Capital Budgeting Project Cash Flows and Risk
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1 Capital Budgeting Project Cash Flows and Risk = NPV = CF 0 + Asset’s Net Value CF 1 (1 + r) 1 ^ + CF 2 (1 + r) 2 ^ + … + CF n (1 + r) n ^ = NPV = CF 0 + Asset’s Net Value CF 1 (1 + r) 1 ^ + CF 2 (1 + r) 2 ^ + … + CF n (1 + r) n ^ When evaluating a capital budgeting project, we must estimate the after-tax cash flows the asset is expected to generate in the future. = NPV = CF 0 + Asset’s Net Value CF 1 (1 + r) 1 ^ + CF 2 (1 + r) 2 ^ + … + CF n (1 + r) n ^ When evaluating a capital budgeting project, we must estimate the after-tax cash flows the asset is expected to generate in the future. Future cash flows generally are uncertain to some degree, so the risk associated with a capital budgeting project should be considered
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^. ^. ^. ^. ^. ^. ^. ^. ^. CF 1 (1 + r ) 1. CF 1 (1 + r) 1. CF 1 (1 + r) 1. CF 2 (1 + r ) 2. CF 2 (1 + r) 2. CF 2 (1 + r) 2. CF n (1 + r ) n. CF n (1 + r) n. CF n (1 + r) n. Asset’s Net Value. Asset’s Net Value. Asset’s Net Value. + … +. + … +. + … +. - PowerPoint PPT Presentation
Transcript of Capital Budgeting Project Cash Flows and Risk
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Capital BudgetingProject Cash Flows and Risk
= NPV = CF0 +Asset’s
Net ValueCF1
(1 + r)1
^+ CF2
(1 + r)2
^+ … + CFn
(1 + r)n
^= NPV = CF0 +
Asset’sNet Value
CF1
(1 + r)1
^+ CF2
(1 + r)2
^+ … + CFn
(1 + r)n
^
When evaluating a capital budgeting project, we must estimate the after-tax cash flows the asset is expected to generate in the future.
= NPV = CF0 +Asset’s
Net ValueCF1
(1 + r)1
^+ CF2
(1 + r)2
^+ … + CFn
(1 + r)n
^
When evaluating a capital budgeting project, we must estimate the after-tax cash flows the asset is expected to generate in the future.Future cash flows generally are uncertain to some degree, so the risk associated with a capital budgeting project should be considered
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Capital BudgetingProject Cash Flows and Risk
Cash Flow EstimationExpansion Project EvaluationReplacement AnalysisRisk Analysis in Capital BudgetingCapital Rationing & Multinational Capital Budgeting
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Capital BudgetingRelevant Cash Flows
Cash flow versus accounting income
capitalReturn capital
Return ofon
onDepreciati incomeNet FlowCashNet
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Capital Budgeting—Relevant Cash Flows
Sunk costOpportunity costExternalitiesShipping and installationDepreciable basis
= Purchase price + (Shipping & Installation)Inflation
Incremental cash flows—marginal cash flows (positive and negative) generated by the asset
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Identifying Incremental Cash Flows Initial investment outlay—includes cash flows that occur only at the beginning of the project’s life.Incremental operating cash flows—changes in cash flows that are sustained throughout the life of the asset—that is, the cash flow effects are ongoing.Terminal cash flow—the cash flows that occur only at the end of the life of the asset.
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Initial Investment OutlayPurchase priceShipping and installationCost/Benefit of disposing of old assetTaxes
Change in net working capitalNet working capital = CA – CL
Other “up-front” inflows/outflows
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Incremental Operating Cash Flows
Cash sales Salaries Costs of raw materials Other cash operating revenues and expenses TaxesΔ revenues or expenses, Δ tax liabilityDepreciation—non-cash expense that affects taxes
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Terminal Cash Flow
Salvage value of new assetTaxes
Salvage value of old assetTaxes Net working capitalOther “terminal” inflows/outflows associated with both the new asset and the old asset
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Capital Budgeting Project EvaluationExpansion projects—marginal cash flows include all cash flows associated with adding a new asset to grow the firm.Replacement analysis—marginal cash flows include changes (+ or -) in the cash flows associated with the new asset that replace the cash flows associated with the old asset that is replaced (maintain existing operations by replacing an old asset).
