IES PROGRAM

INTRODUCTION TO FINANCE
TOPIC 12
Professor: Francesc Prior
Proposed Project

 Total depreciable cost

 Equipment: $200,000
 Shipping and installation: $40,000
 Changes in working capital
 Inventories will rise by $25,000
 Accounts payable will rise by $5,000
 Effect on operations
 New sales: 100,000 units/year @ $2/unit
 Variable cost: 60% of sales
12-2
Proposed Project

 Life of the project

 Economic life: 4 years
 Depreciable life: MACRS 3-year class
 Salvage value: $25,000
 Tax rate: 40%
 WACC: 10%

12-3
Determining Project Value

 Estimate relevant cash flows

 Calculating annual operating cash flows.
 Identifying changes in working capital.
 Calculating terminal cash flows: after-tax
salvage value and return of NWC.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
12-4
Initial Year Net Cash Flow

 Find NWC.
  in inventories of $25,000
 Funded partly by an  in A/P of $5,000
 NWC = $25,000 – $5,000 = $20,000
 Combine NWC with initial costs.
Equipment -$200,000
Installation -40,000
NWC -20,000
Net CF0 -$260,000
12-5
Determining Annual Depreciation
Expense
Year Rate x Basis Deprec.
1 0.33 x $240 $ 79
2 0.45 x 240 108
3 0.15 x 240 36
4 0.07 x 240 17
1.00 $240

Due to the MACRS ½-year convention, a

3-year asset is depreciated over 4 years.

12-6
Annual Operating Cash Flows

1 2 3 4
Revenues 200.0 200.0 200.0 200.0
– Op. costs -120.0 -120.0 - -
120.0 120.0
– Deprec. expense -79.2 -108.0 - -
36.0 16.8
Operating income 0.8 -28.0 44.0 63.2
(BT)
– Tax (40%) 0.3 -11.2
17.6 25.3
Operating income 0.5 -16.8 26.4 37.9
(AT) 12-7
Terminal Cash Flow

Recovery of NWC $20,000

Salvage value 25,000
Tax of SV (40%) -10,000
Terminal CF $35,000

Q. How is NWC recovered?

Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash flow?

12-8
Should financing effects be
included in cash flows?
 No, dividends and interest expense
should not be included in the analysis.
 Financing effects have already been
taken into account by discounting cash
flows at the WACC of 10%.
 Deducting interest expense and
dividends would be “double counting”
financing costs.

12-9
Should a $50,000 improvement cost
from the previous year be included in
the analysis?
 No, the building improvement cost is a
sunk cost and should not be considered.
 This analysis should only include
incremental investment.

12-10
If the facility could be leased out for
$25,000 per year, would this affect the
analysis?
 Yes, by accepting the project, the firm
foregoes a possible annual cash flow of
$25,000, which is an opportunity cost to
be charged to the project.
 The relevant cash flow is the annual
after-tax opportunity cost.
 A-T opportunity cost:
= $25,000(1 – T)
= $25,000(0.6)
= $15,000
12-11
If the new product line decreases the sales
of the firm’s other lines, would this affect
the analysis?
 Yes. The effect on other projects’ CFs is
an “externality.”
 Net CF loss per year on other lines
would be a cost to this project.
 Externalities can be positive (in the case
of complements) or negative
(substitutes).

12-12
Proposed Project’s Cash Flow Time
Line

0 1 2 3 4

-260 79.7 91.2 62.4 89.7

 Enter CFs into calculator CFLO register, and enter

I/YR = 10%.
 NPV = -$4.03 million
 IRR = 9.3%
 MIRR = 9.6%
 Payback = 3.3 years

12-13
If this were a replacement rather than
a new project, would the analysis
change?
 Yes, the old equipment would be sold, and
new equipment purchased.
 The incremental CFs would be the changes
from the old to the new situation.
 The relevant depreciation expense would
be the change with the new equipment.
 If the old machine was sold, the firm would
not receive the SV at the end of the
machine’s life. This is the opportunity cost
for the replacement project.

12-14
What are the 3 types of project
risk?
 Stand-alone risk
 Corporate risk
 Market risk

12-15
What is stand-alone risk?

 The project’s total risk, if it were

operated independently.
 Usually measured by standard deviation
(or coefficient of variation).
 However, it ignores the firm’s
diversification among projects and
investor’s diversification among firms.

12-16
What is corporate risk?

 The project’s risk when considering the

firm’s other projects, i.e., diversification
within the firm.
 Corporate risk is a function of the
project’s NPV and standard deviation
and its correlation with the returns on
other firm projects.

12-17
What is market risk?

 The project’s risk to a well-diversified

investor.
 Theoretically, it is measured by the
project’s beta and it considers both
corporate and stockholder
diversification.

12-18
Which type of risk is most
relevant?
 Market risk is the most relevant risk for
capital projects, because management’s
primary goal is shareholder wealth
maximization.
 However, since corporate risk affects
creditors, customers, suppliers, and
employees, it should not be completely
ignored.

12-19
Which risk is the easiest to
measure?
 Stand-alone risk is the easiest to
measure. Firms often focus on stand-
alone risk when making capital
budgeting decisions.
 Focusing on stand-alone risk is not
theoretically correct, but it does not
necessarily lead to poor decisions.

12-20
Are the three types of risk
generally highly correlated?
 Yes, since most projects the firm
undertakes are in its core business,
stand-alone risk is likely to be highly
correlated with its corporate risk.
 In addition, corporate risk is likely to be
highly correlated with its market risk.

