Chapter 12

Cash Flow Estimation and Risk Analysis

Learning Objectives

After reading this chapter, students should be able to:

 Analyze an expansion project and make a decision whether the project should be accepted on the basis
of standard capital budgeting techniques.

 Discuss difficulties and relevant considerations in estimating net cash flows, and explain how project
cash flow differs from accounting income.

 Define the following terms: incremental cash flow, replacement analysis, sunk cost, opportunity cost,
externalities, and cannibalization effect.

 Identify and briefly explain three separate and distinct types of risk.

 Demonstrate sensitivity and scenario analyses and explain Monte Carlo simulation.

 Explain how risk is incorporated in capital budgeting through either the certainty equivalent or risk-
adjusted discount rate.

Chapter 12: Cash Flow Estimation and Risk Analysis Learning Objectives 303
 Lecture Suggestions

This chapter covers some important but relatively technical topics. Note too that this chapter is more
modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of
continuity. Therefore, if you are experiencing a time crunch, you could skip sections of the chapter.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
solution for Chapter 12, which appears at the end of this chapter solution. For other suggestions about the
lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

304 Lecture Suggestions Chapter 12: Cash Flow Estimation and Risk Analysis
 Answers to End-of-Chapter Questions

12-1 Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of
less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation
chapter we focused on dividends, which represent cash flows, rather than on earnings per share.

12-2 Capital budgeting analysis should only include those cash flows that will be affected by the decision.
Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting
decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather
than its next best alternative, and externalities are the cash flows (both positive and negative) to other
projects that result from the firm taking on this project. These cash flows occur only because the firm
took on the capital budgeting project; therefore, they must be included in the analysis.

12-3 When a firm takes on a new capital budgeting project, it typically must increase its investment in
receivables and inventories, over and above the increase in payables and accruals, thus increasing
its net operating working capital (NOWC). Since this increase must be financed, it is included as an
outflow in Year 0 of the analysis. At the end of the project’s life, inventories are depleted and
receivables are collected. Thus, there is a decrease in NOWC, which is treated as an inflow in the
final year of the project’s life.

12-4 The costs associated with financing are reflected in the weighted average cost of capital. To include
interest expense in the capital budgeting analysis would “double count” the cost of debt financing.

12-5 Daily cash flows would be theoretically best, but they would be costly to estimate and probably no
more accurate than annual estimates because we simply cannot forecast accurately at a daily level.
Therefore, in most cases we simply assume that all cash flows occur at the end of the year.
However, for some projects it might be useful to assume that cash flows occur at mid-year, or even
quarterly or monthly. There is no clear upward or downward bias on NPV since both revenues and
costs are being recognized at the end of the year. Unless revenues and costs are distributed
radically different throughout the year, there should be no bias.

12-6 In replacement projects, the benefits are generally cost savings, although the new machinery may also
permit additional output. The data for replacement analysis are generally easier to obtain than for new
products, but the analysis itself is somewhat more complicated because almost all of the cash flows are
New Expansion incremental, found by whether the project is a new expansion or a replacement project. A new
Project A new expansion project is defined as one where subtracting the firm invests in new assets to increase
investment designed sales. Here the incremental cash flows are simply the cash inflows and outflows. In effect, the company
to increase sales. is comparing what its value looks like with and without the proposed project. By contrast, a
replacement project occurs when the firm replaces an existing asset with a new one in order to
Replacement reduce operating costs, to increase output, or to improve product quality. In this case, the incremental
Project An cash flows are the additional inflows and outflows that result from replacing the old asset. In a
replacement analysis, the company is comparing its value if it makes the replacement versus its value if
investment to replace
old equipment and
thereby reduce costs,
increase output, or

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 305
 it continues to use the existing asset.1new cost numbers from the old numbers. Similarly, differences in
depreciation and any other factor that affects cash flows must also be determined.

12-7 Stand-alone risk is the project’s risk if it is held as a lone asset. It disregards the fact that it is but
one asset within the firm’s portfolio of assets and that the firm is but one stock in a typical
investor’s portfolio of stocks. Stand-alone risk is measured by the variability of the project’s
expected returns. Corporate, or within-firm, risk is the project’s risk to the corporation, giving
consideration to the fact that the project represents only one in the firm’s portfolio of assets, hence
some of its risk will be eliminated by diversification within the firm. Corporate risk is measured by
the project’s impact on uncertainty about the firm’s future earnings. Market, or beta, risk is the
riskiness of the project as seen by well-diversified stockholders who recognize that the project is
only one of the firm’s assets and that the firm’s stock is but one small part of their total portfolios.
Market risk is measured by the project’s effect on the firm’s beta coefficient.

