Lecture Outline

Lecture 13

Lecture Organization
OCF
Scenario analysis
Cost analysis
Alternative Definitions of OCF

Let:

OCF = operating cash flow

S = sales

C = operating costs

D = depreciation

T = corporate tax rate

Alternative Definitions of OCF (concluded)
The Tax-Shield Approach

OCF = (S - C - D) + D - (S - C - D) T

=
The Bottom-Up Approach

OCF = (S - C - D) + D - (S - C - D) T
=
=
The Top-Down Approach
OCF = (S - C - D) + D - (S - C - D) T
T10.22 Solution to Problem 10.5

A proposed new project has projected sales of

$75,000, costs of $40,000, and depreciation of $2,500.
The tax rate is 34 percent. Calculate OCF using the
four different approaches described in the chapter
and verify that the answer is the same in each case.

Sales

Costs
Depreciation
EBIT (=EBT)
Taxes (@ 34%)
Net Income
T10.22 Solution to Problem 10.5 (concluded)

OCF = EBIT + D - T = $32,500 + 2,500 - 11,050

= $23,950

OCF =

OCF =

OCF =
 Now lets put our new-found knowledge to work.
Example: Assume we have the following background
information for a project being considered by Gillis, Inc.
Calculate the projects NPV and payback period.
Assume:
Required NWC = $40; project cost = $60; 3 year life
Annual sales = $100; Annual costs = $50;
Straight line depreciation to $0
Tax rate = 34%; Required return = 12%

Step 1: Calculate the projects OCF

OCF =

OCF =
Now lets put our new-found knowledge to work.

Project cash flows are thus:

0 1 2 3
OCF
- Chg. in NWC
- Cap. Spending.

CF
Capital Budgeting Questions

Projected versus Actual Cash Flows

Capital Budgeting Questions

Forecasting Risk

Forecasting risk

In order to develop reliable cash flow

estimates for the projects we have to
understand


Evaluating NPV Estimates: Scenario and What-If Analyses
Base case estimation

Scenario analysis

Sensitivity analysis

Simulation analysis
 Fairways Driving Range Example
Two golfing buddies are considering opening a new driving range, the
Fairways Driving Range. Because of the growing popularity of golf, they
expect on average rentals to be 20,000 buckets at $3 per bucket. Equipment
costs $20,000 and will be depreciated using SL over 5 years and have a $0
salvage value. Variable costs are 10% of rentals ($0.3 per bucket) and fixed
costs are $40,000 per year. However, the rentals can be as low as 18,000
buckets or as high as 25,000 buckets, while the variable cost can be as high
as $0.36 or as low as $0.24. Assume no increase in working capital nor any
additional capital outlays. The required return is 15% and the tax rate is
15%.

Base Case (average inputs): OCF= (S - C)*(1 - T) + D*T =

=
At 15%, the base-case NPV is:
NPV =
Fairways Driving Range Scenario Analysis

INPUTS FOR SCENARIO ANALYSIS

Base case: Rentals are ___ buckets, variable costs are
$___ per bucket.
Best case: Rentals are ____ buckets, variable costs are
$____ per bucket.
Worst case: Rentals are ____ buckets, variable costs are
____ per bucket.
 Fairways Driving Range Scenario Analysis (concluded)

Project
Scenario Operating Cash Flow NPV

Base Case

Best Case

Worst Case
 Fairways Driving Range Sensitivity Analysis

INPUTS FOR SENSITIVITY ANALYSIS

To conduct a sensitivity analysis:
 Fairways Driving Range Sensitivity Analysis

INPUTS FOR SENSITIVITY ANALYSIS (Rentals Only are

Varied)
Base case Rentals: Rentals are ______buckets

Best case Rentals: Rentals are ______ buckets

Worst case: Rentals are ______ buckets
Fairways Driving Range Sensitivity Analysis (concluded)

Project
Scenario Rentals OCF NPV

Base case rentals

Best case rentals

Worst case rentals

Fairways Driving Range Simulation Analysis

Simulation Analysis

Using computers, the interactions of different likely

scenarios and inputs may be realized through
simulating the different possible cash flows that result.
Cost Analysis

Why Cost Analysis of the Project is Important?

Total Costs of production depend upon __

The quantity of product sold____

Cost Analysis
Fixed and Variable Costs

Variable costs (VC)costs that change as the volume of

sales changes (direct labor and materials, for example).
variable costs =
Variable Cost v are also called the marginal cost
Fixed costs (FC)costs that are constant over a period
regardless of the level of sales.
Total costs, (TC)sum of fixed costs (FC) and variable
costs TC =
Average cost (AC) is total cost divided by output:

AC =
 Average cost versus marginal cost
Example: two alternative cost structures for project A and B;
Project A: FC(Proj. A) =$10,000; VC(Proj. A) = $6
Project B: FC(Proj. B) =$25,000; VC(Proj. B) = $3
consider what minimum quantity of sales would be required
to favor one project over another.

Solution
Example of Different DOL projects Costs for B
=$25,000+$3xQ
Total
Costs

Indifference
Quantity Costs for A
=$10,000+ 6xQ
$40,000

$20,000

$10,000

$0
2,500 5,000 10,000 Q, Quantity
. is better . is better