Wiley Chapter 11 Depreciation Impairments and Depletion

Topic 9
in
Cash Flow Estimation
Analysis
and Risk
Relevant Cash Flows

Types of Risk
Risk Analysis
Unequal Life
Incorporating Inflation
1
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AC6531 Financial Management City University of Hong Kong
A proposed project
• Total depreciable cost

– Equipment: $200,000
– Shipping and installation: $40,000
• Changes in operating working capital
– Inventories will rise by $25,000
– Accounts payable will rise by $5,000
• Effect on operations
– New sales: 100,000 units/year @ $2/unit
– Variable cost: 60% of sales
2

A proposed project
• Life of the project

– Economic life: 4 years
Nm 可忍略略
– Depreciable life: MACRS
zagdawgtogi
3-year class
– Salvage value: $25,000
• Tax rate: 40%
襰
• WACC: 10%

Determining project value
• Estimate relevant cash flows

– Calculating annual operating cash flows.
– Identifying changes in net operating working capital.
– 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
4

Initial year investment outlays
• Find NOWC.
– in inventories of $25,000AccountsPayable
– Funded partly by an in A/P of $5,000
– NOWC = $25,000 – $5,000 = $20,000
• Initial year outlays: 4dontneedtopayincash
Equipment cost -$200,000
Installation -40,000
CAPEX
⼀一⼀一监
Capital E㥃 -240,000
NOWC -20,000
FCF0 -$260,000
5

Determining annual depreciation expense⼀一
mi
Year
加速8
興
Rate x 1 Basis Deprec.
1 0.33 x
2 0.45 x
3 0.15 x
4 0.07 x
1.00

Determining annual depreciation expense
Year Rate x Basis Deprec.

1 0.33 x $240
2 0.45 x 240
3 0.15 x 240
4 0.07 x 240
1.00

Determining annual depreciation expense
Year Rate x Basis Deprec.

1 年年邀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
se惭从年年中开始计
tmmttne
eboe
Due to the MACRS ½-year convention, a 3-year asset is
depreciated over 4 years.

Project operating cash flows
(Thousands of dollars) 1 2 3 4
Revenues 200.0 200.0 200.0 200.0
– Op. costs -120.0 -120.0 -120.0 -120.0
– Depreciation -79.2 -108.0 -36.0 -16.8
z.Oearmhgsbgemterestmdta
EBIT 0.8 -28.0 44.0 63.2
– Taxes (40%) 0.3 -11.2 17.6 25.3
EBIT(1 – T) 0.5 -16.8 26.4 37.9
+ Depreciation 79.2 108.0 36.0 16.8
ofgggpaythistime.fnn.ms
EBIT(1 – T) + DEP 79.7 91.2 62.4 54.7
interest
9

Terminal cash flows
(Thousands of dollars)
Salvage value $25
– Tax on SV (40%) 10
AT salvage value $15
+ NOWC 20
Terminal CF $35
FCF4 = EBIT(1 – T) + DEP + AT SV + NOWC

= $54.7 + $35
= $89.7
10

Terminal cash flows
Q. How is NOWCgqnneoperatgcmrentan.pe
netopng
recovered?
Suppose the company can sell all the watnities.tn
inventory
Q. Is there always a tax on SV? exiting
𠳏退税igodng
feng
Tax on SV = T x (SV – Book value) noneedto
pay
Q. Is the tax on SV ever a positive cash flow? but
government
gain
Not if salvage value is lower than the book value
11

Proposed project’s cash flow time line
(Thousands of dollars)
0 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
⼀一
IRR = 9.3%
MIRR = 9.6%
Payback = 3.3 years
12

Should financing effects be included in cash flows?
• No, dividends and interest expense should not be

included in the analysis.
• Financing effects have already been taken into
account by discounting cash flows at the WACC of
10%.
• Deducting interest expense and dividends would be
“double counting” financing costs.
13

Should a $50,000 improvement cost from the
previous year be included in the analysis?
• No, the building improvement cost is a sunk cost

and should not be considered.
• This analysis should only include incremental
investment.
14

If the facility could be leased out for $25,000 per year,
would this affect the analysis?
• Yes, by accepting the project, the firm foregoes a

possible annual cash flow of $25,000, which is an
opportunity cost to be charged to the project.
• The relevant cash flow is the annual after-tax
opportunity cost.
A-T opportunity cost:
= $25,000(1 – T)
= $25,000(0.6)
= $15,000
15

