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Cash Flow Estimation and Risk

Analysis

3 Relevant cash flows

3 Sunk cost
3 Opportunity cost
3 Incidental effect
3 Risk Analysis

By Donglin Li || |
Some points to remember in
calculating cash flows
3 Focus on incremental cash flowsƜthe
difference in cash flows because of this
project
3 Forget sunk costsƛ costs that have
accrued in the past

By Donglin Li ||
Some points to remember in
calculating cash flows
3 Include opportunity costsƛ costs of highest
potential benefits forgone by taking this
project
3 Consider incidental effectsƜ(also called side
effects, externality)
3 Positive side effects ƛ benefits to other projects
3 Negative side effects ƛ costs to other projects

3 Sounds abstract, but you all have applied

these rules.
By Donglin Li ||

Relevant (incremental) Cash

Flows
3 `he cash flows that should be included in a
capital budgeting analysis are those that will
only occur if the project is accepted
3 `hese cash flows are also called incremental
cash flows
3 We analyze each project in isolation from the
firm simply by focusing on incremental cash
flows

By Donglin Li || 
Asking the Right Question
3  ou should always ask yourself ƠWill this
cash flow occur ONL  if we accept the
project?ơ
3 If the answer is Ơyesơ, it should be included in the
analysis because it is incremental
3 If the answer is Ơnoơ, it should not be included in
the analysis because it will occur anyway
3 If the answer is Ơpart of itơ, then we should include
the part that occurs because of the project

By Donglin Li || 
Sunk costs
3 `he sunk cost is past cost and
irreversible. Since it cannot be affected
by the decision to accept or reject the
project, it should be ignored.
3 Is your education cost so far at SFSU
sunk cost?

By Donglin Li ||
 ou plan to produce ice cream using
some facility that you bought at $50,000
last year.
3 Should this $50,000 cost from the
previous year be included in the
analysis?

3 No, this cost is a —
— and

should not be considered.

By Donglin Li || 
Opportunity cost
3 `he highest benefit forgone when you
take a project
3 `he opportunity cost may be relevant to
the investment decision even when no
cash changes hands.
3 Give me an example about the
opportunity cost of studying at SFSU?

By Donglin Li || 
 ou plan to use the facility to produce ice creams.
`he facility could be leased out for $25,000 per
year, would this affect the analysis?
3  es, by accepting the project, the firm
foregoes a possible annual cash flow of
$25,000, which is an 
— to
be charged to the project.
3 `he relevant cash flow is the annual after-
tax opportunity cost.
3 A-` opportunity cost = $25,000 (1 ƛ `)
= $25,000(0.6)
= $15,000
3 Opportunity cost is relevant.

By Donglin Li || 
Incidental Effects (Externality)
3 `he Ơside effectsơ of taking a project.
3 Give me an example of incidental effect
if you got a degree from SFSU.

By Donglin Li || |
If the ice cream production were to decrease
the sales of the firmƞs other lines (for example,
 ogurt), would this affect the analysis?

3  es. `he effect on other projectsƞ CFs is an

Ơexternality.ơ
3 Decreased CF per year on other lines would
be a cost to this project.
3 Externalities can be positive (in the case of
complements) or negative (substitutes).
3 Externality (also called incidental effect) is
relevant.

By Donglin Li || ||
Evaluating NPV Estimates
3 `he NPV estimates are just that ƛ estimates
3 A positive NPV is a good start ƛ now we need
to take a closer look
3 Forecasting risk ƛ how sensitive is our NPV

to changes in the cash flow estimates; the

more sensitive, the greater the forecasting
risk.

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(Skip)
3Πtypes of project risk
(Stand-alone risk, Corporate risk, Market risk)

3 Sensitivity analysis
3 Scenario analysis
3 Monte Carlo analysis

3 Real Option
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Exercise Questions
A cost that has already been paid, or the
liability to pay has already been incurred,
is a(n):
a. Salvage value expense.
b. Net working capital expense.
c. Sunk cost.
d. Opportunity cost.

By Donglin Li || |
 ou bought some real estate 6 years ago for $25,000, and
you are thinking of using this land for the construction of a
new warehouse as part of a production expansion project.
3  ou include the $25,000 purchase cost of the
land as an initial cost in the capital budgeting
process. By doing so, you are making the
mistake of in the decision-
making process.

3 a. including erosion costs

3 b. including opportunity costs
3 c. including sunk costs
3 d. including net working capital changes
3 e. including financing costs
By Donglin Li || |
 ou bought some real estate 6 years ago for $25,000, and
you are thinking of using this land for the construction of a
new warehouse as part of a production expansion project.

 ou do NO` consider the $25,000 purchase cost of

the land as an initial cost in the capital budgeting
process.  ou also ignore the fact that the land now
can be sold at $28,000. By doing so, you are
making the mistake of ______in the decision-
making process.

3 a. excluding erosion costs

3 b. excluding opportunity costs
3 c. excluding sunk costs
3 d. including opportunity costs
3 e. including sunk costs
By Donglin Li || |
 ou bought some real estate 6 years ago for $25,000, and
you are thinking of using this land for the construction of a
new warehouse as part of a production expansion project.

 ou correctly do NO` consider the $25,000 purchase cost of

the land as an initial cost in the capital budgeting process.
 ou also correctly consider the fact that the land now can be
sold at $Œ0,000. But you forget to consider the fact that the
new warehouse will attract more customer in the region and
your other business (retailing, for example) will be positively
affected. By doing so, you are making the mistake of ____in
the decision-making process.

3 a. excluding erosion costs

3 b. excluding opportunity costs
3 c. excluding sunk costs
3 d. excluding incidental effects
3 e. excluding financing costs
By Donglin Li || |
If two projects are independent, then:

3 a. Accepting one automatically implies

rejection of the other.
3 b. If one is undertaken, the other must be
undertaken as well.
3 c. Both will be undertaken, assuming each
has a positive NPV and the firmƞs capital
budget can afford to include both projects.
3 d. All of the above

By Donglin Li || |
Incremental cash flows refer to:

a.`he difference between after-tax cash

flows and before-tax accounting profits.
b. `he additional cash flows that will be
generated if a project is undertaken.
c.`he cash flows of a project, minus
financing costs.
d. `he cash flows that are foregone if a
firm does not undertake a project.

By Donglin Li || |
Which of the following should be included
in an analysis of a new project?

a. Any sales from existing products that

would be lost if customers were expected
to purchase a new product instead.
b. All financing costs.
c. All sunk costs.
d. All of the above.
e. None of the above.

By Donglin Li || 
Adams Audio is considering whether to make an
investment in a new type of technology.

Which of the following factors should the company

consider when it decides whether to undertake the
investment?
a. `he company has already spent $Πmillion
researching the technology.
b. `he new technology will affect the cash flows
produced by its other operations.
c. If the investment is not made, then the company
will be able to sell one of its laboratories for $2 million.
d. Statements b and c should be considered.
e. All of the statements above should be considered.

By Donglin Li || |