9-1
Chapter 9:
Project Cash
Flows and Risk
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9-2
Cash Flow Estimation
 Most important and most difficult step in
the analysis of a capital project
 Financial staff’s role includes:
 Coordinating the efforts of other
departments
 Ensuring that everyone uses the same
set of economic assumptions
 Making sure that no biases are
inherent in the forecasts
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9-3
Relevant Cash Flows
 Cash Flow Versus Accounting Income
 Incremental Cash Flows
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9-4
Cash Flow Versus
Accounting Income
2001 Situation
Accounting Profits
Cash Flows
Sales
$50,000
$50,000
Costs except depreciation
(25,000)
(25,000)
Depreciation
(15,000)
Net operating income or cash flow
$10,000
Taxes based on operating income (30%)
(3,000)
Net income or net cash flow
$7,000
-$25,000
(3,000)
$22,000
Net cash flow =
Net income plus depreciation = $7,000 + $15,000 = $22,000
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9-5
Cash Flow Versus
Accounting Income
2006 Situation
Accounting Profits
Cash Flows
Sales
$50,000
$50,000
Costs except depreciation
(25,000)
(25,000)
Depreciation
Net operating income or cash flow
Taxes based on operating income (30%)
Net income or net cash flow
(5,000)
$20,000
(6,000)
$14,000
-$25,000
(6,000)
$19,000
Net cash flow =
Net income plus depreciation = $14,000 + $5,000 = $19,000
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9-6
Incremental Cash Flows
An Incremental Cash Flow is the change in a
firm’s net cash flow attributable to an
investment project
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9-7
Problems in Determining
Incremental Cash Flows
 Sunk Cost: A cash outlay that already has been
incurred and cannot be recovered
 Opportunity Cost: The return on the best
alternative use of an asset
 Externalities: The effect accepting a project will
have on the cash flows in other parts of the firm
 Shipping and Installation Costs
 Inflation
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9-8
Identifying Incremental
Cash Flows
 Initial Investment Outlay: The incremental cash
flows associated with a project that will occur
only at the start of a project’s life CF0
 Incremental Operating Cash Flow: The changes
in day-to-day cash flows that result from the
purchase of a capital project and continue until
the firm disposes of the asset
 Terminal Cash Flow: The net cash flow that
occurs at the end of a project’s life
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9-9
Incremental Operating Cash
Flow
Incremental
operating = DNIt + DDeprt
cash flowt
= DEBTt X (1 - T) + DDeprt
= (DSt - DOCt - DDeprt) X (1 - T) + DDeprt
= (DSt - DOCt) X (1 - T) + T(DDeprt)
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9-10
Capital Budgeting Project
Evaluation
 Expansion Project: A project that is intended to
increase sales
 Replacement Analysis: An analysis involving the
decision of whether to replace an existing asset
that is still productive with a new asset
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9-11
Expansion Project
Analysis of the Cash Flows
Initial Investment Outlay
Shipping & installation
Increase in NWC
Initial Investment
2000
$(9,500)
(500)
(4,000)
$(14,000)
Incremental Operating Cash Flow
Sales revenue
Variable Costs
Fixed Costs
Depreciation on new equipment
Earnings before taxes (EBT)
Taxes (40%)
Net Income
Add back depreciation
Incremental operating cash flows
2001
2002
2003
2004
$30,000 $30,000 $30,000 $30,000
(18,000) (18,000) (18,000) (18,000)
(5,000) (5,000) (5,000) (5,000)
(2,000) (3,200) (1,900) (1,200)
$5,000 $3,800 $5,100 $5,800
(2,000) (1,520) (2,040) (2,320)
$3,000 $2,280 $3,060 $3,480
2,000
3,200
1,900 1,200
$5,000 $5,480 $4,960 $4,680
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9-12
Expansion Project
Analysis of the Cash Flows
Year
2001
2002
2003
2004
Incremental Operating Cash Flow Computation
$5,000 =
$5,480 =
$4,960 =
$4,680 =
($30,000 - $18,000 - $5,000)
($30,000 - $18,000 - $5,000)
($30,000 - $18,000 - $5,000)
($30,000 - $18,000 - $5,000)
(1 – 0.40)
(1 – 0.40)
(1 – 0.40)
(1 – 0.40)
+ $2,000(0.40)
+ $3,200(0.40)
+ $1,900(0.40)
+ $1,200(0.40)
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9-13
Expansion Project
Analysis of the Cash Flows
2000
2001
2002
Terminal Cash Flow
Return of net working capital
Net salvage value
Terminal Cash Flow
Annual Net Cash Flow
Total net cash flow/year
Net Present Value
2003
2004
$4,000
1,800
$5,880
$(14,000)
$5,000
$5,480
$4,960 $10,560
$3,790
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9-14
Expansion Project
Cash Flow Time Line
2000
2001
0
1
k = 15%
(14,000)
4,384
4,143
3,261
6,038
NPV = $3,790
Net cash
flows
IRR =
26.3%
5,000
2002
2
2003
3
2004
4
5,480
4,960
10,560
Payback period = 2.7 years
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9-15
Replacement Project
Analysis of the Cash Flows
2000
Initial Investment Outlay
Cost of new asset
Change in net working capital
Net cash flow/sale of old asset
Initial Investment
2001
2002
2003
2004
2005
$(12,000)
(1,000)
1,600
$(11,400)
Incremental Operating Cash Flow
D Operating costs
D Depreciation
D Earnings before taxes (EBT)
D Taxes (40%)
D Net Income
Add back D depreciation
Incremental operating cash flows
$3,500
(3,460)
40
(16)
24
3,460
$3,484
$3,500 $3,500 $3,500 $3,500
(4,900) (1,300)
(340)
500
(1,400) 2,200
3,160 4,000
560
(880) (1,264) (1,600)
(840) 1,320
1,896 2,400
4,900 1,300
340
(500)
$4,060 $2,620 $2,236 $1,900
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9-16
Replacement Project
Analysis of the Cash Flows
2000
Terminal Cash Flow
Return of net working capital
Net salvage value of new asset
Terminal Cash Flow
Annual Net Cash Flow
Total net cash flow each year
Net Present Value (15%)
2001
2002
2003
2004
2005
$1,000
1,200
$2,200
$(11,400)
$3,484 $4,060 $2,620 $2.236 $4,100
$(261)
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9-17
Replacement Project
Cash Flow Time Line
2000
0
2001
1
2002
2
2003
3
2004
4
2005
5
3,484
4,060
2,620
2,236
4,100
k = 15%
Net cash
flows (11,400)
3,030
3,070
1,723
1,278
2,038
NPV = $(261)
IRR = 14.0%
Payback period = 3.6 years
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9-18
Introduction to Project
Risk Analysis
 Stand-Alone Risk: The risk an asset would have if it
were a firm’s only risk

