L08s BasicsCapitalBudgeting

Lecture 9 Cash Flow Estimation, Risk Analysis, and
Optimal Capital Budget

Learning Objectives
Understand and identify what are relevant cash flows that should
be included in cash flow estimation.
- Discuss sunk costs, opportunity costs, and externalities.
Estimate relevant cash flows for expansion project and
replacement project.
- Estimate initial cash flows
- Estimate operating cash flows
- Estimate terminal cash flows
Understand and discuss the use of sensitivity analysis and scenario
analysis in the capital budgeting process and how they can
measure project standalone risk.
Analyse the decision to lease versus borrow-and-buy. Calculate the
net advantage of leasing.
Understand what is the optimal capital budget and what is capital
rationing.
1
AB1201: Financial
Management
Lecture 9 Cash Flow Estimation, Risk Analysis,

And The Optimal Capital Budget
By: Angie Low

Relevant cash flows > Typical timeline of project > Introduction to case study > Case study: Estimating cash flows for
expansion project > Case Study: Evaluating project > Case Study: Sensitivity and Scenario Analysis> Relevant versus
irrelevant cash flows > Replacement project > Lease versus Borrow-and-Buy > Optimal capital budget > Conclusion
Steps to Capital Budgeting

1. Estimate CFs.
Initial investments.
Subsequent cash inflows/ outflows.
2. Assess riskiness of CFs and determine the

appropriate risk-adjusted cost of capital for
discounting cash flows.
3. Find NPV and/or IRR(MIRR).
3
Cash Flows versus Accounting Income

Cash is king in finance
Valuation of assets, such as stock, is based on cash flows the
asset is expected to produce.
Bills are paid with cash, assets are purchased with cash.
Net income and operating income are not cash.

They are accounting numbers.
Includes non-cash items such as depreciation.
Under accrual-based accounting, revenues and expenses
are booked when they occur, not when the cash is
received/ paid.
When evaluating projects, we are interested in the

cash flows that the project produces.
4
Relevant Cash Flows
Relevant cash flows: Incremental cash flows that

will occur if and only if the project is accepted
Calculate relevant cash flows for different types

of projects:
Expansion projects
Replacement projects
Lease versus buy
5
Two New TermsNOWC and FCF
Net Operating Working Capital (NOWC)

NOWC = Current assets (Accrued wages and taxes +
Accounts payable)
NOWC = Current assets (Current liabilities notes payable)
External costly funds needed to finance current assets
Free Cash Flow (FCF)

Cash flows available to shareholders and debtholders less the
need for re-investment to operate and produce future CFs
Capital
FCF EBIT(1 T) Depreciati on - NOWC
expenditur es
6
Timeline of typical project with life of N

years (Expansion project)
0 1 2 N
Initial Project produces Terminal CFs

Investment Operating cash flows (OCF)
Capital
expenditur es
7
Lesson Learnt 1
Accounting figures are different from cash flows.
What matters most to investors are cash flows and
not accounting numbers.
In capital budgeting, we are concern with relevant
cash flows, i.e. incremental cash flows that will be
incurred if and only if a project is taken up.
xx
FCF EBIT(1 T) Depreciati on -
Capital
NOWC

expenditur es

8
Outline of the Rest of Lecture 9

Work through cash flow estimation for an expansion
project based on the case study at the end of
Chapter 13.
Discuss how to deal with uncertainties using sensitivity
analysis and scenario analysis.
Discuss not-so-obvious relevant and irrelevant cash
flows.
Replacement projects.
Lease versus borrow-and-buy decision.
The optimal capital budget.
9
Proposed Lemon Juice Project

1. The project is expected to last for four years, after which it will be
terminated.
2. Equipment will cost $200,000 plus an additional $40,000 for
shipping and installation.
The equipment will be depreciated under the MACRS system.
At the end of four years, the equipment is expected to have a
salvage value of $25,000.
3. The changes to net operating working capital include the
following:
Inventories will increase by $25,000.
Accounts payable will rise by $5,000.
10
Proposed Lemon Juice Project*

4. Effect on operations
New sales of100,000 bottles of lemon juice per year @ $2 per bottle.
Total operating expenses (excluding depreciation) are expected
to be 60% of dollar sales.
5. Other information
Tax rate is 40%.
Cost of capital is 10%.
* This case is a modification of the integrated case in Essentials of Financial Management (p.
471), by Brigham, Houston, Hsu, Kong, and Bany-Ariffin, 2013, Singapore: Cengage Learning.
11
Determining Project Cash Flows

Estimate relevant cash flows
Identifying initial costs: investments in fixed assets and net
operating working capital
Calculating annual operating cash flows.
Calculating terminal cash flows: after-tax salvage value and
return of NOWC.
0 1 2 3 4
Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
FCF0 FCF1 FCF2 FCF3 FCF4
12
Initial Year Free Cash Flow

Capital
expenditur es
Find NOWC.
in inventories of $25,000
Funded partly by an in A/P of $5,000
NOWC = CA (CL - Notes payable)
= $25,000 ($5,000 - 0) = $20,000
Combine NOWC with CAPEX.

