Cash Flow Estimation

and Risk Analysis

Topics
 Estimating cash flows:
 Some conceptual issues
 Relevant cash flows
 Inflation
 Risk Analysis: Sensitivity Analysis, Scenario Analysis,
and Simulation Analysis

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Introduction to CF estimation

 The most difficult part of capital budgeting is

estimating project CFs.
 Many variables and many departments are
involved.
 Marketing: unit sales and sales prices based on price elasticity,
advertising effect, state of the economy, competitive outlook,
consumer tastes.
 Engineering and product development: capital outlays
 Production, Personnel, Procurement, Accounts departments:
operating costs.

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Replacement and Expansion Projects
 Replacement projects: Existing assets are replaced
with similar assets. Objective is to lower cost
(improve efficiency) or increase sales of existing
products.
 Example: A manufacturing company replacing
equipment on an assembly line
 Expansion projects: Primary objective is to
increase the size of the business (new products or
outlets) or production capacity.
 Example: Wal-Mart opening a new retail outlet

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Project Cash Flow

 By project cash flow we mean free cash flow

attributable to a particular project. Just as free
cash flow is the basis of firm value, a project’s free
cash flow forms the basis of project value.
 A firm can be viewed as the sum of a number of
projects undertaken by the firm.
 Consider only incremental CFs: Firm’s CFs with
the project – Firm’s CFs without the project

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Typical project cash flows
 Asset purchases and salvage value:
 The capitalized cost of the asset (the amount to be depreciated) is the sum of the
purchase price of the asset and installation cost (including transportation, shipping,
handling, etc.).

 Changes in net operating working capital

 Annual after-tax operating cash flows
 Opportunity cost associated with assets that the
firm already owns
 Within-firm and environmental externalities:
 Lost/incremental cash flow from existing products or projects
(supplementary/complementary products or projects), cost of meeting
environmental regulations.

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Irrelevant project cash flows
 Sunk costs: An outlay related to the project that
was incurred in the past and cannot be
recovered/changed regardless of whether or not
the project is undertaken. For example, the market
research cost to assess the feasibility of opening a
store.
 Interest charges: Including interest charges in
project CFs would amount to double counting as
these are already a part of after-tax WACC (after-
tax cost of debt)!

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Broad categories of incremental CFs
 Both for replacement and expansion projects, we
will have three categories of incremental cash
flows:
 Initial outlay/investment,
 Annual after-tax operating cash flows, and
 Terminal cash flows.

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Why is it important to include inflation
when estimating cash flows?
 Nominal r > real r. The cost of capital, r, includes a
premium for inflation.
 Nominal CF > real CF. This is because nominal
cash flows incorporate inflation.
 If you discount real CF with the higher nominal r,
then your NPV estimate is too low.

Continued…
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Inflation (Continued)
 Nominal CF should be discounted with nominal r,
and real CF should be discounted with real r.
 It is more realistic to find the nominal CF (i.e.,
increase cash flow estimates with inflation) than it
is to reduce the nominal r to a real r.

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Example: Expansion Project
 $200,000 cost + $10,000 shipping + $30,000
installation.
 Economic life = 4 years.
 Salvage value = $25,000.
 MACRS 3-year class.

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Contd…
 Annual unit sales = 1,250.
 Unit sales price Year 1 = $200 and increases 3% a year.
 Unit costs Year 1 = $100 and increases 3% a year.
 Net operating working capital (NOWC) = 12% of next
year’s sales.
 Tax rate = 40%.
 Project cost of capital = 10%.

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What is the depreciation basis?
The capitalized cost of the asset is
the basis for depreciation:
Basis = Cost
+ Shipping
+ Installation
$240,000

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Annual Depreciation Expense (000s)

(Initial
Year % X = Depr.
Basis)
1 0.33 $240 $79.2

2 0.45 108.0

3 0.15 36.0

4 0.07 16.8

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Annual Sales and Costs
Year 1 Year 2 Year 3 Year 4
Units 1250 1250 1250 1250

Unit Price $200 $206 $212.18 $218.55

Unit Cost $100 $103 $106.09 $109.27

Sales $250,000 $257,500 $265,225 $273,188

Costs $125,000 $128,750 $132,613 $136,588

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Operating Cash Flows
(Years 1 and 2)
Year 1 Year 2
Sales $250,000 $257,500
Costs $125,000 $128,750
Depr. $79,200 $108,000
EBIT $45,800 $20,750
Taxes (40%) $18,320 $8,300
NOPAT $27,480 $12,450
+ Depr. $79,200 $108,000
Net Op. CF $106,680 $120,450

