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Chapter Chapter 77

Project Cash

Flows and

Risk

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The cash flow estimationThe cash flow estimation

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Cash Flow from AssetsCash Flow from Assets

• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

• Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

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Basic TerminologyConventional Versus Nonconventional Cash Flows

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The Relevant Cash Flows

• Incremental cash flows:

– are cash flows specifically associated with the

investment, and

– their effect on the firms other investments (both

positive and negative) must also be considered.

For example, if a day-care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.

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Relevant Cash FlowsMajor Cash Flow Components

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• Categories of Cash Flows:

– Initial Cash Flows are cash flows resulting initially

from the project. These are typically net negative

outflows.

– Operating Cash Flows are the cash flows generated

by the project during its operation. These cash

flows typically net positive cash flows.

– Terminal Cash Flows result from the disposition of

the project. These are typically positive net cash

flows.

Relevant Cash Flows

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Relevant Cash FlowsExpansion Versus Replacement Cash Flows

• Estimating incremental cash flows is relatively

straightforward in the case of expansion projects, but

not so in the case of replacement projects.

• With replacement projects, incremental cash flows

must be computed by subtracting existing project cash

flows from those expected from the new project.

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Relevant Cash FlowsExpansion Versus Replacement Cash Flows

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Relevant Cash Flows

• Note that cash outlays already made (sunk costs) are

irrelevant to the decision process.

• However, opportunity costs, which are cash flows that

could be realized from the best alternative use of the

asset, are relevant.

Sunk Costs Versus Opportunity Costs

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Finding the Initial Investment

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Expansion Project—Example

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34%* Depreciation method MACRS

Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500)* Increase in gross profit $21,000 Marginal tax rate 34%* Depreciation method MACRS

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MACRS Depreciation Life Class of Investment

Year 3-year 5-year 7-year1 33% 20% 14%2 45 32 253 15 19 174 7 12 135 11 96 6 97 98 4

100% 100% 100%

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Expansion Project—Initial Investment Outlay

Purchase Price $(47,000)

Installation ( 3,000)

Δ Net WC ( 1,500)Initial invest outlay $(51,500)

Depreciable basis= $47,000 + $3,000

= $50,000

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Expansion Project—Incremental Operating Cash Flows

Depreciation1 = $50,000(0.33) = $16,500Depreciation2 = $50,000(0.45) = $22,500Depreciation3 = $50,000(0.15) = $ 7,500

Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500)Δ taxable income 4,500 ( 1,500) 13,500Δ taxes (34%) (1,530) 510 ( 4,590)Δ net income 2,970 ( 990) 8,910Depreciation 16,500 22,500 7,500Δ operating CF 19,470 21,510 16,410

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Expansion Project—Terminal Cash Flow

Salvage of asset $5,000• Taxes on sale (510)• Δ net working capital 1,500• Terminal cash flow 5,990

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Expansion Project—Cash Flow Time Line

19,470 21,510 16,410

10 2 3

(51,500.00)

12%

17,383.93

17,147.64

15,943.88

(1,024.55)

5,99022,400

IRR = 10.9%

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Capital Budgeting Project Evaluation

• Expansion projects—marginal cash flows include all cash flows associated with adding a new asset to grow the firm.

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Corporate (Within-Firm) Risk

• Determine how a capital budgeting project is related to the existing assets of the firm.

• If the firm wants to diversify its risk, it will try to invest in projects that are negatively related (or have little relationship) to the existing assets.

• If a firm can reduce its overall risk, then it generally becomes more stable and its required rate of return decreases.

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Beta (Market) Risk

• Theoretically any asset has a beta,, or some way to measure its systematic risk

• If we can determine the beta of an asset, then we can use the capital asset pricing model, CAPM, to compute its required rate of return as follows:

kproj = kRF + (kM - kRF)proj

• Measuring beta risk for a project—it is difficult to determine the beta for a project. – pure play method

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Beta (Market) Risk—Example

Capital Budgeting Project Characteristics:

Cost = $100,000project = 1.5

kRF = 3.0%kM = 9.0%kproject = 3.0% + (9.0% - 3.0%)1.5 = 12.0%

Firm’s Characteristics Before Purchasing the Project:Total assets = $400,000

firm = 1.0 Firm’s Beta Coefficient After Purchasing the Project:

Total assets = $400,000 + $100,000 = $500,000

1.1 500,000100,000

1.5 500,000400,000

1.0 β new-Firm

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Capital Budgeting—Risk Analysis• The firm generally uses its average required rate

of return to evaluate projects with average risk.• The average required rate of return is adjusted to

evaluate projects with above-average or below-average risks.

Project Required Risk Category Rate of Return Above-average 16%Average 12Below-average 10

If risk is not considered, high-risk projects might be accepted when they should be rejected and low-risk projects might be rejected when they should be accepted.