Lecture 8 – Integrative Problems

Project Cash Flows and Risk

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Problem 1
 Mvela textiles is evaluating a new product, a silk/wool blended fabric.
Assume that you were recently hired as assistant to the director of capital
budgeting, and you must evaluate the new project.
 The fabric would be produced in an unused building adjacent to Mvela’s
West Rand plant. Mvela owns the building, which is fully depreciated. The
required equipment would cost R200 000, plus an additional R40 000 for
shipping and installation. In addition, inventories would rise by R25 000,
while accounts payable would go up by R5 000. All of these costs would be
incurred at Year 0. By a special ruling, the machinery could be depreciated
as 3-year class property.
 The project is expected to operate for four years, at which time it will be
terminated. The cash inflows are assumed to begin one year after the
project is undertaken, or at t = 1, and to continue out to t = 4. At the end of
the project's life (Year 4), the equipment is expected to have a salvage value
of R25 000.

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Problem 1

 Unit sales are expected to total 100,000 five-meter rolls per

year, and the expected sales price is R2.00 per roll. Cash
operating costs for the project (total operating costs excluding
depreciation) are expected to total 60 percent of Rand sales.
Mvela’s marginal tax rate is 40 percent, and its required rate of
return is 10 percent. Tentatively, the silk/wool blend fabric
project is assumed to be of equal risk to Mvela’s other assets.
 You have been asked to evaluate the project and to make a
recommendation as to whether it should be accepted or
rejected. To guide you in your analysis, your boss gave you the
following set of tasks to complete:

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A. Draw a cash flow time line that shows when the net cash
inflows and outflows will occur, and explain how the time line
can be used to help structure the analysis.

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B. Mvela has a standard form that is used in the capital
budgeting process; see table on the following slide. Part of the
table has been completed, but you must replace the blanks
with the missing numbers.

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B.

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B 1. Complete the unit sales, sales price, total revenues, and
operating costs excluding depreciation lines.

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B 2. Complete the depreciation line.

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B 3. Now complete the table down to net income and then
down to net operating cash flows.

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B 4. Now fill in the blanks under Year 0 and Year 4 for the
initial investment outlay and the terminal cash flows and
complete the cash flow time line (net CF) line. Discuss working
capital. What would have happened if the machinery were sold
for less than its book value?

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B 4.

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B 4. Discuss working capital. What would have happened if the
machinery were sold for less than its book value?

 Note that accounts payable is an offset to the

inventory buildup, so the net working capital
requirement is R20 000, which is recovered at the end
of Year 4.
 The salvage value is fully taxable, because the asset
has been depreciated to a zero book value. If book
value were something other than zero, the tax effect
could be positive (if the asset was sold for less than
book value) or negative.

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C 1. Mvela uses debt in its capital structure, so some of the
money used to finance the project will be debt. Given this fact,
should the projected cash flows be revised to show projected
interest charges? Explain.
 The projected cash flows in the table should not be
revised to show interest charges. The effects of debt
financing are reflected in the project’s required rate of
return (cost of capital) that is used to discount the
cash flows.

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C 2. Suppose you learned that Mvela had spent R50 000 to
renovate the building last year, expensing these costs. Should
this cost be reflected in the analysis? Explain.
 This expenditure is a sunk cost, so it would not affect
the decision and should not be included in the analysis.

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C 3. Now suppose you learned that Mvela could lease its
building to another party and earn R25 000 per year. Should
that fact be reflected in the analysis? If so, how?
 The rental payment represents an opportunity cost.
 Its after-tax amount should be subtracted from the
operating cash flows the company would have
otherwise.
R25 000(1 - T) = R25 000(0.6) = R15 000

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C 4. Now assume that the silk/wool blend fabric project would
take away profitable sales from Mvela’s cotton/wool blend
fabric business. Should this fact be reflected in your analysis?
If so, how?
 The decreased sales from Mvela’s cotton/wool blend fabric
business should be accounted for in the analysis.
 This is an externality to Mvela and because the silk/wool
blend fabric project will take revenues away from its
cotton/wool blend fabric business, the revenues as shown in
this analysis are overstated, and thus they need to be
reduced by the amount of decreased revenues for the
cotton/wool blend fabric business.

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D. Disregard all the assumptions made in part C, and assume
there was no alternative use for the building over the next four
years. Now calculate the project’s NPV, IRR, and traditional
payback.

 NPV = -R4.0. NPV is negative; do not accept.

 IRR = 9.3%. IRR is less than cost of capital; do not accept.

