.7
PV = - 275000
N=5
CPT I/Y = 12.81 [%]
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15
Compute Payback Period
Number of years to recoup CFo ($ 275,000)
870000 + 99000 + 69000 = 255000 +
20000/61000 = 3.33 years
Sensitivity Analysis
A.
B.
NPV if annual savings are 20% greater (EBDT
= $108,000 per year) NPV = $ 77,975.63
NPV if annual savings are 20% smaller (EBDT
= 72,000 per year) NPV = $ -3,905.37
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Dr. David P. Echevarria
16
HOMEWORK CHAPTER 12
A.
B.
C.
D.
Self-Test: ST-1, parts d, e, standalone risk
Questions: 12-4, 12-6, 12-9
Problems: 12-1, 12-5, 12-9
Excel Simulation #2
1.
2.
The Excel simulation primarily focuses on sensitivity
analysis.
Care should be taken when input the various options.
Make certain you reset to base values before proceeding
to the next option.
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Dr. David P. Echevarria
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