Chapter 12 - Cash Flow Estimation

capital expenditures

Major investments in either tangible long-term assets such as land, buildings, and equipment or intangible assets such as patents, trademarks, and copyrights.

c

Market or Beta risk is the point of view of: a. The managers of the firm. b. The government regulator. c. The investor in the firm. d. The customer of the firm.

GAAP requires revenue and COGS be recorded on the inc. statement when a sale is made, not when cash is received We also have to buy inventory to support sales although we haven't collected cash yet helps adjust for the difference between revenues/costs and cash flows.

Why do we have to consider changes in NOWC separately?

networking capital

current assets - current liabilities

net operating working capital

current assets - non-interest-bearing current liabilities

stand-alone risk

s a project's risk assuming (a) that it is the only asset the firm has and (b) that the firm is the only stock in each investor's portfolio. Stand-alone risk is measured by the variability of the project's expected returns. Diversification is totally ignored.

incremental cash flows

the difference between a firm's future cash flows with a project and those without the project flows that will occur if and only if some specific event occurs

book value

the difference between the cost of a depreciable asset and its related accumulated depreciation

externalities

the effects of a project on other parts of the firm or the environment.

depreciation tax shield

the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate

abandonment option

to shut down a project if operating cash flows turn out to be lower than expected.

terminal cash flows

•includes OCF, after-tax salvage value and recovery of NOWC

false

An opportunity cost is an amount that a firm would receive if it does not make a given investment. An example would be the purchase price from a building that a firm owns and could sell if it does not make an investment that would call for the use of the building. Opportunity costs should not be reflected in a capital budgeting analysis. True or false?

a cash outflow at the beginning and a return at the end (inventory).

In a new project, NOWC will typically be a cash outflow in inflow?

future

In capital budgeting, we are concerned with __________ incremental cash flows—we want to know if the new investment will produce enough incremental cash flow to justify the incremental investment.

true

In some instances, replacements add capacity as well as lower operating costs. When this is the case, sales revenues would be increased; and if that led to an increase in net operating working capital, that number would be shown as a Time 0 expenditure along with its recovery at the end of the project's life. These changes would, of course, be reflected in the differential cash flows for the analysis. True or false?

a

In stand alone risk analysis sensitivity analysis involves changing the ________ of the model. a. assumptions b. number of sellers in the market c. variance d. time frame

If the asset has a salvage value that is different that book value, then there will a tax on SV

Is there always a tax on SV?

Positive Within-Firm Externalities

New project is complementary to old one and the cash flows increase - However, a new project also can be complementary to an old one, in which case cash flows in the old operation will be increased when the new one is introduced. Apple's iPod was a profitable product, but when Apple made an investment in another project, its iTunes music store, that investment boosted sales of the iPod.

True

T or F: Experienced managers make many judgmental assessments, including those related to risk, and they work them into the capital budgeting process. Introductory students like neat, precise answers, and they want to make decisions on the basis of calculated NPVs. Experienced managers consider quantitative NPVs, but they also bring subjective judgment into the decision process.

true

T or F: It is very difficult, if not impossible, to quantitatively measure projects' within-firm and beta risks. Most projects' returns are positively correlated with returns on the firm's other assets and with returns on the stock market. This being the case, because stand-alone risk is correlated with within-firm and market risk, not much is lost by focusing just on stand-alone risk.

true

T or F: Sensitivity analysis, scenario analysis, and Monte Carlo simulation as described in the preceding section dealt with stand-alone risk. They provide useful information about a project's risk, but if the project is negatively correlated with the firm's other projects, it might stabilize the firm's total earnings and thus be relatively safe.

true

T or F: The replacement chain and EAA methods always result in the same decision, so it doesn't matter which one is used. The EAA is a bit easier to implement, especially when the longer project doesn't have exactly twice the life of the shorter one—and thus more than two cycles are needed to find a common life. However, the replacement chain method is often easier to explain to senior managers. Also, it is easier to make modifications to the replacement chain data to deal with anticipated productivity improvements and asset price changes.