Equipment -$200,000
Shipping & Installation -40,000
NOWC -20,000
FCF0 -$260,000
13
Determining Annual Depreciation

Expense Different from accounting. No
need to minus off salvage value
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
MACRS: For tax purposes, the U.S. IRS requires companies to follow MACRS
when calculating asset depreciation. Under MACRS, salvage value is not
subtracted from depreciable basis when calculating annual depreciation.
For this course, regardless of whether we are using MACRS or

straight line depreciation, we do not subtract salvage value from
depreciable basis when calculating annual depreciation unless otherwise
stated.
14
Annual Operating Cash Flows

Capital
expenditur es
1 2 3 4
Revenues 200.0 200.0 200.0 200.0
Cash operating costs -120.0 -120.0 -120.0 -120.0
Deprec. expense -79.2 -108.0 -36.0 -16.8
Operating income(EBIT) 0.8 -28.0 44.0 63.2
Tax (40%) 0.3 -11.2 17.6 25.3
Operating income (AT) 0.5 -16.8 26.4 37.9
+ Deprec. expense 79.2 108.0 36.0 16.8
Operating CF 79.7 91.2 62.4 54.7
(Thousands of dollars)
15
Terminal Cash Flow

Find after-tax salvage value
Machine will be sold for $25,000.
Taxes paid = 40% of difference between salvage value
and remaining book value, i.e., 0.4*(25000 0) = $10,000
After-tax salvage value = 25,000 10,000 = $15,000.
Combining with NOWC

Recovery of NOWC $20,000
After-tax salvage value $15,000
Terminal CF $35,000
16
Proposed Projects Cash Flow Time

Line
0 10% 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
17
Uncertainties in Estimates
Most of the inputs into the capital budgeting
process are estimates.
How sensitive is our decision to the estimates?
Perform the below procedures to help understand
how uncertainties affect our decision to accept/
reject a project.
Sensitivity analysis
Used to understand/ measure
Scenario analysis standalone risk of project
Monte Carlo simulation
18
Sensitivity Analysis, Scenario Analysis, and

Monte Carlo Simulations
Sensitivity Examines how sensitive NPV is to changes in each input
variable. All other variables are held constant at base
Analysis value.
Possible alternative scenarios with different input

Scenario values are proposed.
Analysis Probabilities are assigned to each scenario Projects
expected NPV and standard deviation/CV of NPV.
Monte Simulation techniques where the NPV for many

scenarios are calculated Projects expected NPV
Carlo and standard deviation (CV) of NPV.
Simulation For this course, you do not need to know the details.
19
Lessons Learnt 2: CFs for Expansion

Project
0 1 2 N
Initial
Terminal CFs:
Investment:
Operating cash flows (OCF): Recovery of
Capital
EBIT(1-T) + Depreciation NOWC
expenditures
After-tax
NOWC
salvage value
changes
After-tax SV = SV T*(SV- Remaining BV)
Capital
expenditur es 20
Lessons Learnt 2
The calculation of NPV/ IRR/ MIRR/ payback is
sensitive to the input values.
Sensitivity analysis and scenario analysis can be
used to understand how sensitive is the
recommendation to changes in input values
- Used to measure the standalone risk of the project
21
Not-So-Obvious Relevant/Irrelevant
Cash Flows 1: Interest charges
Firm FM is considering a project. Suppose some of
the capital used to finance the project comes from
debt. Should the projected cash flows be revised to
include projected interest expense? What do you
think?
Yes
No
22
Cash Flows 2: Sunk Costs
The project will be housed in an unused building
owned by Firm FM. The company has spent $50,000
to renovate the building last year. Should this
renovation cost be included in the CF calculation
of the project?
Yes
No
23
Cash Flows 3: Opportunity Costs
The project will be housed in an unused building
owned by Firm FM. Suppose Firm FM could lease
the building out to another party for $25,000 per
year. Would this affect the CF analysis of the
project?
24
Cash Flows 4: Externalities
The proposed project will decrease the sales of Firm
FMs other lines of business, would this affect the CF
analysis?
Externalities can be positive (in the case of

complements) or negative (substitutes).
When the new business takes away the existing business,
we call such externality as cannibalisation.
25
Lessons Learnt 3
When calculating CFs
Ignore Account for
Financing charges Opportunity costs
Sunk Costs Externalities
26
Other Types of Project Categories