12-8 It is often difficult to quantify market risk. On the other hand, we can usually get a good idea of a
project’s stand-alone risk, and that risk is normally correlated with market risk: The higher the
stand-alone risk, the higher the market risk is likely to be. Therefore, firms tend to focus on stand-
alone risk, then deal with corporate and market risk by making subjective, judgmental modifications
to the calculated stand-alone risk.

12-9 Simulation analysis involves working with continuous probability distributions, and the output of a
simulation analysis is a distribution of net present values or rates of return. Scenario analysis
involves picking several points on the various probability distributions and determining cash flows or
rates of return for these points. Sensitivity analysis involves determining the extent to which cash
flows change, given a change in one particular input variable. Simulation analysis is expensive.
Therefore, it would more than likely be employed in the decision for the $500 million investment in
a satellite system than in the decision for the $30,000 truck.

12-10 Scenario analyses, and especially simulation analyses, would probably be reserved for very important
“make-or-break” decisions. They would not be used for every project decision because it is costly (in
terms of money and time) to perform the necessary calculations and it is challenging to gather all the
required information for a full analysis. Simulation analysis, in particular, requires data from many
different departments about costs and projections, including the probability distributions corresponding
to those estimates and the correlation coefficients between various variables.

1 For more discussion on replacement analysis, refer to Web Appendix 12A on the Fundamentals Web site,
http://brigham.swlearning.com and click on the tab for the “Replacement Analysis” worksheet in 12
Chapter Model.xls. The main point to remember when analyzing replacement decisions is that incremental
cash flows represent changes in such items as sales, operating costs, depreciation, and taxes. This means
that more arithmetic is involved in replacement than in expansion decisions, but the concepts are exactly
the same.

306 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 Solutions to End-of-Chapter Problems

12-1 a. Equipment $ 9,000,000

NOWC Investment 3,000,000
Initial investment outlay $12,000,000

b. No, last year’s $50,000 expenditure is considered a sunk cost and does not represent an
incremental cash flow. Hence, it should not be included in the analysis.

c. The potential sale of the building represents an opportunity cost of conducting the project in that
building. Therefore, the possible after-tax sale price must be charged against the project as a cost.

12-2 a. Operating cash flows: t = 1

Sales revenues $10,000,000
Operating costs 7,000,000
Depreciation 2,000,000
Operating income before taxes $ 1,000,000
Taxes (40%) 400,000
Operating income after taxes $ 600,000
Add back depreciation 2,000,000
Operating cash flow $ 2,600,000

b. The cannibalization of existing sales needs to be considered in this analysis on an after-tax

basis, because the cannibalized sales represent sales revenue the firm would realize without
the new project but would lose if the new project is accepted. Thus, the after-tax effect would
be to reduce the firm’s operating cash flow by $1,000,000(1 – T) = $1,000,000(0.6) =
$600,000. Thus, the firm’s OCF would now be $2,000,000 rather than $2,600,000.

c. If the tax rate fell to 30%, the operating cash flow would change to:
Operating income before taxes $1,000,000
Taxes (30%) 300,000
Operating income after taxes $ 700,000
Add back depreciation 2,000,000
Operating cash flow $2,700,000

Thus, the firm’s operating cash flow would increase by $100,000.

12-3 Equipment’s original cost $20,000,000

Depreciation (80%) 16,000,000
Book value $ 4,000,000

Gain on sale = $5,000,000 – $4,000,000 = $1,000,000.

Tax on gain = $1,000,000(0.4) = $400,000.

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 307
 AT net salvage value = $5,000,000 – $400,000 = $4,600,000.

12-4 a. The applicable depreciation values are as follows for the two scenarios:
Scenario 1 Scenario 2
Year (Straight-Line) (MACRS)
1 $200,000 $264,000
2 200,000 360,000
3 200,000 120,000
4 200,000 56,000

b. To find the difference in net present values under these two methods, we must determine the
difference in incremental cash flows each method provides. The depreciation expenses cannot
simply be subtracted from each other, as there are tax ramifications due to depreciation
expense. The full depreciation expense is subtracted from Revenues to get operating income,
and then taxes due are computed Then, depreciation is added to after-tax operating income to
get the project’s operating cash flow. Therefore, if the tax rate is 40%, only 60% of the
depreciation expense is actually subtracted out during the after-tax operating income
calculation and the full depreciation expense is added back to calculate operating income. So,
there is a tax benefit associated with the depreciation expense that amounts to 40% of the
depreciation expense. Therefore, the differences between depreciation expenses under each
scenario should be computed and multiplied by 0.4 to determine the benefit provided by the
depreciation expense.