R79.7 R91.2 R62.4 R89.7

IRR = -R260 + 1
+ 2
+ 3
+ 4
=0
(1+IRR) (1+IRR) (1+IRR) (1+IRR)

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D. Do these indicators suggest that the project should be
accepted?

Payback: Year Cash flow Cumulative

Cash Flow
0 R(260.0)
R(260.0)
1 79.7
(180.3)
2 91.2
( 89.1)
3 62.4
( 26.7)
4 89.7 63.0
Payback = 3 years + R26.7/R89.7 = 3.3 years.
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E. If this project had been a replacement rather than an
expansion project, how would the analysis have changed? No
calculations are needed; just think about the changes that
would have to occur in the cash flow table.
 In a replacement analysis, we must find differences in
cash flows—that is, the cash flows that would exist if
we take on the project versus if we do not.
 In the table there would need to be, for each year, a
column for the existing asset, a column for the new
project, and for the difference.
 The difference column is the one that would be used
to get the NPV, IRR, and so forth.

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F. Assume that inflation is expected to average 3 percent over
the next four years, that this expectation is reflected in the
required rate of return, and that inflation will increase variable
costs and revenues by the same relative amount of 3 percent.
Does it appear that inflation has been dealt with properly in the
analysis? If not, what should be done, and how would the
required adjustment affect the decision?

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F 1. Does it appear that inflation has been dealt with properly
in the analysis? If not, what should be done, and how would
the required adjustment affect the decision?
 It is apparent from the data in the previous table that inflation
has not been reflected in the calculations.
The sales price is held constant rather than rising with
inflation.
Revenues and costs (except depreciation) should both be
increased by 3 percent per year.
Because revenues are larger than operating costs, inflation
will cause cash flows to increase. This will lead to a higher
NPV and IRR, and to a shorter payback.
 When inflation is properly accounted for, the project is seen to
be profitable.

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Problem 2

 The previous problem contained the details of a new-project

capital budgeting evaluation being conducted by Mvela
Textiles. Although inflation was considered in the initial
analysis, the riskiness of the project was not considered.
The expected cash flows considering inflation as they were
estimated are given on the following slide. Mvela’s required
rate of return is 10 percent.

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23
A. What are the three levels, or types, of project risk that are
normally considered?

 Stand‑alone risk is the project’s total risk if it were

operated independently.
 Within‑firm (corporate) risk is the total riskiness of the
project giving consideration to the firm’s other
projects.
 Market risk is the riskiness of the project to a
well‑diversified investor. Theoretically, it is measured
by the project’s beta, and it considers both corporate
risk and shareholder diversification.

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A 2. Which type of risk is the most relevant?

 The most relevant risk for capital projects is market

risk because management’s primary goal is
shareholder wealth maximisation.
 However, creditors, customers, suppliers, and
employees are all affected by a firm’s total risk.
Because these parties influence the firm's profitability,
a project’s within‑firm risk should not be completely
ignored.

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A 3. Which type is the easiest to measure?

 Stand‑alone risk is, by far, the easiest type of risk to

measure.
 Thus, firms often focus primarily on this type of risk
when making capital budgeting decisions.
 Theoretically, this focus is not correct, but it does not
necessarily lead to poor decisions, because most
projects that a firm undertakes are in its core business.

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A 4. How are the three types of risk generally related?

 Because most projects that a firm undertakes are in its

core business, a project’s stand‑alone risk is likely to
be highly correlated with its corporate risk, which in
turn is likely to be highly correlated with its market
risk.

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B 1. What is sensitivity analysis?

 Sensitivity analysis measures the effect of changes in a

particular variable, say revenues, on a project’s NPV.
 To perform a sensitivity analysis, all variables are fixed
at their expected values except one. This one variable
is then changed, often by specified percentages, and
the resulting effect on NPV is noted.

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B 2. Discuss how one would perform a sensitivity analysis on
the unit sales, salvage value, and required rate of return for
the project. Assume that each of these variables deviates from
its base case, or expected, value by plus and minus 10, 20, and
30 percent. Explain how you would calculate the NPV, IRR, and
the payback for each case.

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B 2. Explain how you would calculate the NPV, IRR, and the
payback for each case.

 The base case value for unit sales was 100; therefore, if you were
to assume that this value deviated by plus and minus 10, 20, and
30 percent, the unit sales values to be used in the sensitivity
analysis would be 70, 80, 90, 110, 120, and 130 units.
 Go back to the table at the beginning of the problem, insert 70
sales units and rework the table for the change in sales units
arriving at different net cash flow values for the project. Calculate
the NPV, IRR, and payback as you did previously.
 Repeat the same steps for each of the sales unit values.
 Repeat the same procedure for the sensitivity analysis on salvage
value and on required rate of return.