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Operating Cash Flows
(Years 3 and 4)
Year 3 Year 4
Sales $265,225 $273,188
Costs $132,613 $136,588
Depr. $36,000 $16,800
EBIT $96,612 $119,800
Taxes (40%) $38,645 $47,920
NOPAT $57,967 $71,880
+ Depr. $36,000 $16,800
Net Op. CF $93,967 $88,680

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Cash Flows due to Investments in Net
Operating Working Capital (NOWC)
CF Due to
NOWC Investment
Sales (% of sales) in NOWC
Year 0 $30,000 -$30,000
Year 1 $250,000 $30,900 -$900
Year 2 $257,500 $31,827 -$927
Year 3 $265,225 $32,783 -$956
Year 4 $273,188 $0 $32,783

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Salvage Cash Flow at t = 4 (000s)

Salvage Value $25

Book Value 0
Gain or loss $25
Tax on SV 10
Net Terminal CF $15

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What if you terminate a project before the
asset is fully depreciated?
 Basis = Original basis - Accum. deprec.
 Taxes are based on difference between sales price and
tax basis.
 Cash flow from sale = Sale proceeds- taxes paid.

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Example: If Sold After 3 Years for $25 ($
thousands)
 Original basis = $240.
 After 3 years, basis = $16.8 remaining.
 Sales price = $25.
 Gain or loss = $25 - $16.8 = $8.2.
 Tax on sale = 0.4($8.2) = $3.28.
 Cash flow = $25 - $3.28 = $21.72.

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Example: If Sold After 3 Years for $10 ($
thousands)
 Original basis = $240.
 After 3 years, basis = $16.8 remaining.
 Sales price = $10.
 Gain or loss = $10 - $16.8 = -$6.8.
 Tax on sale = 0.4(-$6.8) = -$2.72.
 Cash flow = $10 – (-$2.72) = $12.72.
 Sale at a loss provides tax credit, so cash flow is
larger than sales price!

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Net Cash Flows for Years 1-3
Year 0 Year 1 Year 2
Init. Cost -$240,000 0 0
Op. CF 0 $106,680 $120,450
NOWC CF -$30,000 -$900 -$927
Salvage CF 0 0 0
Net CF -$270,000 $105,780 $119,523

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Net Cash Flows for Years 4-5
Year 3 Year 4
Init. Cost 0 0
Op. CF $93,967 $88,680
NOWC CF -$956 $32,783
Salvage CF 0 $15,000
Net CF $93,011 $136,463

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Project Net CFs on a Time Line

0 1 2 3 4

(270,000) 105,780 119,523 93,011 136,463

NPV = $88,030.
IRR = 23.9%.

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What is the project’s MIRR? (000s)

0 1 2 3 4

(270,000) 105,780 119,523 93,011 136,463

102,312
144,623
140,793

(270,000) 524,191
MIRR = ?
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What is the project’s payback? (000s)

0 1 2 3 4

(270)* 106 120 93 136

Cumulative:
(270) (164) (44) 49 185

Payback = 2 + 44/93 = 2.5 years.

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 Example 2: Expansion Project
Figure 11-1. Analysis of an Expansion Project: Inputs and Key Results (Dollars in Thousands)

Part 1. Inputs and Key Results

Inputs Base-Case Key Results

Equipment cost $3,400 NPV $36
Salvage value, equipment, Year 4 $300 IRR 10.35%
Opportunity cost $0 MIRR 10.23%
Externalities (cannibalization) $0 PI 1.01
Units sold, Year 1 550 Payback 3.41
Annual change in units sold, after Year 1 4.00% Discounted payback 3.98
Sales price per unit, Year 1 $11.60
Annual change in sales price, after Year 1 2.00%
Variable cost per unit (VC), Year 1 $6.00
Annual change in VC, after Year 1 2.00%
Analyze once assuming MACRS
Nonvariable cost (Non-VC), Year 1 $2,000 (rates given on page 31) and
Annual change in Non-VC, after Year 1 2.00% then assuming straight line
Project WACC 10.00%
Tax rate 40.00%
method.
Working capital as % of next year's sales 12.65%