true

The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the project's risk, the higher its cost of capital. True or false?

negative within-firm externalities, positive within-firm externalities, and environmental externalities

The three types of externalities are...

true

To do a sensitivity analysis, one would set up a spreadsheet model that calculates a project's NPV, using as inputs unit sales, sale prices, fixed and variable costs, the tax rate, and the cost of capital. Input variables are then changed one at a time to determine their effects on the NPV. If small changes in the variables could result in a large decline in the NPV, then the project is judged to be relatively risky. True or false?

expected profitability and NPV's

Types of real options include abandonment, investment timing, expansion, output flexibility, and input flexibility. The existence of options can increase WHAT TWO THINGS as well as decrease their risk??

Numerical analysis sometimes fails to capture all sources of risk for a project. If the project has the potential for a lawsuit, it is riskier than previously thought. If assets can be redeployed or sold easily, the project may be less risky than otherwise thought.

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

the longer-lived machine often will have higher costs and lower NPV.

When considering two machines (or projects) with different usable lives, will the SHORTER OR LONGER-LIVED machine often will have higher costs and lower NPV?

If the salvage value is different from the book value of the asset

When do you know to apply an after-tax effect?

e

Which of the following statements is CORRECT? a. Effects of a project on other parts of the firm or the environment are called externalities. b. Externalities can be either negative or positive but they should be correctly accounted for in a project's cash flows when evaluating that project. c. Positive externalities on a project are called complements. d. Cannibalization is a negative externality that reduces the cash flow in another part of the same company. e. All the statements above are correct.

b

Which of the following statements is NOT CORRECT? a. Opportunity costs and sunk costs are tricky when analyzing capital budgeting projects. In summary, for a correct capital budgeting analysis, opportunity costs must be included in the analysis while sunk costs should be ignored—the money is gone whether the project is undertaken or not. b. Sunk costs are the costs associated with "the road not taken". They represent the alternative cost of an asset if that asset were not already owned by the firm; therefore, these costs should be included in the capital budgeting analysis. c. An opportunity cost represents the best return a company could get on an asset it already owns. It is the cost of losing out on something if you greenlight the project, so you want to include this cost in the capital budgeting analysis. d. Sunk costs are cash outlays a company has made in the past, and they can't be recovered whether the new project goes forward or not. Thus, you don't include these costs in the project's capital budgeting analysis. e. While an opportunity cost is not an actual cash outlay, this cost must be added to the project's costs when you calculate its net present value.

monte carlo simulation analysis

a sophisticated version of scenario analysis. Here the project is analyzed under a large number of scenarios, or "runs." In the first run, the computer randomly picks a value for each variable—units sold, sales price, variable costs per unit, and so forth. Those values are then used to calculate an NPV, and that NPV is stored in the computer's memory. Next, a second set of input values is selected at random, and a second NPV is calculated. This process is repeated perhaps 1,000 times, generating 1,000 NPVs. The mean of the 1,000 NPVs is determined and used as a measure of the project's expected profitability, and the standard deviation (or perhaps the coefficient of variation) of the NPVs is used as a measure of risk. technically more complex than scenario analysis, but simulation software makes the process manageable. Simulation is useful, but because of its complexity, a detailed discussion is best left for advanced finance courses.

after-tax salvage value

an estimate of the after-tax value of an asset at the end of its depreciation

sunk costs

an outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted.

market or beta risk

the riskiness of the project as seen by a well-diversified stockholder who recognizes (a) that the project is only one of the firm's assets and (b) that the firm's stock is but one part of his or her stock portfolio. The project's market risk is measured by its effect on the firm's beta coefficient.