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B 2. The sensitivity data are given here (R thousands):

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B 3. What is the primary weakness of sensitivity analysis?
What are its primary advantages?

 The two primary disadvantages of sensitivity analysis

are that it does not:
1. Reflect the effects of diversification
2. Incorporate any information about the possible magnitudes
of the forecast errors.
 Sensitivity analysis does identify those variables that
potentially have the greatest impact on profitability,
and this helps management focus its attention on
those variables that probably are most important.

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C. Assume that you are confident about the estimates of all
variables that affect the project’s cash flows except unit sales.
If product acceptance is poor, sales would be only 75 000 units
a year, whereas a strong consumer response would produce
sales of 125 000 units. In either case, cash costs would still
amount to 60 percent of revenues. You believe that there is a
25 percent chance of poor acceptance, a 25 percent chance of
excellent acceptance, and a 50 percent chance of average
acceptance (the base case).
(1) What is the worst-case NPV? The best-case NPV?

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C 1. What is the worst-case NPV? The best-case NPV?

Case Probability NPV (000s)

Worst 0.25 (R27.8)
Base 0.50 15.0
Best 0.25 57.8

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C 2. Use the worst-case, most likely (or base) case, and best-
case NPVs and probabilities of occurrence to find the project’s
expected NPV, standard deviation (σNPV) and coefficient of
variation (CVNPV).
 The expected NPV is R14 968 (rounded to the nearest thousands below)

E(NPV) = 0.25(-R27.8) + 0.50(R15.0) + 0.25(R37.8) = R15

 The standard deviation of NPV is R30.3:

σNPV = [0.25(-R27.8 - R15)2 + 0.50(R15 - R15)2 ]1/2 = [916]1/2 = R30.3

 And the project’s coefficient of variation is 2.0:

σNPV R30.3
CVNPV = = = 2.0
E(NPV) R15

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D 1. Assume that Mvela’s average project has a coefficient of
variation (cvNPV) in the range of 1.25 to 1.75. Would the
silk/wool blend fabric project be classified as high risk, average
risk, or low risk? What type of risk is being measured here?
 The project has a CV of 2.0, which is much higher than
the average range of 1.25 to 1.75, so it falls into the
high-risk category.
 The CV measures a project’s stand‑alone risk—it is
merely a measure of the variability of returns (as
measured by σNPV) about the expected return.

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D 2. Based on common sense, how highly correlated do you
think the project would be to the firm’s other assets? (Give a
correlation coefficient, or range of coefficients, based on your
judgement.)
 It is reasonable to assume that if the economy is
strong and people are buying a lot of fabric, then sales
would be strong in all of the company’s lines, so there
would be positive correlation between this project and
the rest of the business.
 However, each line could be more or less successful, so
the correlation would be less than +1.0.
 A reasonable guess might be +0.7, or within a range of

+0.5 to +0.9.
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D 3. How would this correlation coefficient and the previously
calculated σ combine to affect the project’s contribution to
corporate, or within-firm, risk? Explain.
 If the project’s cash flows are likely to be highly correlated
with the firm’s aggregate cash flows, then the project would
have high corporate risk.
 If the project’s cash flows are expected to be totally
uncorrelated with the firm’s aggregate cash flows, or
positively correlated but less than perfectly correlated, the
riskiness of the project would be less than suggested by its
stand‑alone risk.
 If the project’s cash flows were expected to be negatively
correlated with the firm’s aggregate cash flows, then the
project would reduce the total risk of the firm even more.

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E 1. Based on your judgment, what do you think the project’s
correlation coefficient would be with respect to the general
economy and thus with returns on “the market”?
 This project would have a positive correlation with returns
on other assets in the economy, and specifically with the
stock market.
 Mvela Textiles produces cloth items, and such firms tend to
have less risk than the economy as a whole—people must
have clothing regardless of the national economic situation.
 However, people would tend to spend more on non-essential
types of clothing when the economy is good and to cut back
when the economy is weak.
 A reasonable guess might be +0.7, or within a range of
+0.5 to +0.9.

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E 2. How would correlation with the economy affect the
project's market risk?

 This correlation would not directly affect the project’s

corporate risk, but it does, when combined with the
project’s high stand-alone risk, suggest that the
project’s market risk as measured by its market beta is
relatively high.

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F 1. Mvela typically adds or subtracts three percentage points
to the overall cost of capital to adjust for risk. Should the
project be accepted?

