Chapter 10Chapter 10

Cash Flow Estimation Cash Flow Estimation

and Risk Topics in and Risk Topics in

Capital BudgetingCapital Budgeting

© 2000 South-Western College Publishing

CAPITAL BUDGETING: TWO PROCESSESCAPITAL BUDGETING: TWO PROCESSES

• Estimate Incremental Cash Flows Associated

with Every Project

Difficult, subjective and sometimes arbitraryTakes judgment and experience

• Evaluate Estimates Using Techniques Like NPV and IRR

Straightforward given cash flow estimatesLittle ambiguity or risk of error

TM 10-1

THE GENERAL APPROACH TO THE GENERAL APPROACH TO CASH FLOW ESTIMATIONCASH 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 ForecastSales ForecastForecast 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 projectsRequire the same elements as new ventures

but generally fewer and simpler

Replacement projectsGenerally save cost without generating new revenue

Savings are planned over future periods along with required assets

The Typical PatternOutflows 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 IncrementalProject Cash Flows are IncrementalIn addition to and at least conceptually separate from the existing business

Ignore Sunk CostsIgnore Sunk CostsMoney already spent is not part of the decision

Only future costs matter

Opportunity CostOpportunity CostSome 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 CompanyImpacts on Other Parts of the CompanyLost sales

Economies of scale

Overhead LevelsOverhead LevelsLarge incremental projects may require incremental overhead support

E.g., personnel, accounting

TM 10-3 Slide 1 of 2

TaxesTaxesImproved profitability means incremental taxes

All bottom line period cash flows should be net of taxes

Cash vs. Accounting ResultsCash vs. Accounting ResultsManagers 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 CapitalWorking CapitalIncremental sales normally require incremental receivables and inventories

(partially offset by payables) which need to be funded with cash

Ignore Financing CostsIgnore Financing CostsThe NPV and IRR techniques take care of financing

Old Equipment Sold OffOld Equipment Sold OffInclude cash proceeds less taxes

TM 10-3 Slide 2 of 2

ACCURACY AND ESTIMATESACCURACY 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 PROJECTSUsually simpler but identifying what is incremental can be tricky

Example 10-2: HARRINGTON METALS, INC.

REPLACEMENT STAMPING MACHINE

Old Machine: Proposed Machine:

Purchased five years ago for $80,000 Costs $150,000

8 yr straight line depreciation Five-year straight line depreciation

Performs poorly: 2 operators @ $25,000

High maintenance cost One year full warranty

Excessive down-time

Poor quality output

Market value is $45,000

3 operators @ $25,000

TM 10-10 Slide 1 of 2

OLD MACHINE'S DOWN-TIME AND MAINTENANCE COSTOLD MACHINE'S DOWN-TIME AND MAINTENANCE COST

Year 1 2 3 4 _5_

Hours Down 40 60 100 130 128

Maintenance In

Exp ($000) Warranty $10 $35 $42 $45

Down-time is subjectively estimated to cost $500 per hour

PROPOSED MACHINE'S MANUFACTURER CLAIMSPROPOSED 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 ESTIMATETWO KINDS OF CASH FLOW ESTIMATE

Subjective

Objective

Note: The tax rate is 34%

TM 10-10 Slide 2 of 2

SUBJECTIVE ESTIMATESSUBJECTIVE ESTIMATES of Subsequent Cash Flows 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: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 1 2 3 4 5

OLD OLD

Machine $45.0 $45.0 $45.0 $45.0 $45.0

NEWNEW In

Machine Wrnty $15.0 $15.0 $15.0 $15.0

SavingsSavings $45.0 $30.0 $30.0 $30.0 $30.0

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 BUDGETINGRISK 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)

C i

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 BUDGETINGTHE 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 $13M Figure 10-2 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 Abut 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 CompanyChanging 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 METHODS OF INCORPORATING RISK SCENARIO/SENSITIVITY ANALYSISSCENARIO/SENSITIVITY ANALYSIS

Consider A Range of Possible Outcomes Including Good,

Most Likely, and Bad

For each cash flow:

Prob(Ci)

Ci Bad Most Likely Good

Figure 10-3 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

SIMULATIONSIMULATIONUsing 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 $400 Centers of NPV ranges

Figure 10-4 Results of Monte Carlo Simulation for IRR TM 10-18 Slide 1 of 2

Drawbacks to Simulation ApproachDrawbacks 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 BUDGETINGTHE 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 thatRiskier Projects Should Be Less Acceptable

• Incorporate risk into capital budgeting using Risk Adjusted Ratesin 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 RATESReplacement projects - cost of capital

Expansion projects - cost of capital plus 1 to 3%New Venture projects - ???

TM 10-19

ESTIMATING RISK ADJUSTED RATES ESTIMATING RISK ADJUSTED RATES FOR NEW VENTURES USING CAPMFOR 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 WaysThe 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