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### Cash Flow EstimationRisk AnalysisCHAPTER 12

Conceptual Considerations

Analytical Methodology

Decision Metrics

Dr. David P. Echevarria

Conceptual Considerations

- Free Cash Flow = EBIT*(1-Tax Rate) – (CapEx + Changes in WC)
- Accounting Income = Revenues – Expenses*
- Operating and Non-Operating
- Incremental Cash Flows: change in total cash flows as the result of an investment decision
- Sunk Costs: costs incurred in the past which cannot be recovered in the future regardless of the investment decision

Dr. David P. Echevarria

ANALYTICAL METHODOLOGY

A. Tax Considerations When Replacing Old Plant and Equipment.

1. Replacement projects are undertaken to reduce costs.

2. May involve the disposition of the old asset being replaced.

3. Three possible situations when disposing (selling) old assets (continued on next slide)

Dr. David P. Echevarria

ANALYTICAL METHODOLOGY

3. Three possible situations when disposing (selling) old assets

- If salvage value is less than book = tax credit.

The credit is a positive cash flow.

- If salvage value is equal to book = it's a wash.
- If salvage value is more than book = tax liability.

The liability is a negative cash flow.

Dr. David P. Echevarria

ANALYTICAL METHODOLOGY

- Determining Initial Investment (Io)
- The initial investment (or outlay) is the amount of new cash we must provide to launch the venture.
- The initial outlay (Io) is assumed to occur on day zero. Io = CFo [-] in the BA II Plus

C. Typical Investment Objectives

- Support additional sales.
- Lower operating costs.
- All projects must produce additional ATCF.

Dr. David P. Echevarria

ANALYTICAL METHODOLOGY

D. Learning Strategy

1. I will provide the change in operating income before depreciation and taxes.

- Depreciation Schedule according to M-ACRS
- The Net Present Value of a Project (NPV);

NPV = S [ATCFn / (1+ka)n] - Io

Dr. David P. Echevarria

Risk Analysis

- The riskiness of a potential investment can best be approximated by sensitivity analysis
- Changes in the cost of equipment or construction
- Changes on Production Costs: Fixed, Variable
- Changes in Expected Sales
- Changes in the Cost of Capital
- Changes in Tax Rates

Dr. David P. Echevarria

Sensitivity can best be gauged using an NPV profile

- A steep curve is implies less sensitivity
- A shallow curve suggest more sensitivity

Dr. David P. Echevarria

CAPITAL BUDGETING EXERCISE

- Background Information: New Project Analysis
- New machine [installed] cost = $ 250,000
- Benefit: increases EBDT by $ 90,000 per year
- Economic Expected Project Life = 5 years
- Machine in 3 year ACRS category (ADC % rates = 33, 45, 15, 7 for years 1,2,3,4)
- Expected Salvage Value at end of 5th year = $ 23,000
- Startup Working Capital required = $ 25,000 (to be recouped at end of 5th year)
- Tax rate = 40%, WACC = 10%

Dr. David P. Echevarria

Computing Depreciation Schedule

Dr. David P. Echevarria

Compute After Tax Cash Flows

Dr. David P. Echevarria

After Tax Cash Flows

Dr. David P. Echevarria

Compute NPV Using BA II PLUS

Press CF key: Use [ENTER] key to save values. Note CFo is a negative value.

CFo = -275000 ($250,000 cost of new machine + $25,000 WC needs)

↓ C01 = 87000 ↓ F01 = 1

↓ C02 = 99000 ↓ F02 = 1

↓ C03 = 69000 ↓ F03 = 1

↓ C04 = 61000 ↓ F04 = 1

↓ C05 = 92800 ↓ F05 = 1

2ND QUIT

Press NPV key

I = 10 [↓] Press [CPT]: NPV = 37,035.13

Press IRR key

Press [CPT] IRR = 15.30 [%]

Dr. David P. Echevarria

MIRR: Compute FV of ATCF using the WACC (10%) FVIF = (1 + Ka)(5-n)

Table 3

FVIF(1) = (1.10)(5-1) = 1.4641, FVIF(2) = (1.10)3 = 1.3310, etc.

Terminal Value = S FVn from Table 3 = $ 502,535.70

2nd CLR TVM

FV = 502535.7

PV = - 275000

N = 5

CPT I/Y = 12.81 [%]

Dr. David P. Echevarria

Compute Payback Period

Number of years to recoup CFo ($ 275,000) 870000 + 99000 + 69000 = 255000 + 20000/61000 = 3.33 years

Sensitivity Analysis

- NPV if annual savings are 20% greater (EBDT = $108,000 per year) NPV = $ 77,975.63
- NPV if annual savings are 20% smaller (EBDT = 72,000 per year) NPV = $ -3,905.37

Dr. David P. Echevarria

HOMEWORK CHAPTER 12

- Self-Test: ST-1, parts d, e, standalone risk
- Questions: 12-4, 12-6, 12-9
- Problems: 12-1, 12-5, 12-9
- Excel Simulation #2
- The Excel simulation primarily focuses on sensitivity analysis.
- Care should be taken when input the various options. Make certain you reset to base values before proceeding to the next option.

Dr. David P. Echevarria

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