CH 12 FIN

project's cash flows three components

(1) The initial investments that are required at . These include capital expenditures and changes in net operating working capital (ΔNOWC). (2)The operating cash flows the company receives over the life of the project. (3) The terminal cash flows that are realized when the project is completed. These cash flows include the after-tax salvage value of the equipment and the recovery of the NOWC.

types of real options

(1) abandonment, where the project can be shut down if its cash flows are low; (2) timing, where a project can be delayed until more information about demand and/or costs can be obtained; (3) expansion, where the project can be expanded if demand turns out to be stronger than expected; (4) output flexibility, where the output can be changed if market conditions change; and (5) input flexibility, where the inputs used in the production process (say, coal versus natural gas for generating electricity) can be changed if input prices and/or availability change.

sunk cost

A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. In capital budgeting, we are concerned with future incremental cash flows—we want to know if the new investment will produce enough incremental cash flow to justify the incremental investment. 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.

decision tree

A diagram that lays out different branches that are the result of different decisions made or the result of different economic situations.

measuring stand-alone risk

A project's stand-alone risk reflects uncertainty about its cash flows. Indeed, all the inputs are expected values, and actual values can vary from expected values. Three techniques are used to assess stand-alone risk: (1) sensitivity analysis, (2) scenario analysis, and (3) Monte Carlo simulation. We discuss them in the following sections.

Scenario Analysis

A risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation. it allows us to change more than one variable at a time, and it incorporates the probabilities of changes in the key variables. In a scenario analysis, we begin with the base-case scenario, which uses the most likely set of input values. We then ask marketing, engineering, and other operating managers to specify a worst-case scenario (low unit sales, low sales price, high variable costs, and so forth) and a best-case scenario. Often the best and worst cases are defined as having a 25% probability of conditions being that good or bad, with a 50% probability for the base-case conditions. Obviously, conditions can take on more than three values, but such a scenario setup is useful to help understand the project's riskiness.

Monte Carlo Simulation

A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes. so named because this type of analysis grew out of work on the mathematics of casino gambling, is 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. Monte Carlo simulation is 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.

accounting income

After the initial investments are made, the project will hopefully produce positive cash flows over its operating life. The first bracketed term in the free cash flow equation [EBIT(1 − T) + Depreciation and amortization] represents the project's operating cash flows. In most cases, these cash flows will vary over the life of the project.

Within-Firm and Beta Risk

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. The problem is that to measure diversification's effects on risk, we need the correlation coefficient between a project's returns and returns on the firm's other assets, which requires historical data that obviously do not exist for new projects. Experienced managers generally have a "feel" for how a project's returns will relate to returns on the firm's other assets. Generally, positive correlation is expected, and if the correlation is high, stand-alone risk will be a good proxy for within-firm risk. Similarly, managers can make judgmental estimates about whether a project's returns will be high when the economy and the stock market are strong (thus, what the project's beta should be). But for the most part, those estimates are subjective, not based on actual data.

best-case scenario

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

base-case scenario

An analysis in which all of the input variables are set at their most likely values. Note that the base-case results are the same in our sensitivity and scenario analyses, but in the scenario analysis, the worst case is much worse than in the sensitivity analysis and the best case is much better. In scenario analysis, all of the variables are set at their best or worst values, while in sensitivity analysis, only one variable is adjusted, and all the others are left at their base-case values.

worst-case scenario

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

market, or beta, risk

Considers both firm and stockholder diversification. It is measured by the project's beta coefficient. 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.

Externalities

Effects on the firm or the environment that are not reflected in the project's cash flows. negative within-firm externalities, positive within-firm externalities, and environmental externalities

post-audit process

First, we must recognize that each element of the cash flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any reasonably aggressive firm will necessarily go awry. This fact must be considered when appraising the performances of the operating executives who sponsor projects. Second, projects sometimes fail to meet expectations for reasons beyond the control of their sponsors and for reasons that no one could be expected to anticipate. Third, it is often difficult to separate the operating results of one investment from those of a larger system. Although some projects stand alone and permit ready identification of costs and revenues, the cost savings that result from assets like new computers may be very hard to measure. Fourth, it is often hard to hand out blame or praise because the executives who were responsible for launching a given investment have moved on by the time the results are known. Because of these difficulties, some firms tend to play down the importance of the post-audit. However, observations of both businesses and governmental units suggest that the best-run and most successful organizations put a lot of emphasis on post-audits. Accordingly, we regard the post-audit as an important element in a good capital budgeting system.

