CHAPTER 12
Cash Flow Estimation and Risk
Analysis
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Relevant cash flows
Sunk cost
Opportunity cost
Incidental effect
Risk Analysis
By Donglin Li
11-1
Some points to remember in
calculating cash flows
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Focus on incremental cash flows—the
difference in cash flows because of this
project
Forget sunk costs– costs that have
accrued in the past
By Donglin Li
11-2
Some points to remember in
calculating cash flows
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Include opportunity costs– costs of highest
potential benefits forgone by taking this
project
Consider incidental effects—(also called side
effects, externality)
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Positive side effects – benefits to other projects
Negative side effects – costs to other projects
Sounds abstract, but you all have applied
these rules.
By Donglin Li
11-3
Relevant (incremental) Cash
Flows
The cash flows that should be included in a
capital budgeting analysis are those that will
only occur if the project is accepted
 These cash flows are also called incremental
cash flows
 We analyze each project in isolation from the
firm simply by focusing on incremental cash
flows
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By Donglin Li
11-4
Asking the Right Question
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You should always ask yourself “Will this
cash flow occur ONLY if we accept the
project?”
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If the answer is “yes”, it should be included in the
analysis because it is incremental
If the answer is “no”, it should not be included in
the analysis because it will occur anyway
If the answer is “part of it”, then we should include
the part that occurs because of the project
By Donglin Li
11-5
Sunk costs
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The sunk cost is past cost and
irreversible. Since it cannot be affected
by the decision to accept or reject the
project, it should be ignored.
Is your education cost so far at SFSU
sunk cost?
By Donglin Li
11-6
You plan to produce ice cream using
some facility that you bought at $50,000
last year.
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Should this $50,000 cost from the
previous year be included in the
analysis?
No, this cost is a sunk cost and
should not be considered.
By Donglin Li
11-7
Opportunity cost
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The highest benefit forgone when you
take a project
The opportunity cost may be relevant to
the investment decision even when no
cash changes hands.
Give me an example about the
opportunity cost of studying at SFSU?
By Donglin Li
11-8
You plan to use the facility to produce ice creams.
The facility could be leased out for $25,000 per
year, would this affect the analysis?
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Yes, by accepting the project, the firm
foregoes a possible annual cash flow of
$25,000, which is an opportunity cost to
be charged to the project.
The relevant cash flow is the annual aftertax opportunity cost.
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A-T opportunity cost = $25,000 (1 – T)
= $25,000(0.6)
= $15,000
Opportunity cost is relevant.
By Donglin Li
11-9
Incidental Effects (Externality)
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The “side effects” of taking a project.
Give me an example of incidental effect
if you got a degree from SFSU.
By Donglin Li
11-10
If the ice cream production were to decrease
the sales of the firm’s other lines (for example,
Yogurt), would this affect the analysis?
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Yes. The effect on other projects’ CFs is an
“externality.”
Decreased CF per year on other lines would
be a cost to this project.
Externalities can be positive (in the case of
complements) or negative (substitutes).
Externality (also called incidental effect) is
relevant.
By Donglin Li
11-11
Evaluating NPV Estimates
The NPV estimates are just that – estimates
 A positive NPV is a good start – now we need
to take a closer look
 Forecasting risk – how sensitive is our NPV
to changes in the cash flow estimates; the
more sensitive, the greater the forecasting
risk.
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By Donglin Li
11-12
Exercise Questions
A cost that has already been paid, or the
liability to pay has already been incurred,
is a(n):
a. Salvage value expense.
b. Net working capital expense.
c. Sunk cost.
d. Opportunity cost.
By Donglin Li
11-14
You bought some real estate 6 years ago for $25,000, and
you are thinking of using this land for the construction of a
new warehouse as part of a production expansion project.
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You include the $25,000 purchase cost of the
land as an initial cost in the capital budgeting
process. By doing so, you are making the
mistake of
in the decisionmaking process.
a.
b.
c.
d.
e.
including
including
including
including
including
erosion costs
opportunity costs
sunk costs
net working capital changes
financing costs
By Donglin Li
11-15
You bought some real estate 6 years ago for $25,000, and
you are thinking of using this land for the construction of a
new warehouse as part of a production expansion project.
You do NOT consider the $25,000 purchase cost of
the land as an initial cost in the capital budgeting
process. You also ignore the fact that the land now
can be sold at $28,000. By doing so, you are
making the mistake of ______in the decisionmaking process.
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a.
b.
c.
d.
e.
excluding erosion costs
excluding opportunity costs
excluding sunk costs
including opportunity costs
including sunk costs
By Donglin Li
11-16
You bought some real estate 6 years ago for $25,000, and
you are thinking of using this land for the construction of a
new warehouse as part of a production expansion project.
You correctly do NOT consider the $25,000 purchase cost of
the land as an initial cost in the capital budgeting process.
You also correctly consider the fact that the land now can be
sold at $30,000. But you forget to consider the fact that the
new warehouse will attract more customer in the region and
your other business (retailing, for example) will be positively
affected. By doing so, you are making the mistake of ____in
the decision-making process.
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a.
b.
c.
d.
e.
excluding
excluding
excluding
excluding
excluding
erosion costs
opportunity costs
sunk costs
incidental effects
financing costs
By Donglin Li
11-17
If two projects are independent, then:
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a. Accepting one automatically implies
rejection of the other.
b. If one is undertaken, the other must be
undertaken as well.
c. Both will be undertaken, assuming each
has a positive NPV and the firm’s capital
budget can afford to include both projects.
d. All of the above
By Donglin Li
11-18
Incremental cash flows refer to:
a.The difference between after-tax cash
flows and before-tax accounting profits.
b. The additional cash flows that will be
generated if a project is undertaken.
c.The cash flows of a project, minus
financing costs.
d. The cash flows that are foregone if a
firm does not undertake a project.
By Donglin Li
11-19
Which of the following should be included
in an analysis of a new project?
a. Any sales from existing products that
would be lost if customers were expected
to purchase a new product instead.
b. All financing costs.
c. All sunk costs.
d. All of the above.
e. None of the above.
By Donglin Li
11-20
Adams Audio is considering whether to make an
investment in a new type of technology.
Which of the following factors should the company
consider when it decides whether to undertake the
investment?
a.
The company has already spent $3 million
researching the technology.
b.
The new technology will affect the cash flows
produced by its other operations.
c.
If the investment is not made, then the company
will be able to sell one of its laboratories for $2 million.
d.
Statements b and c should be considered.
e.
All of the statements above should be considered.
By Donglin Li
11-21