Chapter12. Cash Flow Estimation and Risk Analysis
* Conceptual issues in cash flow estimation
1) Cash flows for capital budgeting vs. Accounting income=arbitrary
2) Timing ~ end of the year
3) Incremental cash flows from the specific project under consideration
a. Expansion and replacement project ~ additional instead of total cash flows
b. NO sunk costs to be included. E.g., A survey cost
c. Opportunity costs to be included. E.g., $2m market value piece of land
d. Externalities should be considered: within the firm (negative (e.g., cannibalization) and
positive (complementary) and outside of the firm (e.g., pollution)
*Calculating a project’s cash flows
- Initial Investment ~ Co=-IO
-Intermediate Cash Flows ~
Gross Margin – Operating expenses including depreciation = EBIT,
EBIT – Taxes = NOPAT (Net Operating Profit After Tax),
NOPAT + Depreciation = Operating Cash Flows (note that
NOPAT is different from Net Earnings)
Aside) Depreciation schedule ~ depreciation reduces EBIT & NOPAT subsequently. However,
the depreciation amount is added to NOPAT to determine the operating cash flows. MACRS
(Modified Accelerated Cost Recovery System – accelerated depreciation
method) produces a better cash flow stream. Also note that NOPAT does not include financial
cash flows like interest expenses as they are captured by the discount rate (WACC=r).
-Terminal value, if exists ~ to be added to determine the final period cash flow Cn = the last
period Operating Cash flow + Terminal value (after-tax salvage value, recovery of NOWC (Net
Operating Working Capital), etc)
Aplia #3) Terminal value consists of the recovery of NOWC. Also need
to consider the difference in depreciation amounts between the new
and old machines.
The after-tax cash flow selling the equipment = If the equipment is sold
above
the book value, the firm needs to pay tax for any profit above the book
value.
=Book Value + Profit*(1-T).
Aside) If the equipment is sold below the book value, the firm gets a
tax credit for the loss. In this case, Sale Price + Loss*T
* Expansion Project (p. 369 – p. 372)
* Replacement Analysis (p. 372 – p. 374)
* Evaluating risk in capital budgeting (pp.374-379)
-Types of risks
1) Stand-alone risk ~ only one project. No diversification. This risk can
be measured
by standard deviation as the ups and downs of this project directly
affect the
firm and the shareholders.
2) Corporate risk ~ the firm already has a few existing projects. Need
to consider
how this new project performance will be related to the performance
of the existing
projects. We can use correlation coefficients to measure the risk. As
the project
is highly positively correlated with the existing projects, the less is the
diversification
effect and the greater the corporate risk.
3) Systematic risk measured by beta ~ the firm already has a lot of
existing projects and this new one will be just one of them. In this case,
only the
systematic risk (the degree this project performance is related to the
ups and
downs of the entire economy) measured by beta would be relevant.
- Measuring Stand-alone risk
1) Sensitivity analysis ~ what if approach. Allow the value of only one
variable to
change and see how the outcome varies. Excel can be used to do this
analysis
2) Scenario analysis ~ Worst case, Best case, and possibly, neutral case
based on
different scenarios.
3) Monte Carlo ~ expanding the scenario analysis to get the outcomes
for all
possible scenarios.
* Real Options (Abandonment options) Table 12-3 p.384
In the worst case, the firm may be better off by closing down the
business
(or project) instead of keeping it. When you close down the business,
you may have
an improved cash flow from the sale of business.
Given the scenario,
Can you calculate E(NPV)?
However, according to the question, you have an option to abandon the
project
in the worst case scenario and reduce the loss. Cash flow from selling
the project
New E(NPV) using this abandonment option
for the worst case
The value of an abandonment option is the difference between new
E(NPV)
and the old E(NPV).
An option, whatever option it may be (real, stock, or even a rain
check), never
takes a value away from you, as it doesn’t do any harm to you. It is
always
good to have an option, as you have an option of not using
(exercising) the option.
* The Optimal Capital Budgeting (p. 385)