The post-audit has two main purposes

Improve forecasts. When decision makers are forced to compare their projections with actual outcomes, there is a tendency for estimates to improve. Conscious or unconscious biases are observed and eliminated; new forecasting methods are sought as the need for them becomes apparent; and people simply tend to do everything better, including forecasting, if they know that their actions are being monitored. Improve operations. Businesses are run by people, and people can perform at higher or lower levels of efficiency. When a divisional team has made a forecast about an investment, the team members are, in a sense, putting their reputations on the line. Accordingly, if costs are above and sales below predicted levels, then executives in production, marketing, and other areas will strive to improve operations and to bring results into line with forecasts. In a discussion related to this point, one executive made this statement: "You academicians only worry about making good decisions. In business, we also worry about making decisions good."

conclusions regarding risk analysis

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. 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. If a firm does not use the types of analyses covered in this book, it will have trouble. On the other hand, if a firm tries to quantify everything and let a computer make its decisions, it too will have trouble. Good managers understand and use the theory of finance, but they apply it with judgment.

Positive Within-Firm Externalities

New project is complementary to old one and the cash flows increase 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

opportunity cost

The best return that could be earned on assets the firm already owns if those assets are not used for the new project.

negative capital expenditure

Once the project is completed, the company sells the project's fixed assets and inventory and receives cash.Footnote In some respects, we can think of the sale of fixed assets at the end of the project as a negative capital expenditure—instead of using cash to purchase fixed assets, the company is selling the assets to generate cash.

sensitivity analysis

Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant. 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.

Replacement Projects

Replacement analysis is complicated by the fact that almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers. We would need to find the difference in depreciation and other factors that affect cash flows. Once we have found the incremental cash flows, we use them in a "regular" NPV analysis to decide whether to replace the asset or to continue using it.

Taking on a project with a great deal of stand-alone or corporate risk

Taking on a project with a great deal of stand-alone or corporate risk will not necessarily affect the firm's beta. However, if the project has high stand-alone risk and if its returns are highly correlated with returns on the firm's other assets and with returns on most other stocks in the economy, the project will have a high degree of all three types of risk. Market risk is theoretically the most relevant of the three because it is the one reflected in stock prices. Unfortunately, market risk is also the most difficult to estimate, primarily because new projects don't have "market prices" that can be related to stock market returns. Therefore, most decision makers do a quantitative analysis of stand-alone risk and then consider the other two risk measures in a qualitative manner.

base-case NPV

The NPV when sales and other input variables are set equal to their most likely (or base-case) values. If we were comparing two projects, the one with the steeper sensitivity lines would be riskier, other things held constant, because relatively small changes in the input variables would produce large changes in the NPV. Thus, sensitivity analysis provides useful insights into a project's risk.

optimal capital budget

The annual investment in long-term assets that maximizes the firm's value. This assumption is reasonable for large, mature firms with good track records. However, smaller firms, new firms, and firms with dubious track records may have difficulties raising capital, even for projects that the firm concludes would have highly positive NPVs.

suppose Congress wants to encourage companies to increase their capital expenditures to boost economic growth and employment. What change in depreciation would have the desired effect?

The answer is to make accelerated depreciation even more accelerated. For example, if the firm could write off this 4-year equipment at rates of 50%, 35%, 10%, and 5%, its early tax payments would be lower; early cash flows would be higher; and the project's NPV would be higher than that shown in Table 12.1.

risk-adjusted cost of capital

The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital. Projects are generally classified into several categories. Then with the firm's overall WACC as a starting point, a risk-adjusted cost of capital is assigned to each category. Although this approach is probably better than not making any risk adjustments, these adjustments are highly subjective and difficult to justify. Unfortunately, there's no perfect way to specify how high or low the adjustments should be.

option value

The difference between the expected NPVs with and without the relevant option. It is the value that is not accounted for in a traditional NPV analysis. A positive option value expands the firm's opportunities. note that the difference between the expected NPVs with and without abandonment represents the option value to abandon this project. Note too that it might be necessary for the firm to arrange things so that it has the possibility of abandonment when it is making the initial decision about a project. This might require contractual arrangements with suppliers, customers, and its union, and there might be some costs to obtaining these advance permissions. Any such costs could be compared with the value of the option as we calculated it, and this could enter into the initial decision.

