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1 CHAPTER 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk Slide 2 2 Chapter Topics Estimating cash flows: Issues in Project Analysis Depreciation & Tax Effects on Salvage Value Inflation Risk Analysis: Sensitivity Analysis Scenario Analysis Simulation Analysis Decision Trees Real Options Slide 3 3 Relevant Cash Flows: Incremental Cash Flow for a Project Projects incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project. Slide 4 4 Free Cash Flow Capital Expenditures = FA + Deprec NOWC = Current Operating Assets Current Operating Liabilities Current Operating Assets excludes Marketable Securities Current Operating Liabilities excludes Notes Payable Slide 5 5 Free Cash Flow Investment outlay CF = CF 0 Operating CF = Net Income + Non-cash items (deprec) each year NOWC CF = Net working capital requirements each year Salvage CF = After-tax salvage value of assets and NOWC recovery Slide 6 6 Issues in Project Analysis Purchase of Fixed Assets Y Non-cash charges .. Y Changes in Net Working CapitalY Interest/Dividends .... N Sunk Costs .. N Opportunity Costs .. Y Externalities/Cannibalism Y Tax Effects .... Y Slide 7 7 Depreciation Basics Straight Line Salvage Value MACRS 0 Recovery Period = Class Life 1/2 Year Convention Slide 8 8 TABLE 13.1 MACRS Depreciation Classes Slide 9 9 TABLE 13.2 MACRS Depreciation Slide 10 10 Annual Depreciation Expense (000s) Year 1 2 3 4 % 0.33 0.45 0.15 0.07 Depr $ 79.2 108.0 36.0 16.8 x Basis = $240 Book Depr Value 79.2 160.8 187.2 52.8 223.2 16.8 240.0 0 SCC (Minicase): Equipment cost$200 Shipping 10 Installation 30 Slide 11 11 Tax Effect on Salvage Net Cash flow from sale = Sale proceeds - taxes paid Tax basis = difference between sales price and book value, where: Book value = Original basis - Accumulated depreciation Slide 12 12 Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling Price BV = Book Value T = Corporate tax rate Slide 13 13 BV (EOY 3) = $17 IF: Selling price= $20 TCF = $20 - (20-17)(.4) = $18.8 IF: Selling price = $10 TCF = $10 - (10-17)(.4) = $12.8 Example: If Asset Sold After 3 Years Slide 14 14 Adjusting for Inflation Nominal r > real r The cost of capital, r, includes a premium for inflation Nominal CF > real CF Nominal cash flows incorporate inflation If you discount real CF with the higher nominal r, then your NPV estimate is biased downward. Slide 15 15 INFLATION Real vs. Nominal Cash flows Nominal Real Slide 16 16 INFLATION Real vs. Nominal Cash flows 2 Ways to adjust Adjust WACC Cash Flows = Real Adjust WACC to remove inflation Adjust Cash Flows for Inflation Use Nominal WACC Slide 17 17 Regency Integrated Chips Slide 18 18 RIC Depreciation & Salvage Value Slide 19 19 RIC Sales, Costs and NWC Slide 20 20 RIC Cash Flow Estimation Slide 21 21 RIC: Cash Flow Analysis Slide 22 22 Excel Functions Slide 23 23 RIC Background Data Salvage Value Basic Calculations Cash Flow Estimation Cash Flow Analysis Key Slide 24 24 Risk in Capital Budgeting Uncertainty about a projects future profitability Measured by NPV, IRR, beta Will taking on the project increase the firms and stockholders risk? Slide 25 25 Three types of relevant risk Stand-alone risk Corporate risk Market (or beta) risk Slide 26 26 Stand-Alone Risk The projects risk if it were the firms only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the or CV of NPV, IRR, or MIRR. Slide 27 27 0E(NPV) Flatter distribution, larger , larger stand-alone risk. NPV Probability Density Slide 28 28 Corporate Risk Reflects the projects effect on corporate earnings stability. Considers firms other assets (diversification within firm). Depends on projects , and its correlation, , with returns on firms other assets. Measured by the projects corporate beta. Slide 29 29 Profitability 0Years Project X Total Firm Rest of Firm Project X is negatively correlated to firms other assets big diversification benefits If r = 1.0, no diversification benefits. If r < 1.0, some diversification benefits Slide 30 30 Market Risk Reflects the projects effect on a well- diversified stock portfolio. Takes account of stockholders other assets. Depends on projects and correlation with the stock market. Measured by the projects market beta. Slide 31 31 Conclusions on Risk Stand-alone risk is easiest to measure, more intuitive. Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. If the project is highly correlated with the economy, stand-alone risk also reflects market risk. Slide 32 32 Sensitivity Analysis Shows how changes in an input variable affect NPV or IRR Each variable is fixed except one Change one variable to measure the effect on NPV or IRR Answers what if questions Slide 33 33 RIC: Sensitivity Analysis Slide 34 34 RIC: Sensitivity Graph Slide 35 35 Results of Sensitivity Analysis Steeper sensitivity lines = greater risk Small changes large declines in NPV Unit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast Slide 36 36 RIC: Sensitivity Analysis Slide 37 Sensitivity Ratio % NPV = (New NPV - Base NPV)/Base NPV % VAR = (New VAR - Base VAR)/Base VAR If SR>0 Direct relationship If SR