Transcript Essentials of Finance - Ramkhamhaeng University

Chapter 10
Project Cash Flows and Risk
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Learning Outcomes
Chapter 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’ efforts
 Ensuring that everyone uses the same set of
economic assumptions
 Making 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
Shipping and installation
Increase in net working capital
Initial investment
$( 9,500)
( 500)
( 4,000)
$(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
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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 risk
 Measured by the variability of the asset’s expected returns

Corporate (Within-Firm) Risk: risk not considering the
effects of stockholder’s diversification
 Measured 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 diversification
 Measured 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

Advantages
 Reflects probability of each input
 Shows 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
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