Depreciation Expense Depreciation Expense

Year Difference (2 – 1) Diff.  0.4 (MACRS)
1 $ 64,000 $25,600
2 160,000 64,000
3 -80,000 -32,000
4 -144,000 -57,600

Now to find the difference in NPV to be generated under these scenarios, just enter the cash
flows that represent the benefit from depreciation expense and solve for net present value
based upon a WACC of 10%.

CF0 = 0; CF1 = 25600; CF2 = 64000; CF3 = -32000; CF4 = -57600; and I/YR = 10. Solve for
NPV = $12,781.64

So, all else equal the use of the accelerated depreciation method will result in a higher NPV (by
$12,781.64) than would the use of a straight-line depreciation method.

12-5 E(NPV)= 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) + 0.05($30)

= -$3.5 + -$5.0 + $6.0 + $4.0 + $1.5
= $3.0 million.

NPV = [0.05(-$70 – $3)2 + 0.20(-$25 – $3)2 + 0.50($12 – $3)2 + 0.20($20 – $3)2 + 0.05($30 – $3)2]½
= $23.622 million.

308 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
12-6 a. The net cost is $178,000:
Cost of investment at t = 0:
Base price ($140,000)
Modification (30,000)
Increase in NOWC (8,000)
Cash outlay for new machine ($178,000)

b. The operating cash flows follow:

Year 1 Year 2 Year 3
After-tax savings $30,000 $30,000 $30,000
Depreciation tax savings 22,440 30,600 10,200
Net operating cash flow $52,440 $60,600 $40,200

Notes:
1. The after-tax cost savings is $50,000(1 – T) = $50,000(0.6) = $30,000.

2. The depreciation expense in each year is the depreciable basis, $170,000, times the
MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively.
Depreciation expense in Years 1, 2, and 3 is $56,100, $76,500, and $25,500. The
depreciation tax savings is calculated as the tax rate (40%) times the depreciation expense
in each year.

c. The terminal cash flow is $48,760:

Salvage value $60,000
Tax on SV* (19,240)
Return of NOWC 8,000
$48,760
*Tax on SV = ($60,000 – $11,900)(0.4) = $19,240.

Remaining BV in Year 4 = $170,000(0.07) = $11,900.

d. The project has an NPV of ($19,549). Thus, it should not be accepted.

Year Net Cash Flow PV @ 12%

0 ($178,000) ($178,000)
1 52,440 46,821
2 60,600 48,310
3 88,960 63,320
NPV = ($ 19,549)

Alternatively, place the cash flows on a time line:

0 1 2 3
12%
| | | |
-178,000 52,440 60,600 40,200

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 309
 48,760
88,960

With a financial calculator, input the cash flows into the cash flow register, I/YR = 12, and then
solve for NPV = -$19,548.65  -$19,549.

12-7 a. The $5,000 spent last year on exploring the feasibility of the project is a sunk cost and should
not be included in the analysis.

b. The net cost is $126,000:

Price ($108,000)
Modification (12,500)
Increase in NOWC (5,500)
Cash outlay for new machine ($126,000)

c. The operating cash flows follow:

Year 1 Year 2 Year 3
1. After-tax savings $28,600 $28,600 $28,600
2. Depreciation tax savings 13,918 18,979 6,326
Net cash flow $42,518 $47,579 $34,926

Notes:
1. The after-tax cost savings is $44,000(1 – T) = $44,000(0.65) = $28,600.

2. The depreciation expense in each year is the depreciable basis, $120,500, times the MACRS
allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation
expense in Years 1, 2, and 3 is $39,765, $54,225, and $18,075. The depreciation tax savings is
calculated as the tax rate (35%) times the depreciation expense in each year.

d. The terminal cash flow is $50,702:

Salvage value $65,000
Tax on SV* (19,798)
Return of NOWC 5,500
$50,702
*Tax on SV = ($65,000 – $8,435)(0.35) = $19,798.

BV in Year 4 = $120,500(0.07) = $8,435.

e. The project has an NPV of $10,841; thus, it should be accepted.

Year Net Cash Flow PV @ 12%

0 ($126,000) ($126,000)
1 42,518 37,963
2 47,579 37,930
3 85,628 60,948
NPV = $ 10,841

Alternatively, place the cash flows on a time line:

0 1 2 3
12%

310 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 | | | |
-126,000 42,518 47,579 34,926
50,702
85,628

With a financial calculator, input the appropriate cash flows into the cash flow register, input
I/YR = 12, and then solve for NPV = $10,840.51  $10,841.

