Transcript Essentials of Managerial Finance

Chapter 7
Project Cash
Flows and
Risk
Essentials of Managerial Finance by S. Besley & E. Brigham
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The cash flow estimation
Essentials of Managerial Finance by S. Besley & E. Brigham
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Cash 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
Essentials of Managerial Finance by S. Besley & E. Brigham
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Basic Terminology
Conventional Versus Nonconventional Cash Flows
Essentials of Managerial Finance by S. Besley & E. Brigham
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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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Relevant Cash Flows
Major Cash Flow Components
Essentials of Managerial Finance by S. Besley & E. Brigham
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Relevant Cash Flows
• 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Relevant Cash Flows
Expansion 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Relevant Cash Flows
Expansion Versus Replacement Cash Flows
Essentials of Managerial Finance by S. Besley & E. Brigham
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Relevant Cash Flows
Sunk Costs Versus Opportunity Costs
• 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Finding the Initial Investment
Essentials of Managerial Finance by S. Besley & E. Brigham
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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)
$(1,500)*
 Increase in gross profit
$21,000
 Marginal tax rate
34%
34%*
 Depreciation method
MACRS
Essentials of Managerial Finance by S. Besley & E. Brigham
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MACRS Depreciation
Year
1
2
3
4
5
6
7
8
Life Class of Investment
3-year
5-year
7-year
33%
20%
14%
45
32
25
15
19
17
7
12
13
11
9
6
9
9
4
100%
100%
100%
Essentials of Managerial Finance by S. Besley & E. Brigham
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Expansion Project—Initial
Investment Outlay
Purchase Price
Installation
Δ Net WC
Initial invest outlay
$(47,000)
( 3,000)
( 1,500)
$(51,500)
Depreciable basis = $47,000 + $3,000
= $50,000
Essentials of Managerial Finance by S. Besley & E. Brigham
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Expansion Project—Incremental
Operating Cash Flows
Year 1
Year 2
D gross profit
$21,000
$21,000
Depreciation
(16,500)
(22,500)
Δ taxable income 4,500
( 1,500)
Δ taxes (34%)
(1,530)
510
Δ net income
2,970
( 990)
Depreciation
16,500
22,500
Δ operating CF
19,470
21,510
Depreciation1 = $50,000(0.33) = $16,500
Depreciation2 = $50,000(0.45) = $22,500
Depreciation3 = $50,000(0.15) = $ 7,500
Essentials of Managerial Finance by S. Besley & E. Brigham
Year 3
$21,000
( 7,500)
13,500
( 4,590)
8,910
7,500
16,410
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Expansion Project—Terminal
Cash Flow
Salvage of asset
• Taxes on sale
$5,000
(510)
• Δ net working capital
1,500
• Terminal cash flow
5,990
Essentials of Managerial Finance by S. Besley & E. Brigham
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Expansion Project—Cash
Flow Time Line
0
1
2
3
19,470
21,510
16,410
5,990
22,400
12%
(51,500.00)
17,383.93
17,147.64
15,943.88
(1,024.55)
Essentials of Managerial Finance by S. Besley & E. Brigham
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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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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.
Essentials of Managerial Finance by S. Besley & E. Brigham
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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
Essentials of Managerial Finance by S. Besley & E. Brigham
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Beta (Market) Risk—Example
 Capital Budgeting Project Characteristics:
Cost = $100,000
project = 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
 400,000
β Firm -new  1.0
 500,000
Essentials of Managerial Finance by S. Besley & E. Brigham

 100,000
  1.5

 500,000

  1.1

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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 belowaverage risks.
Risk Category
Above-average
Average
Below-average

Project Required
Rate of Return
16%
12
10
If risk is not considered, high-risk projects might be
accepted when they should be rejected and lowrisk projects might be rejected when they should
be accepted.
Essentials of Managerial Finance by S. Besley & E. Brigham
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