12 Chapter model

2/16/2006

3/9/2016 4:05

Chapter 12. Cash Flow Estimation and Risk Analysis

This worksheet contains a model to analyze BQC's new computer control project. Models for analyzing
real options, replacement decisions, projects with unequal lives, and bond refunding are also provided
on separate worksheets. Access those models by pressing the appropriate TAB key at the bottom of
the screen.
In Chapter 13, we extend the analysis done here to deal with real options and other topics.

PROJECT ANALYSIS (Section 12.2)

The main model, on this tab, evaluates the computer project. Part 1 lists the key inputs used in the
calculations. Part 2 develops the depreciation data. Part 3 estimates the cash flows from disposing of
the building and the equipment at the end of the project's life. Part 4 calculates the cash flows during
each year of the project's operating life. Part 5 then uses the estimated cash flows to estimate the key
outputs and shows them as a time line which is used to calculate the NPV, IRR, MIRR, and Payback.
Finally, in Parts 6 and 7, we consider the riskiness of the project by showing how changes in the inputs
would result in changes in the key outputs.
All dollars are shown in thousands. Data are taken from the example in Chapter 12.
The model also does a scenario analysis where three variables--unit sales, the sale price, and the
VC%--are changed. Other variables are held constant at their base case levels. The analysis can be
done manually by inserting data for the various scenarios into the input data cells. However, we also
set up Scenarios using the Scenario Manager tool, which is described in the Tutorial. This tool can be
used to move to the different scenarios, but it is not necessary.

Page 1

Table 12-1. Analysis of a New (Expansion) Project (Thousands of Dollars)

Part 1. Input Data
Building cost (= Depr'n basis)
Equipment cost (= Depr'n basis)
Net Operating WC
First year sales (in units)
Growth rate in units sold
Sales price per unit
Variable cost per unit
Fixed costs

$12,000
$8,000
$6,000
20,000
0.0%
$3.00
$2.10
$8,000

Market value of building in 2010

Market value of equip. in 2010
Tax rate
WACC
Inflation: growth in sales price
Inflation: growth in VC per unit
Inflation: growth in fixed costs

Part 2. Depreciation Schedule a

Building Depr'n Rate
Building Depr'n Expense
Cumulative Depr'n
Ending Book Value: Cost - Cum. Depr'n

2007
1.3%
$156
$156
$11,844

Years
2008
2.6%
$312
$468
$11,532

2009
2.6%
$312
$780
$11,220

2010
2.6%
$312
$1,092
$10,908

Equipment Depr'n Rate

Equipment Depr'n Expense
Cumulative Depr'n
Ending Book Value: Cost - Cum. Depr'n

20.0%
$1,600
$1,600
$6,400

32.0%
$2,560
$4,160
$3,840

19.0%
$1,520
$5,680
$2,320

12.0%
$960
$6,640
$1,360

$7,500
$2,000
40%
12%
0.0%
0.0%
0.0%

The indicated percentages are multiplied by the depreciable basis ($12,000 for the building and $8,000 for
the equipment) to determine the depreciation expense for the year.

Part 3. Salvage Value Calculations

Estimated Market Value in 2010
Book Value in 2010b
Expected Gain or Lossc
Tax liability or credit
Net cash flow from salvaged

Building Equipment
$7,500
$2,000
10,908
1,360
-3,408
640
-1,363
256
$8,863
$1,744

Total

$10,607

Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation.
For the building, accumulated depreciation is $1,092, so book value is $12,000 - $1,092 = $10,908. For the
equipment, accumulated depreciation is $6,640, so book value is $8,000 - $6,640 = $1,360.

Building: $7,500 market value - $10,908 book value = -$3,408, a loss. Thus there's a shortfall in depreciation
taken versus "true" depreciation, and it is treated as an operating expense for 2010. Equipment: $2,000
market value - $1,360 book value = $640 profit. Here the depreciation charge exceeds the "true"
depreciation, and the difference is called "depreciation recapture". It is taxed as ordinary income in 2010.

Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results
in a tax credit, so net salvage value = $7,500 - (-$1,363) = $8,863.

