Transcript Introduction to Financial Management - B-K-Ind

Intro to Financial Management
Cash Flow and Risk in Capital Budgeting
Review
• Homework
• Methods of evaluating a project
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Payback Period
Discounted Payback Period
NPV
PI
IRR
MIRR
• Criteria for accepting a project
Free Cash Flows
• Interested in after-tax cash flows, not profits. Why?
• Interested in incremental cash flows.
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Do not count if take cash from existing products/services
Can count synergistic effects of a new project
Include incremental expenses
“Sunk costs are sunk”
• Interested in free cash flows
– Cash generated by operations
– Cash available to pay creditors or owners
• Separate the investment decision from the financing
– How is the cost of financing already incorporated?
Free Cash Flow
Initial Outlay
• Initial outlay
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Initial start-up costs
Increases in working capital
Sale prices of any replaced assets
Capital gains taxes due to sale above/below depreciated value
initial outlay = cost of new assets
+ sale price of replaced assets
+/- tax impact of sale of replaced assets
Free Cash Flow
Annual and Terminal Flows
• Annually
– Look at cash from operations
– Adjust for
• Depreciation impact on taxes
– Depreciation is not cash but is a cost and lowers taxes
• Interest expenses
• Changes in net working capital
– E.g. if have greater accounts receivable or inventory or
payables
• When project ends
– Calculate terminal (final) value of assets
Projects in Practice
• Projects may end up being delayed
– Due to economic reasons
– Due to political reasons
– Due to technological reasons
• Projects may be expanded
• Projects may be canceled
– Due to economic reasons
– Due to political reasons
– Due to technological reasons
Project Risk
• Stand alone risk
– All projects have risk, uncertainty
• Contribution-to-firm risk
– Project add risk to firm
– Project risk can be diversified with other projects
• Systematic risk
– From viewpoint of shareholder
– A project risk can be diversified by other shareholder investments
• Text says that theoretically only systematic risk is
important
– Not from the viewpoint of the firm!
– Not from the viewpoint of a project manager!
Risk and Capital Budgeting
• Incorporate risk into discount rate
– Increase hurdle rate to account for risk
– Greater risk requires greater return
• Can try to calculate systematic risk
– Calculate a beta for the project
– But there are no historical returns
– Two approaches:
1. Can try comparing past division results to benchmark
(accounting method)
2. Pure play method – use the beta of a firm that looks like the
project
Use Simulations to Evaluate Risk
• Have multiple factors that all have risk and a range of
outcomes
– Market size
– Market share
– Costs
• Evaluate a scenario
– Select values for each factor and compute a result
– Get an IRR or NPV
• Evaluate many (thousands) of scenarios
– Get a distribution of outcomes for IRR or NPV
– Can get a “probability” distribution for IRR or NPV