If the asset is sold for less than book value, the taxes paid would be negative (i.e. the firm would receive a tax credit)

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

true

A firm is choosing between two mutually exclusive projects. If the projects cannot be repeated, then it is not necessary to do any calculations beyond the "regular" NPV method. In this situation, the project with the higher NPV should be accepted. True or false?

replacement chain approach

A method of comparing projects with unequal lives that assumes that each project can be repeated as many times as necessary to reach a common life. The NPVs over this life are then compared, and the project with the higher common-life NPV is chosen.

true

A project's incremental cash flow is the difference between the firm's cash flow if it accepts the project versus if it rejects the project. Thus, if a project has an initial cost of $1 million in Year 1 and no other costs or revenues, then the incremental cash flow in that year will be -$1 million. True or false? a. True b. False

true

A sunk cost is a cost that has been incurred and cannot be recovered regardless of whether a project is accepted or rejected. Sunk costs should not/ be reflected in a capital budgeting analysis. True or false?

worst case scenario analysis

An analysis in which all of the input variables are set at their worst reasonably forecasted values.

replacement analysis

An analysis involving the decision as to whether to replace an existing asset with a new asset.

yes

Are opportunity costs included in relevant cash flows?

b

Corporate Risk, assumes which of the following: a. The corporation faces no competition. b. The cash flows of the project are not separate from the firm's other assets. c. The interest rate for the firm is zero. d. All costs the firm faces are zero.

opportunity cost

Cost of the next best alternative use of money, time, or resources when one choice is made rather than another

it affects taxes

Depreciation itself is a non-cash expense; consequently, it is only relevant because it ....

As a general rule, the unequal life issue never arises for independent projects, but it can be an issue when we compare mutually exclusive projects with significantly different lives. However, the issue arises if and only if the projects will be repeated at the end of their initial lives. Thus, for all independent projects and those mutually exclusive projects that will not be repeated, there is no need to adjust for unequal lives

Do we have to worry about unequal life analysis for all projects that have unequal lives?

externalities

Effects on the firm or the environment that are not reflected in the project's cash flows.

environmental externalities

Government rules and regulations constrain what companies can do, but firms have some flexibility in dealing with the environment. For example, suppose a manufacturer is studying a proposed new plant. The company could meet the environmental regulations at a cost of $1 million, but the plant would still emit fumes that might cause ill feelings in its neighborhood. Those ill feelings would not show up in the cash flow analysis, but they still should be considered.

If the asset is sold for less than book value, the taxes paid would be negative (i.e. the firm would receive a tax credit)

Is the tax on SV ever a positive cash flow?

cannibalization

Home Depot can open new stores that are too close to their existing stores, this takes customers away from their existing stores. In this case, even though the new store has positive cash flows, its existence reduces some of the firm's current cash flows. This type of externality is called _____________________ because the new business eats into the company's existing business.

Once a project is complete, an increase/decrease in NOWC must be offset in the final year.

How is NOWC recovered?

(1) have significantly different lives (2) are mutually exclusive and (3) can be repeated

If a company is choosing between two projects, the "regular" NPV method may not indicate the better project if those projects have 1 of what 3 things?

true

If a project is negatively correlated with the firm's other projects, it might stabilize the firm's total earnings and thus be relatively safe. True or false?

a cash inflow (better machine; less inventory needed) at the beginning, outflow at end.

In a machine replacement/improvement, NOWC will typically be a cash inflow or outflow?

true

Monte Carlo simulation is similar to scenario analysis, except in a simulation the computer chooses the values used for the input variables based on probability distributions for the variables. Simulation analysis provides an expected NPV along with information about the range of possibilities, including the standard deviation of the NPV. True or false?

true

Of the three types of risk, market risk is theoretically the most relevant, but it is quite difficult to measure a new project's market risk. Stand-alone risk is easier to estimate, and it is usually positively correlated with market risk. Therefore, the focus of risk analysis for most projects is on stand-alone risk. True or false?

