Chapter 10Project Cash Flows and Risk

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Learning OutcomesChapter 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’ effortsEnsuring that everyone uses the same set

of economic assumptionsMaking 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 ($ thousands)

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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

Expansion Project Cash Flow Time Line

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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 riskMeasured by the variability of the asset’s expected

returns Corporate (Within-Firm) Risk: risk not

considering the effects of stockholder’s diversificationMeasured 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 diversificationMeasured 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

AdvantagesReflects probability of each inputShows 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