Chapter 10
Cash Flow Estimation
and Risk Topics in
Capital Budgeting
© 2000 South-Western College Publishing
CAPITAL BUDGETING: TWO PROCESSES
• Estimate Incremental Cash Flows Associated
with Every Project
Difficult, subjective and sometimes arbitrary
Takes judgment and experience
• Evaluate Estimates Using Techniques Like
NPV and IRR
Straightforward given cash flow estimates
Little ambiguity or risk of error
TM 10-1
THE GENERAL APPROACH TO
CASH FLOW ESTIMATION
Some Helpful Hints
•Think through the events a project will bring about,
and write down the future financial implications of each
•Forecasts for new ventures tend to be the most complex
Pre-startup, the initial outlay:
Enumerate pre-start expenses after tax and all assets
that must be purchased.
Sales Forecast
Forecast incremental units over time in spreadsheet form
Extend by prices for revenues
TM 10-2 Slide 1 of 3
Cost of Sales and Expenses:
Base costs and expenses on some assumed
relationship with forecast incremental revenues
Assets:
Plan new assets whenever they're expected to be acquired
Include working capital
Depreciation:
Plan depreciation for new assets
It's a non-cash item but impacts taxes
Taxes and Earnings
Summarize tax deductible items in each period to calculate the
project's impact on taxes and earnings
Treat incremental taxes like any other cash flow item
TM 10-2 Slide 2 of 3
Expansion projects
Require the same elements as new ventures
but generally fewer and simpler
Replacement projects
Generally save cost without generating new revenue
Savings are planned over future periods along with required assets
The Typical Pattern
Outflows first followed by inflows
Initial outlay is generally large
Some subsequent outflows are fairly common
(E. g., early losses in a new venture)
TM 10-2 Slide 3 of 3
Project Cash Flows are Incremental
In addition to and at least conceptually separate from the existing business
Ignore Sunk Costs
Money already spent is not part of the decision
Only future costs matter
Opportunity Cost
Some resources that seem to be free aren't
The cost of any resource is whatever has to be given up for it
Value in the next best use
An idle resource is only free if it has no market value
Impacts on Other Parts of the Company
Lost sales
Economies of scale
Overhead Levels
Large incremental projects may require incremental overhead support
E.g., personnel, accounting
TM 10-3 Slide 1 of 2
Taxes
Improved profitability means incremental taxes
All bottom line period cash flows should be net of taxes
Cash vs. Accounting Results
Managers are interested in the net income impact of projects as well as
cash flow based capital budgeting results
Calculate accounting results for their information
Working Capital
Incremental sales normally require incremental receivables and inventories
(partially offset by payables) which need to be funded with cash
Ignore Financing Costs
The NPV and IRR techniques take care of financing
Old Equipment Sold Off
Include cash proceeds less taxes
TM 10-3 Slide 2 of 2
ACCURACY AND ESTIMATES
Estimating the future is generally difficult and imprecise
However
Capital budgeting projects usually come with built-in biases
The people doing the technical estimating are usually proposing the project
and have a self-interest in its approval
Therefore
The elements contributing to the final cash flows tend to be too optimistic
This does not imply deception
Biases are often honest differences of opinion based on point of view and
priorities
TM 10-9
ESTIMATING CASH FLOWS
FOR REPLACEMENT PROJECTS
Usually simpler but identifying what is incremental can be tricky
Example 10-2: HARRINGTON METALS, INC.
REPLACEMENT STAMPING MACHINE
Old Machine:
Purchased five years ago for $80,000
8 yr straight line depreciation
Performs poorly:
High maintenance cost
Excessive down-time
Poor quality output
Market value is $45,000
3 operators @ $25,000
Proposed Machine:
Costs $150,000
Five-year straight line depreciation
2 operators @ $25,000
One year full warranty
TM 10-10 Slide 1 of 2
OLD MACHINE'S DOWN-TIME AND MAINTENANCE COST
Year
Hours Down
Maintenance
Exp ($000)
1
2
40
60
In
Warranty $10
3
100
4
130
_5_
128
$35
$42
$45
Down-time is subjectively estimated to cost $500 per hour
PROPOSED MACHINE'S MANUFACTURER CLAIMS
Down-time per year
30 hours
Maintenance cost per year
$15,000
Higher quality output will increase sales
TWO KINDS OF CASH FLOW ESTIMATE
Subjective
Objective
Note: The tax rate is 34%
TM 10-10 Slide 2 of 2
SUBJECTIVE ESTIMATES
of Subsequent Cash Flows
The issues are the differences in cost or benefit due to:
• Maintenance Expense
• Downtime
• Product Quality
Assumptions must be made about:
•
•
•
•
Whether the old machine will get worse or stay as is
Whether the proposed machine will live up to its claims
What value to place on an hour of downtime
How to handle the quality issue:
Measuring quality
Estimating improvement
Valuing improvement
The analyst must be impartial and keep peoples' biases in mind
TM 10-12 Slide 1 of 2
MAINTENANCE COST($000)
Assume maintenance on the old machine stays at $45,000 and the
proposed machine performs as promised
Year
OLD
Machine
1
$45.0
2
3
4
$45.0
$45.0
$45.0
$45.0
NEW
Machine
In
Wrnty $15.0
$15.0
$15.0
$15.0
Savings
$45.0
$30.0
$30.0
$30.0
$30.0
5
DOWNTIME
Assume 100 hours of downtime per year are saved arbitrarily valued
at $200 per hour
Assume no value for improvement in product quality
TM 10-12 Slide 2 of 2
RISK IN CAPITAL BUDGETING
•Cash flow estimates are risky and can be thought of
as random variables
•Conceptually similar to the return on an investment
•Each future cash flow is a separate random variable
with its own probability distribution
•The risk associated with a particular flow is related to the
variance of its probability distribution
TM 10-14 Slide 1 of 2
Prob (Ci)
Variance
(risk)
Ci
Expected
Value
Figure 10-1 The Probability Distribution of A Future Cash Flow
as a Random Variable
TM 10-14 Slide 2 of 2
Cash Flows as random variables imply project NPV's and IRR's are
also random variables with their own probability distributions
Project Cash Flows
...
