chapter 7 project cash flows and risk
Post on 23-Jan-2016
73 Views
Preview:
DESCRIPTION
TRANSCRIPT
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22
Chapter Chapter 77
Project Cash
Flows and
Risk
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 22
The cash flow estimationThe cash flow estimation
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 22
Cash Flow from AssetsCash Flow from Assets
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders
• Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 22
Basic TerminologyConventional Versus Nonconventional Cash Flows
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 22
The Relevant Cash Flows
• Incremental cash flows:
– are cash flows specifically associated with the
investment, and
– their effect on the firms other investments (both
positive and negative) must also be considered.
For example, if a day-care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 22
Relevant Cash FlowsMajor Cash Flow Components
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 22
• Categories of Cash Flows:
– Initial Cash Flows are cash flows resulting initially
from the project. These are typically net negative
outflows.
– Operating Cash Flows are the cash flows generated
by the project during its operation. These cash
flows typically net positive cash flows.
– Terminal Cash Flows result from the disposition of
the project. These are typically positive net cash
flows.
Relevant Cash Flows
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 22
Relevant Cash FlowsExpansion Versus Replacement Cash Flows
• Estimating incremental cash flows is relatively
straightforward in the case of expansion projects, but
not so in the case of replacement projects.
• With replacement projects, incremental cash flows
must be computed by subtracting existing project cash
flows from those expected from the new project.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 22
Relevant Cash FlowsExpansion Versus Replacement Cash Flows
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 22
Relevant Cash Flows
• Note that cash outlays already made (sunk costs) are
irrelevant to the decision process.
• However, opportunity costs, which are cash flows that
could be realized from the best alternative use of the
asset, are relevant.
Sunk Costs Versus Opportunity Costs
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 22
Finding the Initial Investment
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 22
Expansion Project—Example
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34%* Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500)* Increase in gross profit $21,000 Marginal tax rate 34%* Depreciation method MACRS
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 22
MACRS Depreciation Life Class of Investment
Year 3-year 5-year 7-year1 33% 20% 14%2 45 32 253 15 19 174 7 12 135 11 96 6 97 98 4
100% 100% 100%
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 22
Expansion Project—Initial Investment Outlay
Purchase Price $(47,000)
Installation ( 3,000)
Δ Net WC ( 1,500)Initial invest outlay $(51,500)
Depreciable basis= $47,000 + $3,000
= $50,000
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 22
Expansion Project—Incremental Operating Cash Flows
Depreciation1 = $50,000(0.33) = $16,500Depreciation2 = $50,000(0.45) = $22,500Depreciation3 = $50,000(0.15) = $ 7,500
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500)Δ taxable income 4,500 ( 1,500) 13,500Δ taxes (34%) (1,530) 510 ( 4,590)Δ net income 2,970 ( 990) 8,910Depreciation 16,500 22,500 7,500Δ operating CF 19,470 21,510 16,410
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 22
Expansion Project—Terminal Cash Flow
Salvage of asset $5,000• Taxes on sale (510)• Δ net working capital 1,500• Terminal cash flow 5,990
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 22
Expansion Project—Cash Flow Time Line
19,470 21,510 16,410
10 2 3
(51,500.00)
12%
17,383.93
17,147.64
15,943.88
(1,024.55)
5,99022,400
IRR = 10.9%
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 22
Capital Budgeting Project Evaluation
• Expansion projects—marginal cash flows include all cash flows associated with adding a new asset to grow the firm.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 22
Corporate (Within-Firm) Risk
• Determine how a capital budgeting project is related to the existing assets of the firm.
• If the firm wants to diversify its risk, it will try to invest in projects that are negatively related (or have little relationship) to the existing assets.
• If a firm can reduce its overall risk, then it generally becomes more stable and its required rate of return decreases.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 22
Beta (Market) Risk
• Theoretically any asset has a beta,, or some way to measure its systematic risk
• If we can determine the beta of an asset, then we can use the capital asset pricing model, CAPM, to compute its required rate of return as follows:
kproj = kRF + (kM - kRF)proj
• Measuring beta risk for a project—it is difficult to determine the beta for a project. – pure play method
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 22
Beta (Market) Risk—Example
Capital Budgeting Project Characteristics:
Cost = $100,000project = 1.5
kRF = 3.0%kM = 9.0%kproject = 3.0% + (9.0% - 3.0%)1.5 = 12.0%
Firm’s Characteristics Before Purchasing the Project:Total assets = $400,000
firm = 1.0 Firm’s Beta Coefficient After Purchasing the Project:
Total assets = $400,000 + $100,000 = $500,000
1.1 500,000100,000
1.5 500,000400,000
1.0 β new-Firm
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 22
Capital Budgeting—Risk Analysis• The firm generally uses its average required rate
of return to evaluate projects with average risk.• The average required rate of return is adjusted to
evaluate projects with above-average or below-average risks.
Project Required Risk Category Rate of Return Above-average 16%Average 12Below-average 10
If risk is not considered, high-risk projects might be accepted when they should be rejected and low-risk projects might be rejected when they should be accepted.
top related