ISBN: 0-03-028931-9
Chapter 12 Cash Flow Estimation and Risk Analysis
This chapter discussed several issues in capital budgeting. The key concepts covered are listed below:
The most important (and most difficult) step in analyzing a capital budgeting project is estimating the incremental after-tax cash flows the project will produce.
Remember that free cash flow is calculated by adding depreciation back to the after-tax operating income and then subtracting out both the capital expenditures and the change is net operating working capital.
In determining incremental cash flows, opportunity costs (the cash flows forgone by using an asset) must be included, but sunk costs (cash outlays that have been made and that cannot be recouped) are not included. Any externalities (effects of a project on other parts of the firm) should also be reflected in the analysis.
Cannibalization occurs when a new project leads to a reduction in sales of an existing product.
Capital projects often require an additional investment in net working capital (NWC). An increase in NWC must be included in the Year 0 initial cash outlay, and then shown as a cash inflow in the final year of the project.
The incremental cash flows from a typical project can be classified into three categories: (1) initial investment outlay, (2) operating cash flows over the project's life, and (3) terminal year cash flows.
Inflation effects must be considered in project analysis. The best procedure is to build inflation directly into the cash flow estimates.
Since stockholders are generally diversified, market risk is theoretically the most relevant measure of risk. Market, or beta, risk is important because beta affects the cost of capital, which, in turn, affects the stock price.
Corporate risk is important because it influences a firm's ability to use low-cost debt, to maintain smooth operations over time, and to avoid crises that might consume management's energy and disrupt its employees, customers, suppliers, and community.
Sensitivity analysis is a technique that shows how much a project's NPV will change in response to a given change in an input variable such as sales, other things held constant.
Scenario analysis is a risk analysis technique in which the best- and worst-case NPVs are compared with the project's expected NPV.
Monte Carlo simulation is a risk analysis technique that uses a computer to simulate future events and thus to estimate the profitability and riskiness of a project.
The risk-adjusted discount rate, or project cost of capital, is the rate used to evaluate a particular project. It is based on the corporate WACC, which is increased for projects that are riskier than the firm's average project but decreased for less risky projects.
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