CHAPTER 12Cash Flow Estimation andRisk Analysis.ppt

CHAPTER 12Cash Flow Estimation andRisk Analysis Relevant cash flows Incorporating inflation Types of risk Proposed Project Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost: $240,000. Inventories will rise by $25,000 and payables by $5,000. Economic life = 4 years. Salvage value = $25,000. MACRS 3-year class. Sales: 100,000 units/year @ $2. Variable cost = 60% of sales. Tax rate = 40%. WACC = 10%. Set up, without numbers, a time line for the project’s cash flows. What’s the annual depreciation? Net Terminal CF at t = 4: Should CFs include interest expense? Dividends? No. The cost of capital is accounted for by discounting at the 10% WACC, so deducting interest and dividends would be “double counting” financing costs. Suppose $50,000 had been spent last year to improve the building. Should this cost be included in the analysis? No. This is a sunk cost.Analyze incremental investment. Suppose the plant could be leased out for $25,000 a year. Would this affect the analysis? Yes. Accepting the project means foregoing the $25,000. This is an opportunity cost, and it should be charged to the project. A.T. opportunity cost = $25,000(1 – T) = $25,000(0.6) = $15,000 annual cost. If the new product line would decrease 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 or negative, i.e., complements or substitutes. What’s the project’s MIRR? Use the FV = TV of inputs to find MIRR What’s the payback period? If this were a replacement rather than a new project, would the analysis change? The relevant depreciation would be the change with the new equipment. Also, if the firm sold the old machine now, it would not receive the SV at the end of the machine’s life. This is an opportunity cost for the replacement project. What are the three types of project risk that are norm