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Learning Outcomes
Chapter 10
Describe the relevant cash flows that must be forecast to make
informed capital budgeting decisions.
Identify the relevant cash flows and perform a capital budgeting
analysis for: (a) an expansion project and (b) a replacement
project
Describe how the riskiness of a capital budgeting project is
evaluated and how the results are incorporated in capital
budgeting decisions.
Describe how capital budgeting decisions differ for firms that have
foreign operations and for firms that only have domestic
operations
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Cash Flow Estimation
Most important and most difficult step in the
analysis of a capital project
Financial staff’s role includes:
 Coordinating other departments’ efforts
 Ensuring that everyone uses the same set of
economic assumptions
 Making sure that no biases are inherent in
forecasts
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Relevant Cash Flows
Cash Flow Versus Accounting Income
Incremental Cash Flows
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Unilate’s Accounting Profits
Versus Cash Flows
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Unilate’s Accounting Profits
Versus Cash Flows
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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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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 of accepting a project
on the cash flows in other parts of the firm
Shipping and Installation Costs
Inflation
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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
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 flows that
occur only at the end of a project’s life
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Incremental Operating Cash Flow
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Capital Budgeting Project Evaluation
Expansion Project: A project that is intended
to increase sales; provides growth to the firm
Replacement Analysis: An analysis involving
the decision of whether to replace an
existing, still productive asset with a new
asset
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Expansion Project Analysis of the Cash Flows
Initial Investment Outlay
Cost of new asset
$( 9,500)
Shipping and installation
( 500)
Increase in net working capital
( 4,000)
Initial investment
$(14,000)
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Expansion Project Analysis of the Cash Flows
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Expansion Project Net Salvage Value
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Expansion Project Analysis of the Cash Flows
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Expansion Project
Cash Flow Time Line
Replacement Project Analysis of the Cash Flows
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Replacement Project Cash Flow Time Line
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Incorporating Risk in Capital Budgeting 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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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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Sensitivity Analysis Graph
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Scenario Analysis
A risk analysis technique in which “bad” and
“good” sets of financial circumstances are
compared with a most likely, or base case,
situation.
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Scenario Analysis
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Monte Carlo Simulation
A risk analysis technique in which probable
future events are simulated on a computer,
generating a probability distribution that
indicates the most likely outcomes.
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Advantages/Disadvantages
of Simulation Analysis
Advantages
 Reflects probability of each input
 Shows range of NPVs, expected NPV, σNPV, 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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Corporate (Within-Firm) Risk
Risk that does not take into consideration the
effects of stockholders’ diversification, it is
measured by a project’s effect on the firm’s
earnings variability.
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Beta (or Market) Risk and Required Rate of
Return for a Project
Security Market Line equation:
rS = rRF + (rM - rRF)βS
Erie Steel is all equity financed, so cost of equity is also
its averaged required rate of return, or cost of capital.
Erie’s β = 1.1; rRF = 8%; and rM = 12%
rS = 8% + (12% - 8%)1.1 = 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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Required Rate of Return for a Project
rproj = the risk-adjusted required rate of
return for an individual project
rproj = rRF + (rM - rRF)proj
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Measuring Beta Risk for a Project
Pure Play Method:
1. Identify companies whose only business is the
project in question.
2. Determine the beta for each company.
3. Average the betas to find an approximation of
proposed project’s beta.
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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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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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