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12 Chapter model
2/15/2006
11/7/2014 8:27
Chapter 12. Cash Flow Estimation and Risk Analysis
This worksheet contains a model to analyze BQC's new computer control project. Models for analyzing
real options, replacement decisions, projects with unequal lives, and bond refunding are also provided
on separate worksheets. Access those models by pressing the appropriate TAB key at the bottom of
the screen.
Later in the model, we extend the analysis done here to deal with real options and other top

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12 Chapter model2/15/2006
PROJECT ANALYSIS
(Section 12.2)
This worksheet contains a model to analyze BQC's new computer control project. Models for analyzing real options, replacement decisions, projects with unequal lives, and bond refunding are also provided on separate worksheets. Access those models by pressing the appropriate TAB key at the bottom of the screen.
Chapter 12. Cash Flow Estimation and Risk Analysis
The model also does a scenario analysis where three variables--unit sales, the sale price, and the VC%--are changed. Other variables are held constant at their base case levels. The analysis can be done manually by inserting data for the various scenarios into the input data cells. However, we also set up Scenarios using the Scenario Manager tool, which is described in the Tutorial. This tool can be used to move to the different scenarios, but it is not necessary.The main model, on this tab, evaluates the computer project. Part 1 lists the key inputs used in the calculations. Part 2 develops the depreciation data. Part 3 estimates the cash flows from disposing of the building and the equipment at the end of the project's life. Part 4 calculates the cash flows during each year of the project's operating life. Part 5 then uses the estimated cash flows to estimate the key outputs and shows them as a time line which is used to calculate the NPV, IRR, MIRR, and Payback. Finally, in Parts 6 and 7, we consider the riskiness of the project by showing how changes in the inputs would result in changes in the key outputs. Later in the model, we extend the analysis done here to deal with real options and other topics (see tabs below). All dollars are shown in thousands. Data are taken from the example in Chapter 12.
11/7/2014 8:27
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Table 12-1. Analysis of a New (Expansion) Project (Thousands of Dollars)Part 1. Input Data
Building cost (= Depr'n basis)$12,000Equipment cost (= Depr'n basis)$8,000Market value of building in 2010$7,500
Net Operating WC$6,000Market value of equip. in 2010$2,000
First year sales (in units)20,000Tax rate40%
Growth rate in units sold0.0%WACC12%
Sales price per unit$3.00Inflation: growth in sales price0.0%
Variable cost per unit$2.10Inflation: growth in VC per unit0.0%
Fixed costs$8,000Inflation: growth in fixed costs0.0%
Part 2. Depreciation Schedule
a
Years2007200820092010Building Depr'n Rate1.3%2.6%2.6%2.6%Building Depr'n Expense$156$312$312$312Cumulative Depr'n$156$468$780$1,092Ending Book Value: Cost - Cum. Depr'n$11,844$11,532$11,220$10,908Equipment Depr'n Rate20.0%32.0%19.0%12.0%Equipment Depr'n Expense$1,600$2,560$1,520$960Cumulative Depr'n$1,600$4,160$5,680$6,640Ending Book Value: Cost - Cum. Depr'n$6,400$3,840$2,320$1,360
Part 3. Salvage Value Calculations
Building
Equipment
TotalEstimated Market Value in 2010$7,500$2,000Book Value in 2010
b
10,9081,360Expected Gain or Loss
c
-3,408640Tax liability or credit-1,363256Net cash flow from salvage$8,863$1,744$10,607
the equipment) to determine the depreciation expense for the year.
a
The indicated percentages are multiplied by the depreciable basis ($12,000 for the building and $8,000 for
d
Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results
b
Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation. equipment, accumulated depreciation is $6,640, so book value is $8,000 - $6,640 = $1,360.taken versus true depreciation, and it is treated as an operating expense for 2010. Equipment: $2,000market value - $1,360 book value = $640 profit. Here the depreciation charge exceeds the true For the building, accumulated depreciation is $1,092, so book value is $12,000 - $1,092 = $10,908. For the
c
Building: $7,500 market value - $10,908 book value = -$3,408, a loss. Thus there's a shortfall in depreciation depreciation, and the difference is called depreciation recapture . It is taxed as ordinary income in 2010.in a tax credit, so net salvage value = $7,500 - (-$1,363) = $8,863.