b

Project S has a cost of $1,000, and its expected revenues are $655 per year for 2 years. Project L has a cost of $2,000, and its expected revenues are $700 per year for 4 years. The projects are mutually exclusive, and they can be repeated. Assume that the projects' cost of capital is 10%. What is the NPV for the better project? a. $224.84 b. $249.82 c. $274.80 d. $302.28 e. $332.51

true

Scenario analysis is similar to sensitivity analysis, but here the variables are typically set at "good," "normal," and "bad" levels, and then the NPV is calculated under each situation. This analysis is designed to give management an idea of just how good or bad the results might turn out to be, along with the most likely (or expected) result. The spreadsheet model used to do a sensitivity analysis could be modified slightly and used for the scenario analysis. True or false?

c

Stand alone risk in capital budgeting the assumption is: a. The project is independent of the country where it takes place. b. The project is the only project currently being undertaking. c. The cash flow of the project is separate from the firm's other assets. d. The cash flows of the project are not being taxed.

true

T or F: Although managers recognize the importance of within-firm and beta risk, they generally end up dealing with these risks subjectively, or judgmentally, rather than quantitatively.

true

T or F: Because sunk costs were incurred in the past and cannot be recovered regardless of whether the project is accepted or rejected, they are not relevant in the capital budgeting analysis.

false

T or F: DCF analysis doesn't always lead to proper capital budgeting decisions because capital budgeting projects are not passive- investments like stocks and bonds.

Tax rate x (Salvage value - Book Value)

Taxes paid on salvaged assets = what?

a

The project will require an initial investment of $20,000, but the project will also be using a company-owned truck that is not currently being used. This truck could be sold for $18,000, after taxes, if the project is rejected. What should Fox do to take this information into account? Increase the amount of the initial investment by $18,000. The company does not need to do anything with the value of the truck because the truck is a sunk cost. Increase the NPV of the project by $18,000.

cannibalization

The situation when a new project reduces cash flows that the firm would otherwise have had.

stand-alone risk

a project's risk assuming (a) that it is the only asset the firm has and (b) that the firm is the only stock in each investor's portfolio. Stand-alone risk is measured by the variability of the project's expected returns. Diversification is totally ignored.

corporate or within risk

a project's risk to the corporation as opposed to its investors. Within-firm risk takes account of the fact that the project is only one asset in the firm's portfolio of assets; hence, some of its risk will be eliminated by diversification within the firm. This type of risk is measured by the project's impact on uncertainty about the firm's future returns.

best case scenario analysis

an analysis in which all of the input variables are set at their best reasonably forecasted values.

base case scenario analysis

an analysis in which all of the input variables are set at their most likely values.

equivalent annual annuity

an annuity cash flow that yields the same present value as the project's NPV

salvage value

expected selling price of an asset at the end of its useful life

false; we should be more concerned with within-firm and beta risk than with stand-alone risk.

if a project is negatively correlated with returns on most stocks, it might reduce the firm's beta and thus be correctly evaluated with a relatively low WACC. So in theory, we should be more stand-alone risk rather than within-firm and beta risk.

cash flow at time 0

includes initial cost of fixed asset, installation costs, initial changes in net operating working capital (DNOWC)

scenario analysis

it allows us to change more than one variable at a time, and it incorporates the probabilities of changes in the key variables.

sensitivity analysis

measures the percentage change in NPV that results from a given percentage change in an input, other variables held at their expected values. This is by far the most commonly used type of risk analysis, and it is used by most firms. It begins with a base-case situation, where the project's NPV is found using the base-case value for each input variable.

negative within-firm externalities

open new stores that are too close to their existing stores, this takes customers away from their existing stores. In this case, even though the new store has positive cash flows, its existence reduces some of the firm's current cash flows. This type of externality is called cannibalization because the new business eats into the company's existing business. For example, when it considers whether to open a new store, Starbucks takes into account the extent the proposed store will reduce the sales of its existing coffee shops in the surrounding area.