Section 7 Project Cash Flows and Risk

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Income Estimation. Most critical and most troublesome stride in the investigation of a capital projectFinancial staff\'s part includes:Coordinating other departments\' effortsEnsuring that everybody utilizes the same arrangement of financial assumptionsMaking beyond any doubt that no inclinations are characteristic in conjectures. Important Cash Flows.

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Section 7 Project Cash Flows and Risk © 2005 Thomson/South-Western

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Cash Flow Estimation Most critical and most troublesome stride in the investigation of a capital venture Financial staff's part incorporates: Coordinating other offices' endeavors Ensuring that everybody utilizes a similar arrangement of monetary presumptions Making beyond any doubt that no predispositions are inalienable in conjectures

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Relevant Cash Flows Cash Flow Versus Accounting Income Incremental Cash Flows

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2010 Situation Accounting Profits Cash Flows Sales $50,000 $50,000 Costs aside from depreciation (25,000) (25,000) Depreciation (15,000) - Net working pay or money flow $10,000 $25,000 Taxes in light of working salary (30%) (3,000) (3,000) Net pay or net money flow $7,000 $22,000 Net income = Net pay in addition to deterioration = $7,000 + $15,000 = $22,000 Cash Flow Versus Accounting Income

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2011 Situation Accounting Profits Cash Flows Sales $50,000 $50,000 Costs aside from depreciation (25,000) (25,000) Depreciation (5,000) - Net working wage or money flow $20,000 $25,000 Taxes in light of working pay (30%) (6,000) (6,000) Net wage or net money flow $14,000 $19,000 Net income = Net pay in addition to devaluation = $14,000 + $5,000 = $19,000 Cash Flow Versus Accounting Income

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Incremental Cash Flows An Incremental Cash Flow is the adjustment in an association's net income inferable from a speculation project.

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Problems in Determining Incremental Cash Flows Sunk Cost: A money cost that as of now has been caused and can't be recouped Opportunity Cost: The arrival on the best option utilization of an advantage Externalities: The impact of tolerating a venture on the trade streams out different parts of the firm Shipping and Installation Costs Inflation

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Identifying Incremental Cash Flows Initial Investment Outlay: the incremental money streams related with a venture that will happen just toward the begin of a venture's life Incremental Operating Cash Flow: the adjustments in everyday money streams that outcome from the buy of a capital venture and proceed until the firm discards the benefit Terminal Cash Flow: the net money streams that happen just toward the finish of a venture's life

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Incremental Operating Cash Flow Incremental working income t = D Cash incomes t - D Cash costs t - D Taxes t = D NOI t x (1 - T) + D Depr t = ( D S t - D OC t - D Depr t ) x (1 - T) + D Depr t = ( D S t - D OC t) x (1 - T) + T( D Depr t )

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Capital Budgeting Project Evaluation Expansion Project: A venture that is proposed to build deals; gives development to the firm Replacement Analysis: An examination including the choice of whether to supplant a current, still beneficial resource with another benefit

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Classwork 3 and 4

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Year 2010 $5,000 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $2,000(0.40) 2011 $5,480 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $3,200(0.40) 2012 $4,960 = ($30,000 - $18,000 - $5,000) (1 – 0.40) + $1,900(0.40) - – 2013 $4,680 = ($30,000 $18,000 $5,000) (1 0.40) + $1,200(0.40) Expansion Project Analysis of the Cash Flows Incremental Operating Cash Flow Computation

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0 1 2 3 4 2012 2013 2014 2010 2011 k = 15% (14,000) 4,384 4,143 3,261 6,038 $3,790 5,480 4,960 10,560 5,000 Net money streams NPV = 26.3% IRR = Expansion Project Cash Flow Time Line Payback period = 2.7 years

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2012 2013 2014 2010 2011 2015 0 1 2 3 4 5 k = 15% Net money streams (11,400) 3,030 3,070 1,723 1,278 2,038 $(261) 4,060 2,620 2,236 4,100 3,484 NPV = 14.0% IRR = Replacement Project Cash Flow Time Line Payback period = 3.6 years

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Introduction to Project Risk Analysis Stand-Alone Risk: the hazard a benefit would have on the off chance that it were an association's just hazard Measured by the changeability of the benefit's normal returns Corporate (Within-Firm) Risk: chance not considering the impacts of stockholder's enhancement Measured by a venture's impact on the association's income inconstancy Beta (Market) Risk: p specialty of a venture's hazard that can't be wiped out by broadening Measured by the venture's beta coefficient

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Techniques for Measuring Stand-Alone Risk Sensitivity Analysis: Key factors are changed and the subsequent changes in the NPV and the IRR are watched. Situation Analysis: "Terrible" and "great" arrangements of money related conditions are contrasted and the in all probability circumstance. Monte Carlo Simulation: Probable future occasions are reproduced on a PC.

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80 Unit deals NPV (000s) 60 40 20 SV 0 k - 20 - 40 - 30 - 20 - 10 0 10 20 30 % change from base - 60 Base Sensitivity Analysis Graph

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E(NPV) = $15.0  (NPV) = $30.3 Scenario Analysis Assume we know all factors aside from unit deals, which could extend from 75,000 to 125,000 (or 75 to 125). Here are the situation NPVs:

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Standard Deviation: σ NPV = $30.3 Coefficient of Variation: Scenario Analysis

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Advantages/Disadvantages of Simulation Analysis Advantages Reflects likelihood of each info Shows scope of NPVs, expected NPV, σ NPV , and CV NPV Disadvantages Difficult to indicate likelihood appropriations and relationship If data sources are awful, yield will be awful: GIGO = Garbage In, Garbage Out!

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Beta (or Market) Risk and Required Rate of Return for a Project Security Market Line condition: k S = k RF + (k M - k RF )β s Erie Steel is all value financed, so cost of value is additionally its arrived at the midpoint of required rate of return, or cost of capital. Erie's β = 1.1; k RF = 8%; and k M = 12% k S = 8% + (12% - 8%)1.1 = 12.4% = Erie's cost of value Investors ought to will to give Erie cash to put resources into normal hazard ventures .

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Required Rate of Return for a Project k proj = the hazard balanced required rate of return for an individual venture k proj = k RF + (k M - k RF ) b proj

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Measuring Beta Risk for a Project Pure Play Method: 1. Recognize organizations whose exclusive business is the venture being referred to. 2. Decide the beta for each organization. 3. Normal the betas to discover an estimate of proposed venture's beta.

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How Project Risk Is Considered in Capital Budgeting Decisions Most firms utilize: Risk-Adjusted Discount Rate Discount rate that applies to especially hazardous stream of pay It is equivalent to the hazard free rate of enthusiasm in addition to a hazard premium.

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Capital Rationing A circumstance in which an imperative is set on the aggregate size of the association's capital venture.

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