CHAPTER 11 Cash Flow Estimation And Chapter 12 Risk. Need to be in class for this ch. Relevant Cash Flows New Investment Replacement Investment Measuring Risk Market Risk (Beta) Project Risk Considerations. Capital Budgeting Processes.
CF4Set up, without numbers, a time line for the project’s cash flows:
Due to 1/2-yr conv., a 3-yr asset
is depreciated over 4 years.
This is an income statement with no interest.
Q. Always a tax on SV?
Q. Ever a positive tax number?
Q. How is NWC recovered?
- adjusted basis
= Taxable gain (loss if negative)
x tax rate
= Tax (tax credit if negative)
No. This is a sunk cost.
Analyze incremental investment.
Yes. The cash flows would be the incremental
cash flow or changes in cash flow.
1. The old equipment would be sold now
2. You would calculate the change in revenue
4. Also, if the firm sold the old machine now, it would not receive the SV at the end of the machine’s life.
9-3 Atlantic Control Company purchased a machine two years ago at a cost of $70,000. At that time, the machine’s expected economic life was six years and its salvage value at the end of its life was estimated to be $10,000. It is being depreciated using the straight line method so that its book value at the end of six years is $10,000. In four years, however, the old machine will have a market value of $0.
A new machine can be purchased for $80,000, including shipping and installation costs. The new machine has an economic life estimated to be four years. Three-year MACRS depreciation will be used. During its four-year life, the new machine will reduce cash operating expenses by $20,000 per year. Sales are not expected to change. But the new machine will require net working capital to be increased by $4,000. At the end of its useful life, the machine is estimated to have a market value of $2,500.
The old machine can be sold today for $20,000. The firm’s marginal tax rate is 40 percent. The appropriate required rate of return is ten percent.
a. If the new machine is purchased, what is the amount of the initial investment outlay at Year 0?
b. What incremental operating cash flows will occur at the end of Years 1 through 4 as a result of replacing the old machine?
c. What is the terminal cash flow at the end of Year 4 if the new machine is purchased?
d. What is the NPV of this project? Should Atlantic replace the old machine?
k = k* + IP + DRP + LP + MRP.
Inflation is in denominator but not in
numerator, so downward bias to NPV.
Should build inflation into CF forecasts.
1. Stand-alone risk
2. Within-firm risk
3. Market risk
1. Stand-Alone Risk:
Risk of the project if it were
investor’s only asset. Ignores
diversification. Measured by
the std. dev. or CV of NPV.
1. Does not reflect diversification.
2. Does not incorporate info. about
the likelihood of changing variables, i.e.,
steep sales line not a problem if sales
1. Gives idea of project risk.
2. Identifies dangerous variables.
unit sales, which could range from
75,000 to 125,000 (or 75 to 125). Here
are the scenario NPVs:
E(NPV) = $15.0
(NPV) = $30.3
Problem 6 in lab
NPV = $30.3
Coefficient of Variation:
Target debt ratio = 50%.
kd = 12% Tax rate = 40%
kRF = 10% BetaProject = 1.2
Market risk premium = 6%.
Problem 15, Hudson Furniture in lab
1. Pure-play. Find several publicly
traded companies exclusively in
Use average of their betas as
proxy for project’s beta.
Hard to find such companies.