We have learnt to forecast CFs for an expansion
project.
Other types of projects:

Replacement projects
Refer to Section 13-3 of the textbook for detailed treatment
Lease versus Borrow-and-Buy
27
Timeline of typical project with life of N

years (Replacement Project)
0 1 2 N
Operating cash
Initial Terminal CFs
flows (OCF)
Investment
Operating cash After-tax cash

Cost of the
flows from new inflows from sale
new asset
asset of new asset
After-tax cash After-tax cash

inflow from Operating cash inflows from
sale of old flows from old asset sale of old asset
asset at t = 0 at t = N
28
Leasing
To obtain use of assets, company can buy the
asset or lease the asset
Leasing is similar to renting
Lessor Party owning the leased asset
Lessee Party using the leased asset
Make regular payments to the lessor
Lease payments are fully tax-deductible
29
Capital budgeting decision: Leasing versus

borrow-and-buy
It is already determined that acquiring the asset is a
positive NPV project.
Now, the firm has to decide how to acquire the
asset.
Option 1: Lease the asset
Option 2: Borrow funds to buy the asset
Option 3: Use available cash on hand to buy asset
Option 4: Raise equity to buy asset
Leasing is most similar to debt financing, so we
compare leasing to option 2 (borrow-and-buy)
regardless of how the asset is being financed.
Calculate NPV under leasing compare against NPV of
borrow-and-buy
30
Lease vs. Borrow-and-Buy: Example

Borrow-and-Buy
New machine costs $1,200,000.
Can be financed with a 10% loan to be amortised over four
years with end-of-year payments.
3-year MACRS class life; 4-year economic life.
Maintenance of $25,000/year, payable at beginning of
each year.
Salvage value in Year 4 = $125,000.
Lease
4-year lease includes maintenance.
Lease payment is $340,000/year, payable at beginning of
each year.
Tax rate = 40%.
31
In a lease analysis, at what discount rate

should cash flows be discounted?
Cash flows associated with leasing or borrow-and-
buy are fairly certain since most terms are stated in
contract.
Recommended to use cost of debt.
Since cash flows in a lease analysis are evaluated on
an after-tax basis, we should use the after-tax cost of
borrowing.
We should discount cash flows at 6% = 10%(1 0.4).
32
FCF revisited
33
Cost of owning analysis: Depreciation

Schedule
Depreciable basis = $1,200,000
Year MACRS Depreciation End-of-Year

Rate Expense Book Value
1 0.33 $ 396,000 $804,000
2 0.45 540,000 264,000
3 0.15 180,000 84,000
4 0.07 84,000 0
1.00 $1,200,000
34
Cost of Owning Analysis

0 1 2 3 4
Cost of asset -1,200.0
Deprec. tax savings 158.4 216.0 72.0 33.6
Maintenance (AT) -15.0 -15.0 -15.0 -15.0
Residual value (AT) 75.0
Free Cash flow -1,215.0 143.4 201.0 57.0 108.6
Maintenance expense is a cash
Depreciation expense is a non-
expense and it reduces the taxes that
cash expense but it reduces the
firm pays: Maintenance (AT)
taxes that firm pays (cash inflow):
= - Maint. expense + Maint. tax savings
Depreciation tax savings =
= - Maint. expense + Maint. expense*T
Depreciation expense*Tax rate
= -25+25*(0.4)
PV of the cost of owning (@ 6%) = -$766.948
35
Notes on Cost of Owning Analysis

Depreciation is a tax deductible expense, so it
produces a tax savings of T(Depreciation). E.g.
Year 1 = 0.4($396) = $158.4.
Each maintenance payment of $25 is tax
deductible so the after-tax cost of the
maintenance payment is (1 0.4)($25) = $15.
The ending book value is $0 so the full $125 salvage
(residual) value is taxed. Therefore the after-tax
salvage value = 125-0.4(125-0) = $75
36
Cost of Leasing Analysis
0 1 2 3 4
A-T Lease pmt -204 -204 -204 -204
Each lease payment of $340 is deductible, so

the after-tax cost of the lease is
(1 T)($340) = $204.
PV cost of leasing (@6%) = -$749.294.
37
Net Advantage of Leasing
NAL = PV cost of owning PV cost of

leasing
NAL = $766.948 $749.294

= $17.654 (Dollars in thousands)
Since the cost of owning outweighs the

cost of leasing, the firm should lease.
Choose the option with the least cost
38
The Optimal Capital Budget