If the new product line decreases the sales of the firm’s
other lines, would this affect the analysis?
• Yes. The effect on other projects’ CFs is an

“externality.”
• Net CF loss per year on other lines would be a cost
to this project.
• Externalities can be positive (in the case of
⼀一⼆二
complements) or negative (substitutes).
16

If this were a replacement rather than a new project,
would the analysis change?
• Yes, the old equipment would be sold, and new

equipment purchased.
0值嗮
•
zine
The incremental CFs would be the changes from the
old to the new situation.
• The relevant depreciation expense would be the
change with the new equipment.
17

Class Exercise 1
Thomson Media is considering some new equipment whose data are shown
below. The equipment has a 3-year tax life and would be fully depreciated by the
straight-line method over 3 years, but it would have a positive pre-tax salvage
value at the end of Year 3, when the project would be closed down. Also, some
new working capital would be required, but it would be recovered at the end of
the project's life. Revenues and other operating costs are expected to be
constant over the project's 3-year life. What is the project's NPV?
WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Straight-line depr. rate 33.333%
Sales revenues, each year $80,000
Operating costs (excl. depr.), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%
18

What are the 3 types of project risk?
• Stand-alone risk
• Corporate risk
• Market risk
19

What is stand-alone risk?
• The project’s total risk, if it were operated

independently.
•
驟
Usually measured by standard deviation (or
coefficient of variation).协⽅方差⼀一
w
• However, it ignores the firm’s diversification among
projects and investors’ diversification among firms.
20

What is corporate risk?
• The project’s risk when considering the firm’s other

projects, i.e., diversification within the firm.
• Corporate risk is a function of the standard
deviation of project’s NPV and its correlation with
the returns on other firm projects.
• Since most projects the firm undertakes are in its
core business, stand-alone risk is likely to be highly
correlated with its corporate risk.
21

What is market risk?
• The project’s risk to a well-diversified investor.

• Theoretically, it is measured by the project’s beta
and it considers both corporate and stockholder
diversification.
22

嗮游上
Which type of risk is most relevant?
0 ⼀一
• Market risk is the most relevant risk for capital

projects, because management’s primary goal is
shareholder wealth maximization.
• However, since corporate risk affects creditors,
customers, suppliers, and employees, it should not
be completely ignored.
23

Which risk is the easiest to measure?
• Stand-alone risk is the__ easiest to measure. Firms

often focus on stand-alone risk when making capital
budgeting decisions.
• Focusing on stand-alone risk is not theoretically
correct, but it does not necessarily lead to poor
decisions.
24

What is sensitivity analysis?
•
__ 㶎
Sensitivity analysis measures the effect of changes
in a variable on the project’s NPV.
• To perform a sensitivity analysis, all variables are
fixed at their expected values, except for the
variable in question which is allowed to fluctuate.
• Resulting changes in NPV are noted.
25

26

What are the advantages and disadvantages of
sensitivity__ analysis?
• Advantage
– Identifies variables that may have the greatest
potential impact on profitability and allows
management to focus on these variables.
• Disadvantages
– Does not reflect the effects of diversification.
– Does not incorporate any information about the
possible magnitude of the forecast errors.
27

Perform a scenario analysis of the project, based on
changes in the sales forecast
•
⼀一
Suppose we are confident of all the variable
estimates, except unit sales. The actual unit sales
are expected to follow the following probability
distribution:
Case Probability Unit Sales

Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000
28

Scenario analysis
• All other factors shall remain constant and the NPV

under each scenario can be determined.
Case Probability NPV

Worst 0.25 ($27.8)
Base 0.50 15.0
Best 0.25 57.8
29

Determining expected NPV, NPV, and CVNPV from the
scenario analysis
E(NPV) 0.25(-$27.8) 0.5($15.0) 0.25($57.8)

$15.0
NPV [0.25(-$27.8 $15.0)2 0.5($15.0 $15.0)2

0.25($57.8 $15.0)2 ]1/2
$30.3
CVNPV $30.3/$15.0 2.0
30

If firm’s average projects’ CVNPV range is 1.25-1.75,
would this project have high, average, or low risk?
• With a CVNPV of 2.0, this project would be classified