 Because the project is judged to have above‑average risk,

its differential risk‑adjusted, or project, required rate of
return would be 13 percent.
 At this discount rate, its NPV would be -R2,226, so it would
not be acceptable.
 If it were a low risk project, its cost of capital would be 7
percent, its NPV would be R34,117, and it would be a
profitable project on a risk‑adjusted basis.

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F 2. What subjective risk factors should be considered before
the final decision is made?

 A numerical analysis such as this one might not

capture all of the risk factors inherent in the project.
 If the project has a potential for bringing on harmful
lawsuits, then it might be riskier than first assessed.
 If the project’s assets can be redeployed within the
firm or can be easily sold, then the project might be
less risky than the analysis indicates.

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G. Define scenario analysis and simulation analysis, and discuss
their principal advantages and disadvantages.

 Scenario analysis examines several possible scenarios,

usually the worst case, the most likely case, and the
best case. Thus, it usually considers only three possible
outcomes.

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G. Define simulation analysis.

 Simulation analysis is a type of scenario analysis that uses

relatively powerful financial planning software where the uncertain
cash flow variables are entered as continuous probability
distribution parameters rather than as point values.
 The computer uses a random number generator to select values
for the uncertain variables on the basis of their designated
distributions.
 Once all of the variable values have been selected, they are
combined, and an NPV is calculated.
 The process is repeated many times, say, 1 000, with new values
selected from the distributions for each run. The end result is a
probability distribution of NPV based on a sample of 1 000 values.

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G. Discuss the principal advantages and disadvantages.

 Although simulation analysis is technically refined, its usefulness is limited

because managers often are unable to accurately specify the variables'
probability distributions.
 The correlations among the uncertain variables must be specified, along
with the correlations over time. If managers are unable to do this with
much confidence, then the results of simulation analyses are of limited
value.
 Recognise also that neither sensitivity, scenario, nor simulation analysis
provides a decision rule—they might indicate that a project is relatively
risky, but they do not indicate whether the project’s expected return is
sufficient to compensate for its risk.
 Finally, remember that sensitivity, scenario, and simulation analyses all
focus on stand‑alone risk, which is not the most relevant risk in capital
budgeting analysis.

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H 1. Assume that the risk-free rate is 10 percent, the market
risk premium is 6 percent, and the new project's beta is 1.2.
What is the project’s required rate of return on equity based on
the CAPM?
 The sml can be used to estimate the project's required
rate of return on equity:

rProj = rRF + (rM ‑ rRF)ßProj = 10% + (6%)1.2 = 17.2%.

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H 2. How does the project’s market risk compare with the
firm’s overall market risk?

 Because beta is the measure of market risk, the

project’s market risk is 1.2, which indicates that it is
somewhat riskier than the average stock.
 If Mvela’s beta is less than 1.2, then the new project
has more market risk than the firm’s other assets.

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H 3. How does the project’s stand-alone risk compare with that
of the firm’s average project?

 The project has a CV of 2.0 versus one of about 1.5

for an average project, suggesting that this project
is riskier than the firm’s average project.

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H 4. Briefly describe how you could estimate the project’s beta.
How feasible do you think that procedure would actually be in
this case?
 In the pure play method, one or more companies that are publicly
traded and are engaged exclusively in the line of business as the
project being evaluated are identified. An average of the betas of
these companies is then used as a proxy for the project’s beta.
 The pure-play method often is difficult to implement because it is
hard to find pure play proxy firms. It would be laborious to find a
fabric producer with the same characteristics of Mvela’s Silk/Wool
blend fabric product, because so many factors such as size,
operations, and location are different between firms.

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H 4. Briefly describe how you could estimate the project’s beta.
How feasible do you think that procedure would actually be in
this case?
 In the accounting beta method, normal characteristic line
regressions are run, but using accounting variables such as
EBIT/(Total assets) in place of returns on the market. An
accounting beta is then used as a proxy for the project’s
market‑determined beta.
 Historical accounting betas can be calculated when there
exist historical data for the project, but accounting betas are
only rough proxies for market-determined betas. The
correlation between accounting-determined betas and
market betas historically has been in the 0.5 to 0.6 range.

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H 5. What are the advantages and disadvantages of focusing
on a project’s market risk?

 The advantages of focusing on a project’s market risk

are:
1. It is the most relevant risk to shareholders, hence to
determining the effect of the project on the value of the
share
2. It results in a definite hurdle rate for use in evaluating the
project.
 The disadvantage is that it is virtually impossible to
estimate betas for many projects. Also, people
sometimes focus on market risk to the exclusion of
corporate risk, and this may be a mistake.

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END

 THANK YOU

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