Theory: Accept all positive NPV projects
What happens when there is not enough
internally generated cash to fund all positive NPV
projects?
An increasing marginal cost of capital
Raise expensive external equity
Increasing cost of debt and preferred stock as more
capital is raised
Capital rationing: Company chooses not to fund all
positive NPV projects
39
The Optimal Capital Budget

20%
A
18%
B
16%
IRR and WACC
14% WACC
C
12%
D IRR
10%
8%
6%
4%
0 150 300 450 600 750 900
Capital Budget ($000)
40
Lessons Learnt 4
For replacement projects: Incremental cash flows
from the old machine to the new machine.
Optimal capital budget is the amount of
investments where the marginal cost of capital
equals to the returns on the marginal project
Capital rationing occurs when companies do not invest up
to the optimal capital budget.
41
Lessons Learnt 4
Lease versus Borrow-and-Buy
Compare lease to alternative of borrow-and-buy
regardless of actual financing
Discount CFs with the after-tax cost of debt, i.e. rd*(1-T)
Lease Borrow-and-buy
After-tax lease After-tax maint.

payments = -(1-T)*Maint.
= -(1-T)*Lease After-tax dep.
Other cash flows, = +T*Depreciation
e.g. option to Other cash flows,
purchase assets e.g. after-tax
salvage value
42
Where Do We Stand?
CF vs. accounting income
In capital budget, we only consider after-tax relevant CF, i.e.
CF that occur if and only if the project is taken
Capital
expenditur es
Analyse cash flows for expansion project, replacement

project, and lease versus borrow-and-buy
When calculating CF, ignore:
sunk cost, financing expenses
When calculating CF, take into account:
opportunity cost, externalities
Sensitivity analysis and scenario analysis
Optimal capital budget and capital rationing
43

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Lecture 9 Cash Flow Estimation, Risk Analysis, and

Optimal Capital Budget

Lecture 9 Cash Flow Estimation, Risk Analysis,

By: Angie Low

Steps to Capital Budgeting

2. Assess riskiness of CFs and determine the

3. Find NPV and/or IRR(MIRR).

Cash Flows versus Accounting Income

Net income and operating income are not cash.

When evaluating projects, we are interested in the

Relevant Cash Flows

Relevant cash flows: Incremental cash flows that

Calculate relevant cash flows for different types

Two New TermsNOWC and FCF

Net Operating Working Capital (NOWC)

Free Cash Flow (FCF)

Timeline of typical project with life of N

Initial Project produces Terminal CFs

Outline of the Rest of Lecture 9

Proposed Lemon Juice Project

Proposed Lemon Juice Project*

Determining Project Cash Flows

Initial OCF1 OCF2 OCF3 OCF4

Initial Year Free Cash Flow

Combine NOWC with CAPEX.

Determining Annual Depreciation

Year Rate x Basis Deprec.

For this course, regardless of whether we are using MACRS or

Annual Operating Cash Flows

Revenues 200.0 200.0 200.0 200.0

Cash operating costs -120.0 -120.0 -120.0 -120.0

Deprec. expense -79.2 -108.0 -36.0 -16.8

Operating income(EBIT) 0.8 -28.0 44.0 63.2

Tax (40%) 0.3 -11.2 17.6 25.3

Operating income (AT) 0.5 -16.8 26.4 37.9

+ Deprec. expense 79.2 108.0 36.0 16.8

Operating CF 79.7 91.2 62.4 54.7

Terminal Cash Flow

Combining with NOWC

Proposed Projects Cash Flow Time

-260 79.7 91.2 62.4 89.7

Enter CFs into calculator CFLO register, and enter

Sensitivity Analysis, Scenario Analysis, and

Possible alternative scenarios with different input

Monte Simulation techniques where the NPV for many

Lessons Learnt 2: CFs for Expansion

After-tax SV = SV T*(SV- Remaining BV)

Externalities can be positive (in the case of

Other Types of Project Categories

Other types of projects:

Timeline of typical project with life of N

Operating cash After-tax cash

After-tax cash After-tax cash

Capital budgeting decision: Leasing versus

Lease vs. Borrow-and-Buy: Example

In a lease analysis, at what discount rate

Cost of owning analysis: Depreciation

Year MACRS Depreciation End-of-Year

Cost of Owning Analysis

Notes on Cost of Owning Analysis

Cost of Leasing Analysis

A-T Lease pmt -204 -204 -204 -204

Each lease payment of $340 is deductible, so