__
as a high-risk project.
• Perhaps, some sort of risk correction is required for
proper analysis.
31

Is this project likely to be correlated with the firm’s business?
How would it contribute to the firm’s overall⼀一 risk?
• We would expect a positive correlation with the

firm’s aggregate cash flows.
• As long as correlation is not perfectly positive (i.e.,
ρ 1), we would expect it to contribute to the
lowering of the firm’s overall risk.
32

If the project had a high correlation with the economy, how
would corporate and market risk be affected?
• The project’s corporate risk would not be directly

affected. However, when combined with the
project’s high stand-alone risk, correlation with the
economy would suggest that market risk (beta) is
high.
33

If the firm uses a +/-3% risk adjustment for the cost of
capital, should the project be accepted?
• Reevaluating this project at a 13% cost of capital

(due to high stand-alone risk), the NPV of the
project is -$2.2.
• If, however, it were a low-risk project, we would use
a 7% cost of capital and the project NPV is $34.1.
34

What subjective risk factors should be considered
before a decision is made?
• Numerical analysis sometimes fails to capture all

sources of risk for a project.
• If the project has the potential for a lawsuit, it is
more risky than previously thought.
• If assets can be redeployed or sold easily, the
project may be less risky than otherwise thought.
35

Class Exercise 2
Klott Company encounters significant uncertainty with its sales volume and price
in its primary product. The firm uses scenario analysis in order to determine an
expected NPV, which it then uses in its budget. The base case, best case, and
worse case scenarios and probabilities are provided in the table below. What is
Klott's expected NPV and standard deviation of NPV?
•
• Probability Unit Sales Sales NPV
• of Outcome Volume Price (In Thousands)
•Worst case 0.30 6,000 $3,600 -$6,000
•Base case 0.50 10,000 4,200 +13,000
•Best case 0.20 13,000 4,400 +28,000
36

Evaluating projects with unequal lives
• Machines A and B are mutually exclusive, and will be

repurchased. If WACC = 10%, which is better?
Expected Net CFs
Year Machine A Machine B
0 ($50,000) ($50,000)
1 17,500 34,000
2 17,500 27,500
3 17,500 –
4 17,500 –
37

Solving for NPV with no repetition
• Enter CFs into calculator CFLO register for both projects,

and enter I/YR = 10%.
– NPVA = $5,472.65
– NPVB = $3,636.36
• Is Machine A better?
– If both projects can be repeated, we need replacement
chain and/or equivalent annual annuity analysis.
38

Replacement chain
• Use the replacement chain to calculate an extended

NPVB to a common life.
• Since Machine B has a 2-year life and Machine A has a
4-year life, the common life is 4 years.
0 1 2 3 4
10%
-50,000 34,00027,500
-50,000 34,000 27,500
-22,500
NPVB = $6,641.62 (on extended basis)
39

Equivalent annual annuities
• Using the previously solved project NPVs, the EAA is the

annual payment that the project would provide if it
were an annuity.
• Machine A
– Enter N = 4, I/YR = 10, PV = -5472.65, FV = 0; solve for
PMT = EAAA = $1,726.46.
• Machine B
– Enter N = 2, I/YR = 10, PV = -3636.36, FV = 0; solve for
PMT = EAAB = $2,095.24.
• Machine B is better!
40

Class Exercise 3
Carlyle Inc. is considering two mutually exclusive projects. Both require an initial
investment of $15,000 at t = 0. Project S has an expected life of 2 years with
after-tax cash inflows of $7,000 and $12,000 at the end of Years 1 and 2,
respectively. In addition, Project S can be repeated at the end of Year 2 with no
changes in its cash flows. Project L has an expected life of 4 years with after-tax
cash inflows of $5,200 at the end of each of the next 4 years. Each project has a
WACC of 9.00%. Which project should be accepted?
41

CITY UNIVERSITY OF HONG KONG
DEPARTMENT OF ACCOUNTANCY
Cash Flow Estimation and Risk Analysis – Answers
Question 1
WACC= 10% t=0 t=1 t=2 t=3

Investment in fixed assets -$70,000
Investment in net working capital -10,000
Sales revenues $80,000 $80,000 $80,000
Operating costs (excl. dep.) -30,000 -30,000 -30,000
Depreciation rate = 33.33% -23,333 -23,333 -23,333
Operating income (EBIT) $26,667 $26,667 $26,667
Taxes rate = 35% -9,333 -9,333 -9,333
After-tax EBIT $17,334 $17,334 $17,334
+ Depreciation 23,333 23,333 23,333
Cash flow from operations -$80,000 $40,667 $40,667 $40,667
Recovery of working capital 10,000
Salvage value, pre-tax 5,000
Tax on salvage value rate = 35% -1,750
Total cash flows -$80,000 $40,667 $40,667 $53,917
NPV $31,088
Question 2
Calculate expected value of NPV (in thousands):