environmental externalities

The most common type of negative externality is a project's impact on the environment. Government rules and regulations constrain what companies can do, but firms have some flexibility in dealing with the environment. Of course, everyone's profits depend on the earth remaining healthy, so companies have an incentive to do things to protect the environment even though those actions are not required. However, if one firm decides to take actions that are good for the environment but costly, its products must reflect those higher costs. If its competitors decide to get by with less costly but less environmentally friendly processes, they can price their products lower and make more money. Of course, more environmentally friendly companies can advertise their environmental efforts, and this might—or might not—offset their higher costs. All of this illustrates why government regulations are necessary, both nationally and internationally. Finance, politics, and the environment are all interconnected.

option to abandon

The option to shut down a project if operating cash flows turn out to be lower than expected. This option can both raise expected profitability and lower project risk. In capital budgeting we generally assume that a project will be operated for its full physical life. However, this is not always the best course of action. If the firm has the option to abandon a project during its operating life, this can lower its risk, increase its expected profitability, and raise its calculated NPV.

salvage value

The price that the company receives for a fixed asset at the end of the project is often referred to as its salvage value. The company will also have to pay taxes if the asset's salvage value exceeds its book value. Taxes paid on salvaged assets = Tax rate x (salvage value - book value)

real options

The right but not the obligation to take some future action. capital budgeting projects are not passive investments—managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options—"real" to distinguish them from financial options like an option to purchase shares of Boeing stock, and "options" because they offer the right but not the obligation to take the future action to increase cash flows. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.

stand-alone risk

The risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns. 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.

capital rationing

The situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has. In such circumstances, the size of the capital budget may be constrained, a situation called capital rationing. If capital is limited, it should be used in the most efficient way possible. Procedures have been developed for allocating capital so as to maximize the aggregate NPV subject to the constraint that the capital rationing ceiling is not exceeded. However, these procedures are extremely complicated, so they are best left for advanced finance courses.

Other Changes to the Inputs

Variables other than depreciation also could be varied, and these changes would alter the calculated cash flows and thus NPV and IRR. For example, we could increase or decrease the projected unit sales, the sales price, the variable and/or the fixed costs, the initial investment cost, the working capital requirements, the salvage value, and even the tax rate if we thought Congress was likely to raise or lower taxes. Such changes could be made easily in an Excel model, making it possible to see the resulting changes in NPV and IRR immediately. This is called sensitivity analysis

corporate, or within-firm, 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. Risk considering the firm's diversification, but not stockholder diversification. It is measured by a project's effect on uncertainty about the firm's expected future returns.

Negative within-firm externalities

cannibalization: The situation when a new project reduces cash flows that the firm would otherwise have had. This type of externality is called cannibalization because the new business eats into the company's existing business. Manufacturers also can experience cannibalization.

cash flow differentials

for replacement projects, we must find cash flow differentials between the new and old projects, and these differentials are the incremental cash flows that we analyze.

timing of cash flows

capital budgeting analyses should deal with cash flows exactly when they occur, so, daily cash flows theoretically would be better than annual flows. However, it would be costly to estimate and analyze daily cash flows, and they would probably be no more accurate than annual estimates because we simply cannot accurately forecast at a daily level out 10 years or so into the future. Therefore, we generally assume that all cash flows occur at the end of the year. Note, however, for projects with highly predictable cash flows, it might be useful to assume that cash flows occur at midyear (or even quarterly or monthly); but for most purposes, we assume end-of-year flows.

incremental cash flows

flows that will occur if and only if some specific event occurs. In capital budgeting, the event is the firm's acceptance of a project and the project's incremental cash flows are ones that occur as a result of this decision. Cash flows such as investments in buildings, equipment, and working capital needed for the project are obviously incremental, as are sales revenues and operating costs associated with the project. However, some items are not so obvious, as we explain later in this section.

post-audit

involves (1) comparing actual results with those predicted by the project's sponsors and (2) explaining why any differences occurred.

book value

the book value equals the initial price for the asset minus the asset's total accumulated depreciation. Although depreciation is not a cash expense, it does affect the company's taxes. For this reason, what matters is the depreciation rate that the firm's accountants use for tax purposes. In many cases, these depreciation rates and salvage values may be considerably different from the values used in GAAP accounting to report accounting income in the firm's financial statements. Note, that the equation above indicates that the taxes paid would be negative (i.e., the firm would receive a tax credit) if the company sold the asset for less than its book value.

t = 0

we will assume that investments in fixed assets and net operating working capital will occur only at t =0 .