Page 2

Part 4. Projected Cash Flows

0
2006
Investment Outlays at Time Zero
Building
Equipment
Increase in Net Working Capital

1
2007

Years
2
2008

3
2009

-$12,000
-8,000
-6,000

Operating Cash Flows over the Project's Life

Units sold
Sales price
Sales revenue
Variable costs
Fixed operating costs
Depreciation (building)
Depreciation (equipment)
EBIT
Taxes on operating income (40%)
NOPAT
Add back depreciation
Operating cash flow

20,000
$3.00

20,000
$3.00

20,000
$3.00

20,000
$3.00

$60,000
42,000
8,000
156
1,600
$8,244
3,298
$4,946
1,756
$6,702

$60,000
42,000
8,000
312
2,560
$7,128
2,851
$4,277
2,872
$7,149

$60,000
42,000
8,000
312
1,520
$8,168
3,267
$4,901
1,832
$6,733

$60,000
42,000
8,000
312
960
$8,728
3,491
$5,237
1,272
$6,509

Terminal Year Cash Flows

Return of net operating working capitale
Net salvage value
Total termination cash flows
Projected Cash Flows (CF time line)
e

4
2010

$6,000
10,607
$16,607
-$26,000

$6,702

$7,149

$6,733

$23,116

Net working capital will be recovered at the end of the project's operating life, at year-end 2010, as
inventories are sold off and receivables are collected.

Part 5. Appraisal of the Proposed Project

NPV (at 12%)
IRR
MIRR
Payback (Excel function)
Manual Payback = 3 + 5,416/23,116=

$5,166
19.33%
17.19%
3.23
3.23

Cumulative cash flow for payback:

0

Years
2

-26,000
-

-19,298
-

-12,149
-

-5,416
-

17,700
3.23

Payback: We first calculate the cumulative CFs. The payback period is the year before the cumulative
CF turns positive, which in this case is 3, plus a fraction equal to (unrecovered after Year 3) / (CF in
Year 4) = 0.23, so the payback is 3.23 years.
We also used an Excel Logical Function to automate payback calculation. This is useful if you plan
to do sensitivity analysis or want to analyze a lot of projects. See the Excel tutorial on the Web site for
an explanation of the payback function we developed.

Page 3

Based on the 12% WACC, the project's NPV is $5,166. Since the NPV is positive and both the IRR
and MIRR exceed the WACC, we tentatively conclude that the project should be accepted. Note,
though, that no risk analysis has been conducted. It is possible that BQC's managers, after appraising
the project's risk, might conclude that its projected return is insufficient to compensate for the risk
and thus reject it. Also, senior managers might conclude that the project is inconsistent with the firm's
long-run strategic plan. Finally, bringing in real options, which we discuss in Chapter 13, might
change the project's risk/return profile.

MEASURING STAND-ALONE RISK (Section 12.5)

Part 6. Evaluating Risk: Sensitivity Analysis
Risk in capital budgeting essentially means the probability that the actual outcome will be much worse
than the expected outcome. For example, if there were a high probability that the $5,166 expected NPV
as calculated above will turn out to be quite negative, then the project would be classified as relatively
risky. The reason for a worse-than-expected outcome is, typically, that sales are lower than expected,
costs are higher than expected, or the project turns out to have a higher than expected initial cost. In
other words, if the assumed inputs turn out to be worse than expected, then the output will likewise be
worse than expected. We use Excel to examine the project's sensitivity to changes in the input
variables.

The model analyzes the sensitivity of the project's NPV to variations in WACC, unit sales, variable
costs, growth rates, sales price, and fixed costs. We developed the following Excel Data Tables to find
NPV at different levels for each variable, holding other things constant.