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Example 2: Expansion Project (contd.)
Part 2. Cash Flows and Performance Measures
Variables Used in the Cash Flow Forecast 0 1 2 3 4
Unit sales 550 572 595 619
Sales price per unit $11.60 $11.83 $12.07 $12.31
Variable cost per unit $6.00 $6.12 $6.24 $6.37
Nonvariable costs (excluding depreciation) $2,000 $2,040 $2,081 $2,122
Cash Flows At End of Year
Investment Outlays at Time = 0 0 1 2 3 4
Equipment -$3,400
Initial investment in working capital -807
Opportunity cost, after taxes 0
Net Cash Flows Over the Project's Life
Sales revenues = Units × Price/unit $6,380 $6,768 $7,179 $7,616
Variable costs = Units × Cost/unit 3,300 3,501 3,713 3,939
Nonvariable costs (excluding depreciation) 2,000 2,040 2,081 2,122
Depreciation: Accelerated, from table below 1,122 1,530 510 238
Operating profit (EBIT) -$42 -$303 $875 $1,316
Taxes on operating profit -17 -121 350 526
Net operating profit after taxes -$25 -$182 $525 $790
Add back depreciation 1,122 1,530 510 238
Opportunity cost, after taxes 0 0 0 0
Cannibalization or complementary effects, after taxes 0 0 0 0
Salvage value (taxed as ordinary income) 300
Tax on salvage value (SV is taxed at 40%) -120
Change in WC: Outflow (–) or recovery (+) -49 -52 -55 963

Project net cash flows: Time Line -$4,207 $1,048 $1,296 $980 $2,171
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Example 2: Expansion Project (contd.)
Model Using Straight-Line Depreciation 0 1 2 3 4
Variables Used in the Cash Flow Forecast
Unit sales 550 572 595 619
Sales price per unit $11.60 $11.83 $12.07 $12.31
Variable cost per unit $6.000 $6.120 $6.242 $6.367
Nonvariable costs (excluding depreciation) $2,000 $2,040 $2,081 $2,122
Cash Flows At End of Year
Investment Outlays at Time = 0 0 1 2 3 4
Equipment -$3,400
Initial investment in working capital -807
Opportunity cost, after taxes 0
Net Cash Flows Over the Project's Life
Sales revenues = Units × Price/unit $6,380 $6,768 $7,179 $7,616
Variable costs = Units × Cost/unit 3,300 3,501 3,713 3,939
Nonvariable costs (excluding depreciation) 2,000 2,040 2,081 2,122
Depreciation: Accelerated, from table below 850 850 850 850
Operating profit (EBIT) $230 $377 $535 $704
Taxes on operating profit 92 151 214 282
Net operating profit after taxes $138 $226 $321 $423
Add back depreciation 850 850 850 850
Opportunity cost, after taxes 0 0 0 0
Cannibalization or complementary effects, after taxes 0 0 0 0
Salvage value (taxed as ordinary income) 300
Tax on salvage value (SV is taxed at 40%) -120
Change in WC: Outflow (–) or recovery (+) -49 -52 -55 963

Project net cash flows: Time Line -$4,207 $939 $1,024 $1,116 $2,416
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Example 2: Expansion Project (contd.)
Project Evaluation Accelerated Straight Line
Results Formulas Results
NPV $36 =NPV(E59,F101:I101)+E101 -$18
IRR 10.35% =IRR(E101:I101) 9.83%
MIRR 10.23% =MIRR(E101:I101,E59,E59) 9.88%
Profitability index 1.01 =NPV(E59,F101:I101)/(-E101) 1.00
Payback 3.41 =PERCENTRANK(E112:I112,0,6)*I111 3.47
Discounted payback 3.98 =PERCENTRANK(E114:I114,0,6)*I111 #N/A
Calculations for Payback Year: 0 1 2 3 4
Cumulative cash flows for payback -$4,207 -$3,159 -$1,863 -$883 $1,288
Discounted cash flows for disc. payback -$4,207 $952 $1,071 $736 $1,483
Cumulative discounted cash flows -$4,207 -$3,255 -$2,183 -$1,447 $36
Accelerated Depreciation
Depreciable basis: $3,400 Rate/year 33% 45% 15% 7%
Dollars/year $1,122 $1,530 $510 $238