12-8 a. Expected annual cash flows:

Project A: Probable
Probability × Cash Flow = Cash Flow
0.2 $6,000 $1,200
0.6 6,750 4,050
0.2 7,500 1,500
Expected annual cash flow = $6,750

Project B: Probable
Probability × Cash Flow = Cash Flow
0.2 $ 0 $ 0
0.6 6,750 4,050
0.2 18,000 3,600
Expected annual cash flow = $7,650

Coefficient of variation:

Project A:

Project B:

CVA = $474.34/$6,750 = 0.0703.

CVB = $5,797.84/$7,650 = 0.7579.

b. Project B is the riskier project because it has the greater variability in its probable cash flows,
whether measured by the standard deviation or the coefficient of variation. Hence, Project B is
evaluated at the 12% cost of capital, while Project A requires only a 10% cost of capital.

Using a financial calculator, input the appropriate expected annual cash flows for Project A into
the cash flow register, input I/YR = 10, and solve for NPVA = $10,036.25.

Using a financial calculator, input the appropriate expected annual cash flows for Project B into
the cash flow register, input I/YR = 12, and solve for NPVB = $11,624.01.

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 311
 Project B has the higher NPV; therefore, the firm should accept Project B.

c. The portfolio effects from Project B would tend to make it less risky than otherwise. This
would tend to reinforce the decision to accept Project B. Again, if Project B were negatively
correlated with the GDP (Project B is profitable when the economy is down), then it is less risky
and Project B's acceptance is reinforced.

12-9 If actual life is 5 years:

Using a time line approach:
0 1 2 3 4 5
10%
| | | | | |
Investment outlay (36,000)
Operating cash flows
excl. deprec. (AT) 7,200 7,200 7,200 7,200 7,200
Depreciation savings 2,880 2,880 2,880 2,880 2,880
Net cash flow (36,000) 10,080 10,080 10,080 10,080 10,080

NPV10% = $2,211.13.

If actual life is 4 years:

Using a time line approach:
0 1 2 3 4
10%
| | | | |
Investment outlay (36,000)
Operating cash flows
excl. deprec. (AT) 7,200 7,200 7,200 7,200
Depreciation savings 2,880 2,880 2,880 2,880
Tax savings on loss 2,880
Net cash flow (36,000) 10,080 10,080 10,080 12,960

NPV10% = -$2,080.68.

If actual life is 8 years:

Using a time line approach:
0 1 5 6 7 8
10%
| |  | | | |
Investment outlay (36,000)
Operating cash flows
excl. deprec. (AT) 7,200 7,200 7,200 7,200 7,200
Depreciation savings 2,880 2,880
Net cash flow (36,000) 10,080 10,080 7,200 7,200 7,200

NPV10% = $13,328.93.

If the life is as low as 4 years (an unlikely event), the investment will not be desirable. But, if the
investment life is longer than 4 years, the investment will be a good one. Therefore, the decision

312 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 will depend on the managers' confidence in the life of the tractor. Given the low probability of the
tractor's life being only 4 years, it is likely that the managers will decide to purchase the tractor.

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 313
12-10 a. 0 1 2 3 4 5
Initial investment ($250,000)
Net oper. WC (25,000)

Cost savings $90,000 $ 90,000 $90,000 $90,000 $90,000

Depreciationa 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes $ 7,500 ($ 22,500) $52,500 $72,500 $90,000
Taxes (40%) 3,000 (9,000) 21,000 29,000 36,000
Oper. Inc. (AT) $ 4,500 ($ 13,500) $31,500 $43,500 $54,000
Add: Depreciation 82,500 112,500 37,500 17,500 0
Oper. CF $87,000 $ 99,000 $69,000 $61,000 $54,000

Return of NOWC $25,000

Sale of Machine 23,000
Tax on sale (40%) (9,200)
Net cash flow ($275,000) $87,000 $ 99,000 $69,000 $61,000 $92,800

NPV = $37,035.13
IRR = 15.30%
MIRR = 12.81%
Payback = 3.33 years

Notes:
a
Depreciation Schedule, Basis = $250,000
MACRS Rate
 Basis =
Year Beg. Bk. Value MACRS Rate Depreciation Ending BV
1 $250,000 0.33 $ 82,500 $167,500
2 167,500 0.45 112,500 55,000
3 55,000 0.15 37,500 17,500
4 17,500 0.07 17,500 0
$250,000

b. If savings increase by 20%, then savings will be (1.2)($90,000) = $108,000.

