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# Ch11 Show - CHAPTER 11 Cash Flow Estimation and Risk...

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1 CHAPTER 11 Cash Flow Estimation  and  Risk Analysis

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2 Topics n Estimating cash flows: n Relevant cash flows n Working capital treatment n Risk analysis:  n Sensitivity analysis n Scenario analysis n Simulation analysis n Real options
Project’s Cash  Flows (CFt) Market interest rates Project’s  business risk Market risk aversion Project’s debt/equity capacity Project’s risk- adjusted cost of capital  (r) The Big Picture: Project Risk Analysis NPV =                  +                +  ···  +                 − Initial cost CF 1 CF 2 CF N (1 + r )1 (1 + r)N (1 + r)2

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4 Proposed Project Data n \$200,000 cost + \$10,000 shipping +  \$30,000 installation. n Economic life = 4 years. n Salvage value = \$25,000. n MACRS 3-year class. Continued…
5 Project Data  (Continued) n Annual unit sales = 1,250. n Unit sales price = \$200. n Unit costs = \$100. n Net working capital: n NWCt = 12%(Salest+1) n Tax rate = 40%. n Project cost of capital = 10%.

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6 Incremental Cash Flow for a  Project n Project’s incremental cash flow is: Corporate cash flow with the project Minus  Corporate cash flow without the project.
7 Treatment of Financing Costs n Should you subtract interest expense or  dividends when calculating CF?  n NO. n 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.   n They are part of the costs of capital.  If we  subtracted them from cash flows, we would be  double counting capital costs.

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8 Sunk Costs n Suppose \$100,000 had been spent last year  to improve the production line site.  Should  this cost be included in the analysis? n NO. This is a sunk cost.  Focus on  incremental investment and operating cash  flows.
9 Incremental Costs n Suppose the plant space could be leased out  for \$25,000 a year.  Would this affect the  analysis? n 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. n A.T. opportunity cost = \$25,000 (1 – T) =  \$15,000 annual cost.

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10 Externalities n If the new product line would decrease sales  of the firm’s other products by \$50,000 per  year, would this affect the analysis?  n Yes. The effects on the other projects’ CFs  are “externalities.” n Net CF loss per year on other lines would be  a cost to this project.
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## This note was uploaded on 02/27/2012 for the course BUS 510 taught by Professor Mehdi during the Spring '11 term at University of La Verne.

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Ch11 Show - CHAPTER 11 Cash Flow Estimation and Risk...

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