Credit Analysis and Management

for Examiners

Credit Appraisal – Project risk

1
 Cash Flow Versus Accounting Income

Accounting Profits Cash Flows

Sales $50,000 $50,000
Costs except depreciation (25,000) (25,000)
Depreciation (15,000) --
Net operating income or cash flow $10,000 $25,000
Taxes based on operating income (30%) (3,000) (3,000)
Net income or net cash flow $7,000 $22,000
Net cash flow =
Net income plus depreciation = $7,000 + $15,000 = $22,000
 Analysis of the Cash Flows
2006 2007 2008 2009 2010
Initial Investment Outlay $(9,500)
Installation (500)
Increase in NWC (4,000)
Initial Investment $(14,000)

Incremental Operating Cash Flow

Sales revenue $30,000 $30,000 $30,000 $30,000
Variable Costs (18,000) (18,000) (18,000)
(18,000)
Fixed Costs (5,000) (5,000) (5,000) (5,000)
Depreciation (2,000) (3,200) (1,900) (1,200)
Earnings before taxes (EBT) $5,000 $3,800 $5,100 $5,800
Taxes (40%) (2,000) (1,520) (2,040) (2,320)
Net Income $3,000 $2,280 $3,060 $3,480
Add back depreciation 2,000 3,200 1,900 1,200
Incremental operating cash flows $5,000 $5,480 $4,960 $4,680
Investment criteria
Investment
Criteria

Non-
Discounting
Discounting
Method
Methods

NPV Payback Period

IRR ARR

Profitability
index

Discounted
Payback
 Payback period example
Year Cash Flow Cumulative Net Cash
Flow
0 -10,000 -10,000

1 2,000 -8,000

2 2,500 -5,500

3 3,000 -2,500

4 3,500 1,000

Hence, Payback Period lies between year 3 and 4

 NPV example
n

 1  r 
CFt
NPV  t
 Io
t 1

NPV = $288,180 - $ 250,000 = $ 38,180 >0

 IRR example
n

 1  IRR
CFt
100 t
I o
t 1

50 30 20 10 10

50 30 20 10 10
     100
1  IRR 1 1  IRR 2 1  IRR 3 1  IRR 4 (1  IRR ) 5

 IRR  9,08%
 Stand-Alone risk
 Stand-Alone Risk is the risk associated with a particular project without
regard to a firm's overall risk.
 Assessing a project's stand-alone risk is to identify the uncertainty
inherent in project cash flows, evaluation of risk associated with
individual cash flows, their relations with and effects on one another,
and in particular, the nature of NPV and IRR distributions.
 The standard deviation or the coefficient of variation of NPV and IRR
measure the Stand-Alone Risk.
 Adjusting for risk

Certainty equivalent approach

 1  r 
CFt
NPV  t
 Io
t 1

Discount rate risk- adjustment approach

Certainty equivalent approach

n
a  CFt
NPV    Io
t 1 1  r 
t

riskyCF
a
certainCF
 Example

Expected CF CE Coefficient

1 10,000 .95

2 20,000 .90

3 40,000 .85

4 80,000 .75

5 80,000 .65
 Example

Expected CF CE Coefficient at Certainty equivalent CF

1 10,000 .95 9,500

2 20,000 .90 18,000

3 40,000 .85 34,000

4 80,000 .75 60,000

5 80,000 .65 52,000

 Example

Certainty PV Factor @ 6% PV
equivalent CF

1 9,500 .943 8,959

2 18,000 .890 16,020

3 34,000 .840 28,560

4 60,000 .792 47,520

5 52,000 .747 38,844

NPV= -120,000+8,959+16,020+28,560+47,520+38,844=19,902
 Behavioral Approaches for Dealing
with Risk: Scenario Analysis
 Scenario analysis is a behavioral approach similar to sensitivity analysis
but is broader in scope.
 This method evaluates the impact on the firm’s return of simultaneous
changes in a number of variables, such as cash inflows, outflows, and the
cost of capital.
 NPV is then calculated under each different set of variable assumptions.
Scenario Analysis example
 Behavioral Approaches for Dealing
with Risk: Sensitivity Analysis
 Suppose we want to evaluate the sensitivity of NPV of project X to its unit
sales. Based on our expected sales of 1 million units per year, the NPV of
the project is $80 million. This is considered the base case. Now, let's
change our unit sales by -20%; -10%; 0%;+10% and +20% and calculate the
new appropriated NPV for each case.
Decision tree example