Calculations for Payback Year: 0 1 2 3 4

Cumulative cash flows for payback -$4,207 -$3,268 -$2,244 -$1,128 $1,288
Discounted cash flows for discounted payback -$4,207 $854 $847 $838 $1,650
Cumulative discounted cash flows -$4,207 -$3,353 -$2,507 -$1,669 -$18
Straight-Line Depreciation
Depreciable basis: $3,400 Rate/year 25% 25% 25% 25%
Dollars/year $850 $850 $850 $850
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Example 2: Expansion Project (contd.)
Taxation of Salvage

Suppose GPC terminates operations before the equipment is fully depreciated. The after-tax
salvage value depends upon the price at which GPC can sell the equipment and upon the book
value of the equipment (i.e., the original basis less all previous depreciation charges). See
below for calculations of yearly book values.

Year: 1 2 3 4
Beginning book value $3,400 $2,278 $748 $238
Depreciation $1,122 $1,530 $510 $238
Ending book value $2,278 $748 $238 $0

If GPC terminates at Year 2 and can sell the equipment for $898, what is the after-tax salvage
cash flow? What if GPC can only sell the equipment for $98 at Year 2?

Case 1: Case 2:
Gain Loss
Market value when salvaged at Year 2 $898.00 $98.00
Book value when salvaged at Year 2 $748.00 $748.00
Expected gain or loss $150.00 -$650.00
Tax expense (credit) $60.00 -$260.00

Cash from sale $898.00 $98.00

Tax expense (credit) $60.00 -$260.00
Net cash flow from salvage $838.00 $358.00

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Example: Replacement Project
Figure 11-9. Replacement Analysis

Applies to:
Both Old New
Part I. Inputs: Machines Machine Machine
Cost of new machine $2,000
After-tax salvage value old machine $400
Sales revenues (fixed) $2,500
Annual operating costs except depreciation $1,200 $280
Tax rate 40%
WACC 10%
Depreciation 1 2 3 4 Totals:
Depr. rates (new machine) 33% 45% 15% 7% 100%
Depreciation on new machine $660 $900 $300 $140 $2,000
Depreciation on old machine $400 $400 $400 $400 $1,600
∆: Change in depreciation $260 $500 -$100 -$260 $400

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Example: Replacement Project (contd.)
Part II. Net Cash Flows Before Replacement: Old Machine
0 1 2 3 4
Sales revenues $2,500 $2,500 $2,500 $2,500
Operating costs except depreciation 1,200 1,200 1,200 1,200
Depreciation 400 400 400 400
Total operating costs $1,600 $1,600 $1,600 $1,600
Operating income $900 $900 $900 $900
Taxes 40% 360 360 360 360
After-tax operating income $540 $540 $540 $540
Add back depreciation 400 400 400 400
Net cash flows before replacement $0 $940 $940 $940 $940
Part III. Net Cash Flows After Replacement: New Machine
0 1 2 3 4
New machine cost: -$2,000
After-tax salvage value, old machine $400
Sales revenues $2,500 $2,500 $2,500 $2,500
Operating costs except depreciation 280 280 280 280
Depreciation 660 900 300 140
Total operating costs $940 $1,180 $580 $420
Operating income $1,560 $1,320 $1,920 $2,080
Taxes 40% 624 528 768 832
After-tax operating income $936 $792 $1,152 $1,248
Add back depreciation 660 900 300 140
Net cash flows after replacement -$1,600 $1,596 $1,692 $1,452 $1,388

Part IV. Incremental CF: Row 51 - Row 38 -$1,600 $656 $752 $512 $448

Part V. Evaluation NPV = $308.51 IRR = 19.33% MIRR = 14.96%

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Example: Replacement Project (contd.)
Part VI. Alternative Calculation for Net Cash Flows
New machine cost -$2,000
Salvage value, old machine 400
Net cost of new machine -$1,600
Other operating cost savings = Old — New $920 $920 $920 $920
A-T savings = Other cost savings × (1 — Tax rate) 552 552 552 552
∆ Depreciation = (New — Old) 260 500 -100 -260
Depr'n tax savings = ∆ Depreciation × Tax rate 104 200 -40 -104
NCF = A-T cost savings + Depr'n tax savings -$1,600 $656 $752 $512 $448

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