Probability of Unit Sales Sales NPV
Outcome, Pi Volume Price (In 000s) Pi(x)
Worst case 0.30 6,000 $3,600 -$6,000 0.3(-6,000) = -1,800
Base case 0.50 10,000 4,200 13,000 0.5(13,000) = 6,500
Best case 0.20 13,000 4,400 28,000 0.2(28,000) = 5,600
Expected NPV = $10,300
Calculate standard deviation of NPV (in thousands):

Pi (x - x )2 (x - x )2 Pi(x - x )2
Worst case 0.3 (-6 - 10.3)2 265.69 79.707

Base case 0.5 (13 - 10.3)2 7.29 3.645
Best case 0.2 (28 - 10.3)2 313.29 62.658
Sum 146.01
(146.01)½ = 12.083.
σNPV = $12,083
Question 3
WACC = 9.00%
Project S: 0 1 2
CFs -$15,000 $7,000 $12,000
NPVS$1,522.18
EAAS: Enter the following inputs in your financial calculator:

N = 2; I/YR = 9; PV = -1522.18; FV = 0; and solve for PMT = EAA =
$865.31.
Project L: 0 1 2 3 4
CFs -$15,000 $5,200 $5,200 $5,200 $5,200
NPVL$1,846.54
EAAL: Enter the following inputs in your financial calculator:

N = 4; I/YR = 9; PV = -1846.54; FV = 0; and solve for PMT = EAA =
$569.97.
The most profitable project is the one with the higher EAA. Since EAAS > EAAL,
choose Project S with EAA = $865.31.

Wiley Chapter 11 Depreciation Impairments and Depletion

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Topic 9

Relevant Cash Flows

• Total depreciable cost

AC6531 Financial Management City University of Hong Kong

• Life of the project

AC6531 Financial Management City University of Hong Kong

• Estimate relevant cash flows

Initial OCF1 OCF2 OCF3 OCF4

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

Year Rate x Basis Deprec.

AC6531 Financial Management City University of Hong Kong

Year Rate x Basis Deprec.

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

FCF4 = EBIT(1 – T) + DEP + AT SV + NOWC

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

-260 79.7 91.2 62.4 89.7

• Enter CFs into calculator CFLO register, and enter

AC6531 Financial Management City University of Hong Kong

• No, dividends and interest expense should not be

AC6531 Financial Management City University of Hong Kong

• No, the building improvement cost is a sunk cost

AC6531 Financial Management City University of Hong Kong

• Yes, by accepting the project, the firm foregoes a

AC6531 Financial Management City University of Hong Kong

• Yes. The effect on other projects’ CFs is an

AC6531 Financial Management City University of Hong Kong

• Yes, the old equipment would be sold, and new

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

• The project’s total risk, if it were operated

AC6531 Financial Management City University of Hong Kong

• The project’s risk when considering the firm’s other

AC6531 Financial Management City University of Hong Kong

• The project’s risk to a well-diversified investor.

AC6531 Financial Management City University of Hong Kong

• Market risk is the most relevant risk for capital

AC6531 Financial Management City University of Hong Kong

• Stand-alone risk is the__ easiest to measure. Firms

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

AC6531 Financial Management City University of Hong Kong

Case Probability Unit Sales

AC6531 Financial Management City University of Hong Kong

• All other factors shall remain constant and the NPV

Case Probability NPV

AC6531 Financial Management City University of Hong Kong

E(NPV) 0.25(-$27.8) 0.5($15.0) 0.25($57.8)

NPV [0.25(-$27.8 $15.0)2 0.5($15.0 $15.0)2

CVNPV $30.3/$15.0 2.0

AC6531 Financial Management City University of Hong Kong

• With a CVNPV of 2.0, this project would be classified

AC6531 Financial Management City University of Hong Kong

• We would expect a positive correlation with the

AC6531 Financial Management City University of Hong Kong

• The project’s corporate risk would not be directly

AC6531 Financial Management City University of Hong Kong

• Reevaluating this project at a 13% cost of capital