FIN MAN CHAPTER 12 Cash Flow Estimation and Risk Analysis
Terms in this set (21)
>Total depreciable cost
-Shipping and installation: $40,000
>Changes in operating working capital
-Inventories will rise by $25,000
-Accounts payable will rise by $5,000
>Effect on operations
-New sales: 100,000 units/year @ $2/unit
>Life of the project
-Economic life: 4 years
-Depreciable life: MACRS 3-year class
-Salvage value: $25,000
>Tax rate: 40%
Determining Project Value
>Estimate relevant cash flows
-Calculating annual operating cash flows.
-Identifying changes in net operating working capital.
-Calculating terminal cash flows: after-tax salvage value and return of NOWC.
Should financing effects be included in cash flows?
- No, dividends and interest expense should not be included in the analysis.
- Financing effects have already been taken into account by discounting cash flows at the WACC of 10%.
- Deducting interest expense and dividends would be "double counting" financing costs.
Should a $50,000 improvement cost from the previous year be included in the analysis?
- No, the building improvement cost is a sunk cost and should not be considered.
- This analysis should only include incremental investment.
If the facility could be leased out for $25,000 per year, would this affect the analysis?
•Yes, by accepting the project, the firm foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project.
If the new product line decreases the sales of the firm's other lines, would this affect the analysis?
•Yes. The effect on other projects' CFs is an "externality."
•Net CF loss per year on other lines would be a cost to this project.
•Externalities can be positive (in the case of complements) or negative (substitutes).
If this were a replacement rather than a new project, would the analysis change?
- Yes, the old equipment would be sold, and new equipment purchased.
- The incremental CFs would be the changes from the old to the new situation.
- The relevant depreciation expense would be the change with the new equipment.
- If the old machine was sold, the firm would not receive the SV at the end of the machine's life. This is the opportunity cost for the replacement project.
3 types of project risk
•The project's total risk, if it were operated independently.
•Usually measured by standard deviation (or coefficient of variation).
•However, it ignores the firm's diversification among projects and investors' diversification among firms.
•The project's risk when considering the firm's other projects, i.e., diversification within the firm.
•Corporate risk is a function of the project's NPV and standard deviation and its correlation with the returns on other firm projects.
•The project's risk to a well-diversified investor.
•Theoretically, it is measured by the project's beta and it considers both corporate and stockholder diversification.
Which type of risk is most relevant?
•Market risk is the most relevant risk for capital projects, because management's primary goal is shareholder wealth maximization.
•However, since corporate risk affects creditors, customers, suppliers, and employees, it should not be completely ignored.
Which risk is the easiest to measure?
•Stand-alone risk is the easiest to measure. Firms often focus on stand-alone risk when making capital budgeting decisions.
•Focusing on stand-alone risk is not theoretically correct, but it does not necessarily lead to poor decisions.
Are the three types of risk generally highly correlated?
•Yes, since most projects the firm undertakes are in its core business, stand-alone risk is likely to be highly correlated with its corporate risk.
•In addition, corporate risk is likely to be highly correlated with its market risk.
- measures the effect of changes in a variable on the project's NPV.
- To perform a sensitivity analysis, all variables are fixed at their expected values, except for the variable in question which is allowed to fluctuate.
- Resulting changes in NPV are noted.
The advantages and disadvantages of sensitivity analysis
-Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables.
-Does not reflect the effects of diversification.
-Does not incorporate any information about the possible magnitude of the forecast errors.
•Use the replacement chain to calculate an extended NPVB to a common life.
•All other factors shall remain constant and the NPV under each scenario can be determined.
Is this project likely to be correlated with the firm's business? How would it contribute to the firm's overall risk?
•We would expect a positive correlation with the firm's aggregate cash flows.
•As long as correlation is not perfectly positive (i.e., ρ 1), we would expect it to contribute to the lowering of the firm's overall risk.
If the project had a high correlation with the economy, how would corporate and market risk be affected?
•The project's corporate risk would not be directly affected. However, when combined with the project's high stand-alone risk, correlation with the economy would suggest that market risk (beta) is high.
What subjective risk factors should be considered before a decision is made?
•Numerical analysis sometimes fails to capture all sources of risk for a project.
•If the project has the potential for a lawsuit, it is more risky than previously thought.
•If assets can be redeployed or sold easily, the project may be less risky than otherwise thought.