If savings decrease by 20%, then savings will be (0.8)($90,000) = $72,000.

314 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 (1) Savings increase by 20%:
0 1 2 3 4 5
Initial investment ($250,000)
Net oper. WC (25,000)

Cost savings $108,000 $108,000 $108,000 $108,000 $108,000

Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes $ 25,500 ($ 4,500) $ 70,500 $ 90,500 $108,000
Taxes (40%) 10,200 (1,800) 28,200 36,200 43,200
Oper. Inc. (AT) $ 15,300 ($ 2,700) $ 42,300 $ 54,300 $ 64,800
Add: Depreciation 82,500 112,500 37,500 17,500 0
Oper. CF $ 97,800 $109,800 $ 79,800 $ 71,800 $ 64,800

Return of NOWC $ 25,000

Sale of Machine 23,000
Tax on sale (40%) (9,200)
Net cash flow ($275,000) $ 97,800 $109,800 $ 79,800 $ 71,800 $103,600

NPV = $77,975.63

(2) Savings decrease by 20%:

0 1 2 3 4 5
Initial investment ($250,000)
Net oper. WC (25,000)

Cost savings $72,000 $ 72,000 $72,000 $72,000 $72,000

Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes ($10,500) ($ 40,500) $34,500 $54,500 $72,000
Taxes (40%) (4,200) (16,200) 13,800 21,800 28,800
Oper. Inc. (AT) ($ 6,300) ($ 24,300) $20,700 $32,700 $43,200
Add: Depreciation 82,500 112,500 37,500 17,500 0
Oper. CF $76,200 $ 88,200 $58,200 $50,200 $43,200

Return of NOWC $25,000

Sale of Machine 23,000
Tax on sale (40%) (9,200)
Net cash flow ($275,000) $76,200 $ 88,200 $58,200 $50,200 $82,000

NPV = -$3,905.37

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 315
 c. Worst-case scenario:
0 1 2 3 4 5
Initial investment ($250,000)
Net oper. WC (30,000)

Cost savings $72,000 $ 72,000 $72,000 $72,000 $72,000

Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes ($10,500) ($ 40,500) $34,500 $54,500 $72,000
Taxes (40%) (4,200) (16,200) 13,800 21,800 28,800
Oper. Inc. (AT) ($ 6,300) ($ 24,300) $20,700 $32,700 $43,200
Add: Depreciationa 82,500 112,500 37,500 17,500 0
Oper. CF $76,200 $ 88,200 $58,200 $50,200 $43,200

Return of NOWC $30,000

Sale of Machine 18,000
Tax on sale (40%) (7,200)
Net cash flow ($280,000) $76,200 $ 88,200 $58,200 $50,200 $84,000

NPV = -$7,663.52

Base-case scenario:
This was worked out in part a. NPV = $37,035.13.

Best-case scenario:
0 1 2 3 4 5
Initial investment ($250,000)
Net oper. WC (20,000)

Cost savings $108,000 $108,000 $108,000 $108,000 $108,000

Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes $ 25,500 ($ 4,500) $ 70,500 $ 90,500 $108,000
Taxes (40%) 10,200 (1,800) 28,200 36,200 43,200
Oper. Inc. (AT) $ 15,300 ($ 2,700) $ 42,300 $ 54,300 $ 64,800
Add: Depreciationa 82,500 112,500 37,500 17,500 0
Oper. CF $ 97,800 $109,800 $ 79,800 $ 71,800 $ 64,800

Return of NOWC $ 20,000

Sale of Machine 28,000
Tax on sale (40%) (11,200)
Net cash flow ($270,000) $ 97,800 $109,800 $ 79,800 $ 71,800 $101,600

NPV = $81,733.79

Prob. NPV Prob.  NPV

Worst-case 0.35 ($ 7,663.52) ($ 2,682.23)
Base-case 0.35 37,035.13 12,962.30
Best-case 0.30 81,733.79 24,520.14
E(NPV) $34,800.21

316 Integrated Case Chapter 12: Cash Flow Estimation and Risk Analysis
 NPV = [(0.35)(-$7,663.52 – $34,800.21)2 + (0.35)($37,035.13 – $34,800.21)2 + (0.30)
($81,733.79 – $34,800.21)2]½
= [$631,108,927.93 + $1,748,203.59 + $660,828,279.49]½
= $35,967. 84.

CV = $35,967.84/$34,800.21 = 1.03.

Chapter 12: Cash Flow Estimation and Risk Analysis Integrated Case 317