% Deviation

from
Base Case
-30%
-15%
0%
15%
30%

WACC
WACC
8.4%
10.2%
12.0%
13.8%
15.6%

% Deviation 1st YEAR UNIT SALES

NPV
from
5,166
Base Case
$8,294
-30%
$6,674
-15%
$5,166 Base Case
0%
$3,761
15%
$2,450
30%

VARIABLE COSTS
% Deviation
from
Variable
NPV
from
Base Case
Cost
$5,166
Base Case
-30%
$1.47
$28,129
-30%
-15%
$1.79
$16,647
-15%
0%
$2.10
$5,166 Base Case
0%
15%
$2.42
-$6,315
15%
30%
$2.73
-$17,796
30%

% Deviation

% Deviation

from
Base Case
-30%
-15%
0%
15%
30%

SALES PRICE
% Deviation
Sales
NPV
from
Price
$5,166
Base Case
$2.10
-$27,637
-30%
$2.55
-$11,236
-15%
$3.00
$5,166 Base Case
0%
$3.45
$21,568
15%
$3.90
$37,970
30%

Units
Sold
14,000
17,000
20,000
23,000
26,000

NPV Extra Question: At what

$5,166 1st Year Sales would
-$4,675 the project break even
$246 in the sense that NPV
$5,166 = $0?
$10,087
$15,007 Answer: You could plot
NPV against Sales and
see about where NPV
= 0. Alternatively, you
GROWTH RATE, UNITS
Growth
NPV could use Tools > Goal
Rate %
$5,166 Seek as described in
-30%
-$5,847 the columns to the right.
-15%
-$907 The answer is 16,850
0%
$5,166 units.
15%
$12,512
30%
$21,269

FIXED COSTS
Fixed
NPV
Costs
$5,166
$5,600
$9,540
$6,800
$7,353
$8,000
$5,166
$9,200
$2,979
$10,400
$792

Page 4

We summarize the data tables, arranged by sensitivity, and graph the results in the following chart:

Figure 12-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)

Deviation
from
Base
-30%
-15%
0%
15%
30%
Range

NPV at Different Deviations from Base

Sales
Variable
Sales
Year 1
Fixed
Price
Cost/Unit Growth Units Sold
Cost
-$27,637
$28,129
-$5,847
-$4,675
$9,540
-11,236
16,647
-907
246
7,353
5,166
5,166
5,166
5,166
5,166
21,568
-6,315
12,512
10,087
2,979
37,970
-17,796
21,269
15,007
792
$65,607

$45,925

$27,116

$19,682

$8,748

WACC
$8,294
6,674
5,166
3,761
2,450
$5,844

Sensitivity Analysis Graph

$40,000
Sales price
$30,000
Sales growth

NPV

$20,000
$10,000

Unit sales
WACC

$0

Fixed cost

-$10,000
Variable cost
-$20,000
-$30,000
-30%

-15%

0%
Deviation

15%

30%

We see from the graph and the tables that NPV is quite sensitive to changes in the sales price and
variable costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not
very sensitive to changes in WACC and fixed costs. Thus, the key issue is our confidence in the
forecasts of the sales price and variable costs.

Note too that NPV can change dramatically if the key input variables change, but we do not know how
much the variables are likely to change. For example, if we were buying components under a fixed
price contract, then variable costs might be locked in and not likely to rise by more than say 5%, and
we might have a firm contract to sell the projected number of units at the indicated price per unit. In
that case, the "bad conditions" would not materialize, and a positive NPV would be pretty well
guaranteed. We bring probabilities of different conditions into the analysis in Part 7.

Page 5

Part 7. Evaluating Risk: Scenario Analysis

Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable
at a time, hence to see the combined effects of changes in several variables, and (2) It allows us to
bring in the probabilities of changes in the key variables. In this section we do a scenario analysis for
the computer project.
We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales,
and the unit growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base
case levels and then examine the situation when the key variables change. We assume that the
company regards the worst case as one where each of the three variables is 30% worse than the base
level, and in the best case each variable is 30% better than base. We also assume that there is a 25%
chance of the best and worst cases, and a 50% chance of base case levels.

Figure 12-2. Scenario Analysis (Dollars in Thousands)

Scenario
Good

Units
Price
VC

26,000
$3.90
$1.47

Base

20,000
$3.00
$2.10

Bad

14,000
$2.10
$2.73

Scenario Cash Flows:

Best Case
Base
Worst Case

Prob:
25%
50%
25%

0
-26,000
-26,000
-26,000

Change the inputs to these values get the

NPVs for the different scenarios. When
finished, return to base case variable
levels. We also used Scenario Manager as
described in the Tutorial, but this step is
not necessary.
Predicted Cash Flow for Each Year
1
2
3
33,810
34,257
33,841
6,702
7,149
6,733
-9,390
-8,943
-9,359