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Expansion Project—Example
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34% Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500) Increase in gross profit $21,000 Marginal tax rate 34%* Depreciation method MACRS
Increase production by adding a machine Purchase price $(47,000) Installation $(3,000) Life 3 years Salvage $5,000 Increase in net WC $(1,500)* Increase in gross profit $21,000 Marginal tax rate 34%* Depreciation method MACRS
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MACRS Depreciation
Life Class of InvestmentYear 3-year 5-year 7-year
1 33% 20% 14%2 45 32 253 15 19 174 7 12 135 11 96 6 97 98 4
100% 100% 100%
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Expansion ProjectInitial Investment Outlay
Purchase Price $(47,000)Installation ( 3,000)Δ Net WC ( 1,500)
Initial invest outlay $(51,500)Depreciable basis= $47,000 + $3,000
= $50,000
Purchase Price $(47,000)Installation ( 3,000)Δ Net WC ( 1,500)
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Expansion ProjectIncremental Operating CF
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500)
Depreciation1 = $50,000(0.33) = $16,500Depreciation1 = $50,000(0.33) = $16,500Depreciation2 = $50,000(0.45) = $22,500
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500)
Depreciation1 = $50,000(0.33) = $16,500Depreciation2 = $50,000(0.45) = $22,500Depreciation3 = $50,000(0.15) = $ 7,500
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Expansion ProjectIncremental Operating CF
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) net income
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) net income 2,970
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 net income 2,970
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 net income 2,970 ( 990)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990)
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910Depreciation 16,500
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910Depreciation 16,500 operating CF 19,470
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910Depreciation 16,500 22,500 operating CF 19,470
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910Depreciation 16,500 22,500 operating CF 19,470 21,510
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910Depreciation 16,500 22,500 7,500 operating CF 19,470 21,510
Year 1 Year 2 Year 3 gross profit $21,000 $21,000 $21,000Depreciation (16,500) (22,500) ( 7,500) taxable income 4,500 ( 1,500)
13,500 taxes (34%) (1,530) 510 ( 4,590) net income 2,970 ( 990) 8,910Depreciation 16,500 22,500 7,500 operating CF 19,470 21,510 16,410
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Expansion ProjectTerminal Cash Flow
Salvage of asset $5,000Taxes on sale (510)
% of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500Gain on sale = Sale price – Book value
% of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500Gain on sale = $5,000 – Book value
% of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500Gain on sale = $5,000 – $3,500 = $1,500Tax on gain = 0.34 x $1,500 = $510
Salvage of asset $5,000Taxes on sale (510)Δ net working capital 1,500
% of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500Gain on sale = $5,000 – $3,500
Salvage of asset $5,000Taxes on sale (510)Δ net working capital 1,500Terminal cash flow 5,990
% of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500Gain on sale = $5,000 – $3,500 = $1,500
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Expansion ProjectCash Flow Time Line
19,470 21,510 16,410
10 2 3
(51,500.00)12%
17,383.93
17,147.6415,943.88
(1,024.55)
5,99022,400
IRR = 10.9%
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Replacement Decision—Example
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000*Marginal tax rate 40% 40%*
Old machine New Machine
Purchase price $(34,000) $(40,000)Original life 6 years 4 yearsRemaining life 4 years 4 yearsCurrent salvage value $16,000 --Book value in four years $4,000 $0Salvage in four years $1,000 $2,000Depreciation $5,000 MACRS: 3-yrOperating expense savings -- $8,000Δ Net WC -- $1,000Marginal tax rate 40% 40%*
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Replacement DecisionInitial Investment Outlay
Purchase price of new machine $(40,000)Salvage value of old machine $16,000Tax on sale of old machine $3,200
Σ depreciation of old machine = $5,000 x 2 = $10,000Book value of old machine = $34,000 – $10,000 = $24,000Loss on sale of old machine = $16,000 – $24,000 = $(8,000)Tax on sale = $(8,000) x 0.40 = $(3,200)