12-21
What is sensitivity analysis?

 Sensitivity analysis measures the effect

of changes in a variable on the project’s
NPV.
 To perform a sensitivity analysis, all
variables are fixed at their expected
values, except for the variable in
question which is allowed to fluctuate.
 Resulting changes in NPV are noted.

12-22
What are the advantages and
disadvantages of sensitivity analysis?

 Advantage
 Identifies variables that may have the
greatest potential impact on profitability
and allows management to focus on these
variables.
 Disadvantages
 Does not reflect the effects of
diversification.
 Does not incorporate any information about
the possible magnitudes of the forecast
errors.
12-23
What if there is expected inflation
of 5%, is NPV biased?
 Yes, inflation causes the discount rate to
be upwardly revised.
 Therefore, inflation creates a downward
bias on PV.
 Inflation should be built into CF
forecasts.

12-24
Annual Operating Cash Flows, If
Expected Inflation = 5%
1 2 3 4
Revenues 210 220 232 243
Op. costs (60%) -126 -132 -139 -146
– Deprec. expense -79 -108 -36 -17
– Oper. income (BT) 5 -20 57 80
– Tax (40%) 2 -8 23 32
Oper. income (AT) 3 -12 34 48
+ Deprec. expense 79 108 36 17
Operating cash flows 82 96 70 65

12-25
Considering Inflation:
Project CFs, NPV, and IRR

0 1 2 3 4

-260 82.1 96.1 70.0 65.1

35.0
Terminal CF =100.1

 Enter CFs into calculator CFLO register,

and enter I/YR = 10%.
 NPV = $15.0 million.
 IRR = 12.6%.
12-26
Perform a Scenario Analysis of the
Project, Based on Changes in the Sales
Forecast
 Suppose we are confident of all the variable
estimates, except unit sales. The actual unit sales
are expected to follow the following probability
distribution:

Case Probability Unit Sales

Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000

12-27
Scenario Analysis

 All other factors shall remain constant and the

NPV under each scenario can be determined.

Case Probability NPV

Worst 0.25 ($27.8)
Base 0.50 15.0
Best 0.25 57.8

12-28
Determining Expected NPV, NPV, and
CVNPV from the Scenario Analysis

E(NPV)0.25(-$27.8)  0.5($15.0)  0.25($57.8)

$15.0

.8  $15.0)2  0.5($15.0 $15.0)2

NPV [0.25(-$27
 0.25($57.8 $15.0)2 ]1/2
$30.3

CVNPV $30.3/$15.
0 2.0
12-29
If the firm’s average projects have CVNPV
ranging from 1.25 to 1.75, would this
project be of high, average, or low risk?

 With a CVNPV of 2.0, this project would

be classified as a high-risk project.
 Perhaps, some sort of risk correction is
required for proper analysis.

12-30
Is this project likely to be correlated with the
firm’s business? How would it contribute to
the firm’s overall risk?

 We would expect a positive correlation

with the firm’s aggregate cash flows.
 As long as correlation is not perfectly
positive (i.e., ρ  1), we would expect it
to contribute to the lowering of the
firm’s overall risk.

12-31
If the project had a high correlation with the
economy, how would corporate and market
risk be affected?

 The project’s corporate risk would not

be directly affected. However, when
combined with the project’s high stand-
alone risk, correlation with the economy
would suggest that market risk (beta) is
high.

12-32
If the firm uses a +/-3% risk adjustment for
the cost of capital, should the project be
accepted?

 Reevaluating this project at a 13% cost

of capital (due to high stand-alone risk),
the NPV of the project is -$2.2.
 If, however, it were a low-risk project,
we would use a 7% cost of capital and
the project NPV is $34.1.

12-33
What subjective risk factors should be
considered before a decision is made?

 Numerical analysis sometimes fails to

capture all sources of risk for a project.
 If the project has the potential for a
lawsuit, it is more risky than previously
thought.
 If assets can be redeployed or sold
easily, the project may be less risky
than otherwise thought.

12-34
Evaluating Projects with Unequal
Lives
 Machines A and B are mutually
exclusive, and will be repurchased. If
WACC = 10%, which is better?
Expected Net CFs
Year Machine A Machine B
0 ($50,000) ($50,000)
1 17,500 34,000
2 17,500 27,500
3 17,500 –
4 17,500 –
12-35
Solving for NPV with No
Repetition
 Enter CFs into calculator CFLO register
for both projects, and enter I/YR = 10%.
 NPV A = $5,472.65
 NPV B = $3,636.36
 Is Machine A better?
 Need replacement chain and/or equivalent
annual annuity analysis.

12-36
Replacement Chain

 Use the replacement chain to calculate

an extended NPVB to a common life.
 Since Machine B has a 2-year life and
Machine A has a 4-year life, the
common life is 4 years.
0 1 2 3 4
10%

-50,000 34,000 27,500 34,000 27,500

-50,000
-22,500
NPVB = $6,641.62 (on extended basis)
12-37
Equivalent Annual Annuity

 Using the previously solved project NPVs,

the EAA is the annual payment that the
project would provide if it were an annuity.
 Machine A
 Enter N = 4, I/YR = 10, PV = -5472.65, FV =
0; solve for PMT = EAA = $1,726.46.
 Machine B
 Enter N = 2, I/YR = 10, PV = -3636.36, FV =
0; solve for PMT = EAA = $2,095.24.
 Machine B is better!
12-38