# Ch 12 - CHAPTER12 CashFlowEstimation andRiskAnalysis 1...

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1 CHAPTER 12 Cash Flow Estimation  and Risk Analysis

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2 Estimating cash flows: Relevant cash flows Working capital treatment Inflation Risk Analysis: Sensitivity Analysis,  Scenario Analysis, and Simulation  Analysis
3 Proposed Project \$200,000 cost + \$10,000 shipping +  \$30,000 installation. Economic life = 4 years. Salvage value = \$25,000. MACRS 3-year class.

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4 Annual unit sales = 1,250. Unit sales price = \$200. Unit costs = \$100. Net operating working capital (NOWC)  = 12% of sales. Tax rate = 40%. Project cost of capital = 10%.
5 Incremental Cash Flow for a  Project Project’s incremental cash flow is: Corporate cash flow with the project Minus  Corporate cash flow without the project.

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6 Treatment of Financing Costs Should you subtract interest expense or  dividends when calculating CF?  NO.  We discount project cash flows with a  cost of capital that is the rate of return  required by all investors (not just debtholders  or stockholders), and so we should discount  the total amount of cash flow available to all  investors.   They are part of the costs of capital.  If we  subtracted them from cash flows, we would  be double counting capital costs.
7 Sunk Costs Suppose \$100,000 had been spent last year  to improve the production line site.  Should  this cost be included in the analysis? NO. This is a sunk cost.  Focus on  incremental investment and operating cash  flows.

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8 Incremental Costs Suppose the plant space could be leased out  for \$25,000 a year.  Would this affect the  analysis? Yes. Accepting the project means we will not  receive the \$25,000.  This is an opportunity  cost and it should be charged to the project. A.T. opportunity cost = \$25,000 (1 - T) =  \$15,000 annual cost.
9 Externalities If the new product line would decrease sales  of the firm’s other products by \$50,000 per  year, would this affect the analysis?  Yes. The effects on the other projects’ CFs  are “externalities”. Net CF loss per year on other lines would be  a cost to this project. Externalities will be positive if new projects  are complements to existing assets, negative  if substitutes.

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10 What is the depreciation  basis? Basis = Cost + Shipping + Installation \$240,000
11 Annual Depreciation Expense  (000s) Year %      X (Initial  Basis) = Depr. 1 0.33 \$240 \$79.2 2 0.45 108.0 3 0.15 36.0 4 0.07 16.8

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12 Annual Sales and Costs Year 1 Year 2 Year 3 Year 4 Units 1250 1250 1250 1250 Unit  Price \$200 \$206 \$212.18 \$218.55 Unit Cost \$100 \$103 \$106.09 \$109.27 Sales \$250,000 \$257,500 \$265,225 \$273,188 Costs \$125,000 \$128,750 \$132,613 \$136,588
13 Why is it important to include inflation  when estimating cash flows?

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