Purchase price of new machine $(40,000)Salvage value of old machine $16,000Tax on sale of old machine $3,200 working capital $1,000
Purchase price of new machine $(40,000)Salvage value of old machine $16,000Tax on sale of old machine $3,200 working capital $1,000Initial investment outlay $(19,800)
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Replacement DecisionIncremental Operating CF
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000
Depreciation1 = New depreciation – Old depreciation= $40,000(0.33) – $5,000 = $8,200
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000)
Depreciation1 = $40,000(0.33) – $5,000 = $8,200 Depreciation2 = $40,000(0.45) – $5,000 = $13,000
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000)
Depreciation1 = $40,000(0.33) – $5,000 = $8,200 Depreciation2 = $40,000(0.45) – $5,000 = $13,000 Depreciation3 = $40,000(0.15) – $5,000 = $1,000
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200
Depreciation1 = $40,000(0.33) – $5,000 = $8,200 Depreciation2 = $40,000(0.45) – $5,000 = $13,000 Depreciation3 = $40,000(0.15) – $5,000 = $1,000 Depreciation4 = $40,000(0.07) – $5,000 = $(2,200)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000)
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 Operating CF 8,080
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 13,000 Operating CF 8,080
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 13,000 Operating CF 8,080 10,000
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 13,000 1,000 Operating CF 8,080 10,000
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 13,000 1,000 Operating CF 8,080 10,000 5,200
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 13,000 1,000 (2,200) Operating CF 8,080 10,000 5,200
Year 1 Year 2 Year 3 Year 4
Savings $8,000 $8,000 $8,000 $8,000 depreciation (8,200) (13,000) (1,000) 2,200 taxable income (200) (5,000) 7,000
10,200 taxes (40%) 80 2,000 (2,800) (4,080) net income (120) (3,000) 4,200 6,120Depreciation 8,200 13,000 1,000 (2,200) Operating CF 8,080 10,000 5,200 3,920
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Replacement DecisionTerminal Cash Flow
Salvage value of new machine $2,000Tax on sale of new machine (800)
Book value of new machine = $0Gain on sale = $2,000 – $0 = $2,000Tax on sale = $2,000(0.40) = $800
Salvage value of new machine $2,000Tax on sale of new machine (800) working capital (1,000)
Salvage value of new machine $2,000Tax on sale of new machine (800) working capital (1,000)Loss of salvage value of old machine (1,000)
Salvage value of new machine $2,000Tax on sale of new machine (800) working capital (1,000)Loss of salvage value of old machine (1,000)Loss of tax effect on sale of old machine
(1,200)
Book value of old machine in four years = $4,000Gain on potential sale = $1,000 – $4,000 = $(3,000)Tax on potential sale = $(3,000) x 0.40 = $(1,200)
Salvage value of new machine $2,000Tax on sale of new machine (800) working capital (1,000)Loss of salvage value of old machine (1,000)Loss of tax effect on sale of old machine
(1,200) Terminal cash flow (2,000)
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Replacement DecisionCash Flow Time Line
8,080 10,000 5,200 3,920
10 2 3 4
(19,800.00)12%
7,214.297,971.943,701.261,220.19
(2,000)1,920
IRR = 12.9%307.68
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Incorporating Risk In Capital Budgeting AnalysisProject risk should be evaluated to determine if the appropriate required rate of return is used to compute the project’s NPV (or to compare to its IRR). If a firm is considering a project that is much riskier than the existing assets, then it makes sense that the firm should expect to earn a higher return on the project than on its existing assets (and vice versa).
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Capital Budgeting Project Risk
Types of risk associated with projects:Stand-alone risk—risk of the asset when it is held in isolation—that is, when it stands aloneCorporate, or within-firm, risk—measured by the impact an asset is expected to have on the operations of the firm—that is, how an asset will affect the firm’s total risk if it is purchased and added to existing assetsBeta, or market, risk—the portion of an asset’s risk that cannot be eliminated through diversification—that is, how an asset will affect the firm’s market risk, or beta, if it is purchased and added to existing assets.