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Part 4. Projected Cash Flows
Years0123420062007200820092010
Investment Outlays at Time Zero
Building-$12,000Equipment-8,000Increase in Net Working Capital-6,000
Operating Cash Flows over the Project's Life
Units sold20,00020,00020,00020,000Sales price$3.00$3.00$3.00$3.00Sales revenue$60,000$60,000$60,000$60,000Variable costs42,00042,00042,00042,000Fixed operating costs8,0008,0008,0008,000Depreciation (building)156312312312Depreciation (equipment)1,6002,5601,520960EBIT$8,244$7,128$8,168$8,728Taxes on operating income (40%)3,2982,8513,2673,491NOPAT$4,946$4,277$4,901$5,237Add back depreciation1,7562,8721,8321,272 Operating cash flow (OCF)$6,702$7,149$6,733$6,509
Terminal Year Cash Flows
Return of net operating working capital
e
$6,000Net salvage value10,607Total termination cash flows$16,607Projected Cash Flows (CF time line)-$26,000$6,702$7,149$6,733$23,116 with recovery of NWC and net salvage value Projected Cash Flows (CF time line)-$26,000$6,702$7,149$6,733$47,562 with terminal or horizon value
Part 5. Appraisal of the Proposed Project
with recovery of NWC and net salvage value with termin NPV (at 12%)$5,166$20,702IRR19.33%34.90%MIRR17.19%29.66%
Manual Payback = 3 + 5,416/23,116=
3.233.11Cumulative cash flow for payback:01234-26,000-19,298-12,149-5,41617,700-26,000-19,298-12,149-5,41642,146 YearsPayback: We first calculate the cumulative CFs. The payback period is the year before the cumulative CF turns positive, which in this case is 3, plus a fraction equal to (unrecovered after Year 3) / (CF in Year 4) = 0.23, so the payback is 3.23 years. We also used an Excel Logical Function to automate payback calculation. This is useful if you plan to do sensitivity analysis or want to analyze a lot of projects. See the Excel tutorial on the Web site for an explanation of the payback function we developed.
e
Net working capital (NWC) will be recovered at the end of the project's operating life, at year-end 2010, as inventories are sold off and receivables are collected.
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MEASURING STAND-ALONE RISK
(Section 12.5)
Part 6. Evaluating Risk: Sensitivity Analysis
% Deviation% Deviation
fromNPVfromUnitsNPV Extra Question: At wh Base CaseWACC5,166Base CaseSold$5,166 1st Year Sales would
-30%8.4%$8,294-30%14,000 -$4,675 the project break eve
-15%10.2%$6,674-15%17,000 $246 in the sense that NPV
0%12.0%$5,166Base Case0%20,000 $5,166 = $0?
15%13.8%$3,76115%23,000 $10,087
30%15.6%$2,45030%26,000 $15,007
Answer: You could pl NPV against Sales an see about where NPV
% Deviation% Deviation
= 0. Alternatively, yofromVariableNPVfromGrowthNPV could use Tools > Go
Base CaseCost$5,166Base CaseRate %$5,166 Seek as described in
-30%$1.47$28,129-30%-30%-$5,847 the columns to the rig
-15%$1.79$16,647-15%-15%-$907 The answer is 16,850
0%$2.10$5,166Base Case0%0%$5,166 units.
15%$2.42-$6,31515%15%$12,512
30%$2.73-$17,79630%30%$21,269
% Deviation% Deviation
fromSalesNPVfromFixedNPV
Base CasePrice$5,166Base CaseCosts$5,166
-30%$2.10-$27,637-30%$5,600$9,540
-15%$2.55-$11,236-15%$6,800$7,353
0%$3.00$5,166Base Case0%$8,000$5,166
15%$3.45$21,56815%$9,200$2,979
30%$3.90$37,97030%$10,400$792
GROWTH RATE, UNITS
VARIABLE COSTS
1st YEAR UNIT SALES
WACCSALES PRICEFIXED COSTSThe model analyzes the sensitivity of the project's NPV to variations in WACC, unit sales, variable costs, growth rates, sales price, and fixed costs. We developed the following Excel Data Tables to find NPV at different levels for each variable, holding other things constant. Based on the 12% WACC, the project's NPV is $5,166. Since the NPV is positive and both the IRR and MIRR exceed the WACC, we tentatively conclude that the project should be accepted. Note, though, that no risk analysis has been conducted. It is possible that BQC's managers, after appraising the project's risk, might conclude that its projected return is insufficient to compensate for the risk and thus reject it. Also, senior managers might conclude that the project is inconsistent with the firm's long-run strategic plan. Finally, bringing in real options, which we discuss in the next tab, might change the project's risk/return profile.Risk in capital budgeting essentially means the probability that the actual outcome will be much worse than the expected outcome. For example, if there were a high probability that the $5,166 expected NPV as calculated above will turn out to be quite negative, then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is, typically, that sales are lower than expected, costs are higher than expected, or the project turns out to have a higher than expected initial cost. In other words, if the assumed inputs turn out to be worse than expected, then the output will likewise be worse than expected. We use Excel to examine the project's sensitivity to changes in the input variables.
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