C0
C1
C2
Cn
Time
Probabilistic Cash Flows Lead To Probabilistic
NPV and IRR
NPV
IRR
Figure 10-2 Risk in Estimated Cash Flows
Hence NPV's and IRR's also have most likely values but will probably turn out
somewhat differently depending on the variances of the distributions
TM 10-15
THE IMPORTANCE OF RISK IN CAPITAL BUDGETING
Ignoring the possibility that NPV or IRR can turn out to be other than
expected means there's a good chance of making wrong decisions
Example
NPVA
NPVB
$12M
Figure 10-2
$13M
Project NPV's Reflecting Risky Cash Flows
• NPVB has a higher expected value than NPVA, but is much more risky
Standard capital budgeting techniques will invariably choose B over A
but there's a good chance the actual NPVB < NPVA
• If that happens the wrong decision may cost millions.
•The principle of risk aversion is applicable
• Less risky capital projects are preferred to those with more risk.
TM 10-16 Slide 1 of 2
Changing the Nature of the Company
A firm that takes on risky projects over time
becomes more risky itself which eventually affects
its beta and stock price
Hence, some consideration of risk should be
included in project analysis.
TM 10-16 Slide 2 of 2
METHODS OF INCORPORATING RISK
SCENARIO/SENSITIVITY ANALYSIS
Consider A Range of Possible Outcomes Including Good,
Most Likely, and Bad
For each cash flow:
Prob(Ci)
Ci
Bad
Figure 10-3
Most Likely
Good
Possible Cash Flows for a Particular Period
TM 10-17 Slide 1 of 2
• Calculate NPV and IRR three times using
good, bad, and most likely cases for each cash flow
• Gives a range of values for NPV and IRR
along with the most likely values
and a subjective feel for a project's risk
• Tests the sensitivity of NPV and IRR
to changes in assumptions about cash flows.
• However, it does not give a very good notion of the
probability distribution of outcomes
TM 10-17 Slide 2 of 2
SIMULATION
Using the Computer to Build an NPV or IRR Probability Distribution
Input the probability distributions for all Ci
Draw observations from each and compute NPV or IRR
Repeat and display as histogram
Approximates the probability distributions of NPV and IRR
Number of
Observations
600
500
400
300
200
100
NPV
-$100
0
$100
$200
$300
Centers of NPV ranges
$400
Figure 10-4 Results of Monte Carlo Simulation for IRR
TM 10-18 Slide 1 of 2
Drawbacks to Simulation Approach
• Cash flow distributions have to be subjectively
estimated
• Distributions are not generally independent
Tend to be correlated: if early flows are low,
it's likely that later flows will also be low
• There are no decision rules for
choosing among projects with respect to risk
TM 10-18 Slide 2 of 2
INCORPORATING RISK INTO CAPITAL BUDGETING
THE THEORETICAL APPROACH
RISK ADJUSTED RATES OF RETURN - CAPM
• In both NPV and IRR an interest rate (the cost of capital, k) determines
project acceptability
• The higher the rate, the less likely is acceptance
• Risk aversion implies that
Riskier Projects Should Be Less Acceptable
• Incorporate risk into capital budgeting using Risk Adjusted Rates
in place of the cost of capital in applying NPV and IRR
techniques to riskier projects
• The cost of capital is the starting point reflecting normal risk
for the company
CHOOSING RISK ADJUSTED RATES
Replacement projects - cost of capital
Expansion projects - cost of capital plus 1 to 3%
New Venture projects - ???
TM 10-19
ESTIMATING RISK ADJUSTED RATES
FOR NEW VENTURES USING CAPM
If a project is viewed as a business,
a beta common to the field (pure play) may be
appropriate for estimating a risk adjusted rate
using the SML
kX = kRF + (kM - kRF)bX
The calculated rate approximates the required return
for an equity investment in the project
TM 10-20
PROBLEMS WITH THE CAPM APPROACH
It is questionable whether the CAPM calculated rate is appropriate
because it considers only systematic risk
A Project is a Diversification in Two Ways
The firm is a collection (portfolio) of projects
A new venture simply adds one more
and
A new venture effectively
diversifies the investment portfolios
of stockholders into the new line of business
This calls for a new look at diversified risk
TM 10-21 Slide 1 of 2
Total Risk
Risk Diversified
Away by Project
Portfolio
Risk Added To
Company
Risk Diversified
Away by Stockholder's
Investment Portfolio
Systematic Risk
Figure 10-5
Components of Project Risk
• Beta is associated with systematic risk, but total risk may be more
appropriate in the context of a project
• Hence the CAPM rate may be TOO LOW
• In Orion example(10-3) this implies the project is probably unacceptable
TM 10-21 Slide 2 of 2