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Class 6 Measuring and Managing Cash Flow Risk.pdf

# Class 6 Measuring and Managing Cash Flow Risk.pdf - BUS...

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BUS 2300: Principles of Finance Measuring and Managing Cash Flow Risk

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Overview of Lecture 2 How do we deal with inherent uncertainty of forecasts? 1. Sensitivity Analysis 2. Breakeven scenarios 3. Decision tree analysis
What can go wrong with an NPV analysis? Garbage in, garbage out…. If the information is flawed, the NPV calculation will be flawed Cash flows to be discounted (numerator) Discount rate (denominator) In this class, we will focus on practical problems with estimating cash flows (i.e., the numerator), why cash flows rather than earnings are the correct metric, and how to incorporate uncertainty in the determination of NPVs 3

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Sensitivity Analysis Vary individual assumptions behind cash flow forecasts to assess NPV sensitivity to the assumptions If accept/reject decision (i.e., NPV) is insensitive to changes in a particular assumption, it is not worthwhile investing resources to refine managers’ information about that assumption If accept/reject decision is sensitive to an assumption…it may make sense to invest resources to clarify the assumption Investment in information about the project can be used to eliminate downside risk Abandon losers 4
Sensitivity Analysis Example \$ 1500 machine producing low-grade wine 5 Cost of Wine Making Machine: \$1,500 Economic Life: 5 years Depreciation (Straight Line): \$300 /yr Expected annual sales (jugs): 3,000 units/yr Expected price per unit: \$2.00 Expected cost per unit: \$1.00 Yearly Overhead Costs: \$1,791 Taxes: 34% Years 0 1-5 Initial Investment (\$1,500) Revenue \$6,000 Variable Costs (\$3,000) Fixed Costs (\$1,791) Depreciation (\$300) Pre-tax Profit \$909 Taxes (\$309) Net Profit \$600 Depreciation \$300 Cash Flow \$900 Assume cost of capital is 15% EAR

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