4
50,224
23,116
7,024

NPV @
12%
$87,503
$5,166
-$43,711

Expected NPV
Standard deviation
Coefficient of Variation

$13,531
$47,139
3.48

a. Probability Graph
Probability
50%

25%

-$43,711

$87,503
NPV ($)

$5,166
Most Likely NPV

$13,531
Expected NPV

b. Continuous Approximation
Probability Density

-$43,711

$0

$87,503
NPV ($)

$5,166

Page 6

The scenario analysis suggests that the project would be highly profitable, but it is quite risky. There is
a 25% probability that the project would result in a loss of $43.7 million. There is also a 25%
probability that it could produce an NPV of $87.5 million. The standard deviation is high, at $47.1
million, and the coefficient of variation is a high 3.48.
Note that the expected NPV in the scenario analysis is much higher than the base case value. This
occurs because under good conditions we have high numbers multiplied by other high numbers,
giving a very high result.
This analysis suggest that the project is relatively risky, thus the base case NPV should be
recalculated using a higher WACC. At a WACC of 15%, the base case NPV is shown below. That
number is not very high in relation to the project's cost.
NPV @ 15% =

$2,877

Changing the WACC would also change the scenario analysis. Here are new figures:

Best Case
Base Case
Worst Case

Prob.
25%
50%
25%

Expected NPV:
Standard Deviation:
Coefficient of Variation:

NPV @ 15%

$80,270
$2,877
($43,065)
$10,740
$44,309
4.13

Based on the analysis to this point, the project looks risky but acceptable. There is a good chance that
it will produce a positive NPV, but there is also a chance that the NPV could be dramatically higher or
lower.
If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large
company.
We also noted that this project's returns would be highly correlated with the firm's other projects and
also with the general stock market. Thus, its stand-alone risk (which is what we have been analyzing)
also reflects its within-firm and market risk. If this were not true, then we would need to consider risk
further.

Finally, recall that we stated at the start that if the firm undertakes the project, it will be committed to
operate it for the full 4-year life. That is important, because if it were not so committed, then if the bad
conditions occurred during the first year of operations, the firm could simply close down operations.
This would cut its losses, and the worse case scenario would not be nearly as bad as we indicated.
Then, the expected NPV would be higher, and the standard deviation and coefficient of variation would
be lower. We extend the model to deal with abandonment and other real options in the next tab, "Real
Options".

Page 7

Base

12000
8000
6000
20000
0
3
2.1
8000

Page 8

Base

7500
2000
0.4
0.12
0
0
0

Page 9

Best Case

12000
8000
6000
26000
0
3.9
1.47
8000

Page 10

Best Case

7500
2000
0.4
0.12
0
0
0

Page 11

Worst Case

12000
8000
6000
14000
0
2.1
2.73
8000

Page 12

Worst Case

7500
2000
0.4
0.12
0
0
0

Page 13

A
1
2
3

REPLACEMENT PROJECT ANALYSIS (WEB APPENDIX 12B)

This model analyzes decisions related to replacing assets that are currently being used with more
efficient assets. While the mechanics of the analysis are somewhat different from that used for a
new project, the concepts are identical.

4
5

Input Data

6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54

Cost of the new machine

Reduction in operating costs
New machine's salvage value at end of Year 5
Old machine's current market value
Old machine's current book value
Increase in net operating working capital
Tax rate
WACC

$12,000
$5,000
$2,000
$1,000
$2,500
$1,000
40%
11.5%

MACRS 3-year Depreciation Schedule

Year
Depr. Rate

Depr'n

1
33%
$3,960

2
45%
$5,400

3
15%
$1,800

4
7%
$840

$3,000
3,960
500
$3,460
1,384
$4,384

$3,000
5,400
500
$4,900
1,960
$4,960

$3,000
1,800
500
$1,300
520
$3,520

$3,000
840
500
$340
136
$3,136

$3,000
0
500
-$500
-200
$2,800

Projected Cash Flows

Investment Outlays at Time Zero
Cost of new equipment
Market value of old equipment
Tax savings on old equipment
Increase in net working capital

Years

-$12,000
1,000
600
(1,000)