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Stand-Alone Risk of a Project
Sensitivity analysis—determine by how much the final result of a computation, such as NPV, changes when the values (inputs) needed for the computation are changed.Example—replacement decision illustration:
Operating Expense Required RateDeviation from Savings per Year of Return (k)
Base Case (%) NPV % NPV %
-10 $(421.29) (237%) $519.27 69%0 307.68 0 307.68 0
10 1,036.64 237 99.85 (68)
Operating Expense Required RateDeviation from Savings per Year of Return (k)
Base Case (%) NPV % NPV %
-10 $(421.29) (237%) $519.27 69%0 307.68 0 307.68 0
10 1,036.64 237 99.85 (68)
Operating Expense Required RateDeviation from Savings per Year of Return (k)
Base Case (%) NPV % NPV %
-10 $(421.29) (237%) $519.27 69%0 307.68 0 307.68 0
10 1,036.64 237 99.85 (68)
Operating Expense Required RateDeviation from Savings per Year of Return (k)
Base Case (%) NPV % NPV %
-10 $(421.29) (237%) $519.27 69%0 307.68 0 307.68 0
10 1,036.64 237 99.85 (68)
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Stand-Alone Risk of a Project
Scenario analysis—compute outcomes using various circumstances, or scenarios. Scenario Savings NPV Probability
Best case $10,000 $3,953 0.2Most likely case 8,000 308 0.7Worst case 6,000 (3,337) 0.1
Scenario Savings NPV Probability NPV x PrBest case $10,000 $3,953 0.2 $790.60Most likely case 8,000 308 0.7215.60Worst case 6,000 (3,337) 0.1 (333.70)
(333.70)Expected NPV = 672.50
(333.70)Expected NPV = 672.50
NPV = 1,962.89
(333.70)Expected NPV = 672.50
NPV = 1,962.89CVNPV = 2.92
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Stand-Alone Risk of a Project
Monte Carlo simulation—try to simulate the real world by identifying all the possible outcomes for all the situations, or variables, that are associated with a capital budgeting project.
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Corporate (Within-Firm) Risk
Determine how a capital budgeting project is related to the existing assets of the firm. If the firm wants to diversify its risk, it will try to invest in projects that are negatively related (or have little relationship) to the existing assets. If a firm can reduce its overall risk, then it generally becomes more stable and its required rate of return decreases.
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Beta (Market) Risk
Theoretically any asset has a beta,, or some way to measure its systematic riskIf we can determine the beta of an asset, then we can use the capital asset pricing model, CAPM, to compute its required rate of return as follows:
rproj = rRF + (rM - rRF)proj Measuring beta risk for a project—it is difficult to determine the beta for a project. pure play method
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Beta (Market) Risk—Example
Capital Budgeting Project Characteristics:
Cost = $100,000project = 1.5
rRF = 3.0%rM = 9.0%rproject = 3.0% + (9.0% - 3.0%)1.5 = 12.0%
Firm’s Characteristics Before Purchasing the Project:Total assets = $400,000
firm = 1.0 Firm’s Beta Coefficient After Purchasing the Project:
Total assets = $400,000 + $100,000 = $500,0001.1 500,000
100,0001.5 500,000400,0001.0 β new-Firm
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Capital Budgeting—Risk Analysis
The firm generally uses its average required rate of return to evaluate projects with average risk.The average required rate of return is adjusted to evaluate projects with above-average or below-average risks. Project Required
Risk Category Rate of Return Above-average 16%Average 12Below-average 10
If risk is not considered, high-risk projects might be accepted when they should be rejected and low-risk projects might be rejected when they should be accepted.
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Capital Rationing
If the amount of funds that is invested in capital budgeting projects is constrained, then capital rationing exists. The firm should invest in the combination of projects that provides the highest combined NPV—that is, that increases the firm’s value by the greatest total amount.
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Multinational Capital Budgeting
For the most part, the capital budgeting projects of multinational firms should be evaluated the same as for domestic firms.Repatriation of cash (earnings) might be restrictedProjects associated with foreign operations generally are considered riskier than domestic projects because:Movements in exchange rates—that is, exchange
rate risk—affect the translation of foreign currency into domestic currency
Risk that foreign governments will takeover or severely restrict operations of foreign subsidiaries—that is, political risk exists
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What are the relevant cash flows associated with a capital budgeting project? Initial investment outlay Incremental operating cash flowsTerminal cash flow
What is depreciation and how does it affect a project’s relevant cash flows?The means by which a long-term asset is
expensed over time.
Project Cash Flows and RiskThe Answers
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How is risk incorporated in capital budgeting analysis?
Projects that are riskier than average are evaluated with higher required rates of return
How do capital budgeting analyses/decisions differ for multinational firms?
Because risk is greater the required rate of return used to evaluate a foreign investment is higher than the required rate of return for similar domestic investments
Project Cash Flows and RiskThe Answers