Measured by the variability of the asset’s expected returns
 Corporate (Within-Firm) Risk: Risk not considering
the effects of stockholder’s diversification

Measured by a project’s effect on the firm’s earnings
variability
 Beta (Market) Risk: Part of a project’s risk that cannot
be eliminated by diversification

Measured by the project’s beta coefficient
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9-19
Techniques for Measuring
Stand-Alone Risk
 Sensitivity Analysis: Key variables are
changed and the resulting changes in the
NPV and the IRR are observed
 Scenario Analysis: “Bad” and “good” sets of
financial circumstances are compared with
the most likely situation.
 Monte Carlo Simulation: Probable future
events are simulated on a computer
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9-20
Sensitivity Analysis Graph
NPV (000s) 80
Unit sales
60
40
20
SV
0
k
-20
-40
-30
-60
-20
-10
0
Base
10
20
30
% change
from base
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9-21
Scenario Analysis
Assume we know all variables except unit sales,
which could range from 75,000 to 125,000 (or 75
to 125). Here are the scenario NPVs:
Scenario
Probability
NPV (000)
Worst
0.25
-$27.8
Base
0.50
15.0
Best
0.25
57.8
E(NPV) =
(NPV) =
$15.0
$30.3
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9-22
Scenario Analysis
Standard Deviation:
NPV = $30.3
Coefficient of Variation:
σ
$30.3
NPV
CV


 2 .0
NPV ENPV  $15
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9-23
Advantages / Disadvantages of
Simulation Analysis?
Advantages
 Reflects probability of each input.
 Shows range of NPVs, expected
NPV, NPV, and CVNPV.
Disadvantages
 Difficult to specify probability
distributions and correlation.
 If inputs are bad, output will be bad:
GIGO = Garbage In, Garbage Out!
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9-24
Beta (or Market) Risk
Beta Risk and Required Rate of
Return for a Project
Security Market Line equation:
kS = kRF + (kM - kRF)bs
Erie Steel is all equity financed, so cost of equity is also
its averaged required rate of return, or cost of capital.
Erie’s b = 1.1; kRF = 8%; and kM = 12%
kS = 8% + (12% - 8%) = 12.4% = Erie’s cost of equity
Investors should be willing to give Erie money to invest
in average-risk projects.
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9-25
Project Required Rate of Return,
kproj
kproj = The risk adjusted required
rate of return for an individual
project
kproj = kRF + (kM - kRF)bproj
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9-26
Measuring Beta Risk
for a Project
Pure Play Method:
 Identify companies whose only
business is the project in question
 Determine the beta for each company
 Average the betas to find an
approximation of proposed project’s
beta
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9-27
How Project Risk Is Considered in
Capital Budgeting Decisions
Most firms use:
Risk Adjusted Discount Rate
 Discount rate that applies to
particularly risky stream of income
 It is equal to the risk-free rate of
interest plus a risk premium
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9-28
Capital Rationing
A situation in which a constraint is
placed on the total size of the firm’s
capital investment.
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9-29
Multinational
Capital Budgeting
Repatriation of Earnings: The process of
sending cash flows from a foreign subsidiary back
to the parent company.
Exchange Risk Rate: The uncertainty associated
with the price at which the currency from one
country can be converted into the currency of
another country.
Political Risk: The risk of seizure of a foreign
subsidiary’s assets by the host country or
unanticipated restrictions on cash flows to the
parent company.
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9-30
End of Chapter 9
Project Cash Flows
and Risk
Copyright (C) 2000 by Harcourt, Inc. All rights
reserved.