326 CHAPTER 8 Cash Flow Estimation and Risk Analysis
been made and that cannot be recouped) are not included. Any externalities(ef-
fects of a project on other parts of the firm) should also be reflected in the analysis.
Cannibalizationoccurs when a new project leads to a reduction in sales of an
existing product.
Tax lawsaffect cash flow analysis in two ways: (1) They reduce operating cash flows,
and (2) they determine the depreciation expense that can be taken in each year.
Capital projects often require additional investments in net operating working
capital (NOWC).
The incremental cash flows from a typical project can be classified into three cate-
gories: (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 expected inflation into the cash flow estimates.
Since stockholders are generally diversified, market riskis theoretically the most
relevant measure of risk. Market, or beta, risk is important because beta affects the
cost of capital, which, in turn, affects stock prices.
Corporate riskis important because it influences the firm’s ability to use low-cost
debt, to maintain smooth operations over time, and to avoid crises that might con-
sume management’s energy and disrupt its employees, customers, suppliers, and
community.
Sensitivity analysisis 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 analysisis a risk analysis technique in which the best- and worst-case
NPVs are compared with the project’s expected NPV.
Monte Carlo simulationis a risk analysis technique that uses a computer to sim-
ulate 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 in-
creased for projects that are riskier than the firm’s average project but decreased
for less risky projects.
Decision tree analysis shows how different decisions in a project’s life affect its
value.Questions
Define each of the following terms:
a.Cash flow; accounting income
b.Incremental cash flow; sunk cost; opportunity cost
c.Net operating working capital changes; salvage value
d.Real rate of return, rr, versus nominal rate of return, rn
e.Sensitivity analysis; scenario analysis; Monte Carlo simulation analysis
f.Risk-adjusted discount rate; project cost of capital
Operating cash flows, rather than accounting profits, are listed in Table 8-3. What is the basis
for this emphasis on cash flows as opposed to net income?
Why is it true, in general, that a failure to adjust expected cash flows for expected inflation bi-
ases the calculated NPV downward?
Explain why sunk costs should not be included in a capital budgeting analysis, but opportunity
costs and externalities should be included.
Explain how net operating working capital is recovered at the end of a project’s life, and why it
is included in a capital budgeting analysis.
8–6 Define (a) simulation analysis, (b) scenario analysis, and (c) sensitivity analysis.8–58–48–38–28–1