Operating Cash Flows over the Project's Life

After-tax decrease in costs
Depreciation on new machine
Depreciation on old machine
Change in depreciation
Tax savings from depreciation
Operating cash flows
Terminal Year Cash Flows
Estimated salvage value of new machine
Tax on salvage value (40%)
Return of net operating working capital
Total termination cash flows
Projected Cash Flows (CF timeline)

$2,000
-800
1,000
$2,200
-$11,400

$4,384

$4,960

0
($11,400)
-

1
($7,016)
-

$3,520

$3,136

$5,000

Years
2
3
($2,056)
$1,464
2.58

4
$4,600
-

Appraisal of the Proposed Project

NPV (at 11.5%)
IRR
MIRR
Payback (Excel function)
Cumulative cash flow for payback:

$3,991
25.03%
18.40%
2.58
5
$9,600
-

A
1
2
3

REFUNDING OPERATIONS (WEB APPENDIX 12C)

This example examines the issue of replacing existing debt with newly issued debt. At its core, this
issue raises two important questions. First, "Is it profitable to call an outstanding issue and replace it
with a new issue?" Second, even if refunding now is profitable, "Would the firm's expected value be
further increased if the refunding were postponed until a later date?"

6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54

The net present value method is used to analyze the advantages of refunding. The firm should refund
only if the present value of the savings exceeds the cost of the refunding. The after-tax cost of debt
should be used as the discount rate, since there is relative certainty to the cash flows to be received.
Using the example laid out in Web Appendix 12C, we will now evaluate such a scenario.

Input Data (in thousands of dollars)

Existing bond issue
Original flotation cost
Maturity of original debt
Years since old debt issue
Call premium (%)
Original coupon rate
After-tax cost of new debt

$60,000
$3,000
25
5
10%
12%
5.4%

New
New
New
New

bond issue
flotation cost
bond maturity
cost of debt

Tax rate
Short-term interest rate

$60,000
$2,650
20
9%
40%
6%

Cash flow schedule

Before-tax
Investment Outlay
Call premium on the old bond
Flotation costs on new issue
Immediate tax savings on old flotation cost expense
Extra interest paid on old issue
Interest earned on short-term investment
Total after-tax investment
Annual Flotation Cost Tax Effects: t=1 to 20
Annual tax savings from new issue flotation costs
Annual lost tax savings from old issue flotation costs
Net flotation cost tax savings
Annual Interest Savings Due to Refunding: t=1 to 20
Interest on old bond
Interest on new bond
Net interest savings

After-tax

-$6,000
-2,650
2,400
-600
300

-$3,600
-2,650
960
-360
180
-$5,470

$133
-120
$13

$53
-48
$5

$7,200
-5,400
$1,800

$4,320
-3,240
$1,080

Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they
represent annuities. To evaluate this project, we must find the present values of these savings. Using
the function wizard and solving for present value, we find that the present values of these annuities are:

Calculating the annual flotation cost tax effects and the annual interest savings
Annual flotation Cost Tax Effects
Maturity of the new bond
After-tax cost of new debt
Annual flotation cost tax savings

20
5.4%
$5

NPV of flotation cost savings

$60

Annual Interest Savings

Maturity of the new bond
After-tax cost of new debt
Annual interest savings
NPV of annual interest savings

20
5.4%
$1,080
$13,014

Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the
present values of the annual flotation cost tax effects and interest savings.

Bond Refunding NPV =

Bond Refunding NPV =
Bond Refunding NPV =

Initial Outlay
($5,470)
$7,604

+
+

PV of flot. costs +
$60
+

PV of interest savings
$13,014

A
55
56
57
58

Our refunding analysis tells us that should the firm proceed with the bond refunding, the project will
have a positive net present value. However, unlike traditional capital budgeting decisions, the positive
NPV does not tell the firm if it should refund the bond issue now. That decision is dependent upon
several external factors, including interest rate expectations.

SECTION 12.2
SOLUTIONS TO SELF-TEST QUESTIONS
1a If the WACC increased to 15% in Table 12-1, what would the new NPV be?
WACC

15%

CFs

0
-$26,000

NPV =

$2,877

1
$6,702

Years
2
$7,149

3
$6,733

4
$23,116