LESSON 7 MINI CASE

Bipin Dangol
International American University
FIN500: FINANCIAL MANAGEMENT
Dr. Tatiana Verren
Mr. Bivab Neupane
Mr. Rajan Kadel
11th December, 2014

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LESSON 7 MINI CASE

Incremental cash flow means additional revenue that is generated when an organization
takes on a new operation or project. A positive incremental cash flow shows that the
companys operating cash flow will increase with the acceptance of the project. In other
words, incremental cash flows are the firms cash flow with the project minus the firms
cash flow without project.

A projects net cash flow does not include interest payments, since they are accounted for
by the discounting process. If we deducted interest and then discount cash flow at the
WACC this would double interest charges.

The $100,000 cost to rehabilitate the production line site was incurred last year, and
presumably also expensed for tax purpose. Since, it is a sunk cost; it should not be
included in the analysis.

If the plant space could be leased out to another firm, then if shrieves accepts this project,
it is an opportunity to receive $25,000 in annual cash flows. This represents an
opportunity cost to the project, and it should be included in the analysis.
Opportunity cost = 25000 (1-t)
= 25000(0.6) = $15,000

If a project affects the cash flows of another project, this is an externality which must be
considered in the analysis. If the firms sales would be reduced by $50,000 then the net
cash flow loss would be a cost to the project.

Solution:
Depreciation Basis= cost + shipping +installation
= 200,000+10,000+30,000
= $240,000
Year
1
2
3
4

Rate
0.33
0.45
0.15
0.07

Basis
$240
240
240
240

Depreciation
79
108
36
17

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LESSON 7 MINI CASE

$240

Solution:
Inflation rate = 3%,
Calculation of the annual revenues and costs are:

Particular
Units
Unit price
Unit cost
Sales
Costs

Year 1
1250
$200
$100
$250,000
$125,000

Year2
1250
206
103
257,500
128,750

Year 3
1250
212.18
106.09
265,225
132,613

Year 4
1250
218.55
109.27
273,188
136,588

Nominal r >real r. The cost of capital r, includes a premium for inflation.

Nominal CF > real CF. this is because nominal cash flows incorporate inflation.
If discount real CF with the higher nominal r, then NPV estimate is too low.
Nominal CF should be discounted with nominal r, and real CF should be discounted with real r.
It is more realistic to find the nominal CF, than it is to reduce the nominal r to a real r.

Solution:
Calculation of annual incremental operating cash flow statement:

Particulars
Sales
Costs
Depreciation
EBIT
Tax (40%)
NOPAT

Year 1
$ 250,000
$ 125,000
$ 79,200
$45,800
$183,20
$27,480

Year 2
257,500
128,759
108,00
20,750
8,300
12,450

Year 3
265,225
132,613
36,000
96,612
38,645
57,976

Year 3
273,188
136,588
16,800
119,800
47,920
71,880

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LESSON 7 MINI CASE

Depreciation
Net operating
CF

$79,200
$106,680

108,00
120,450

36,000
93,967

16,800
88,680

Calculation of net working capital for each year and cash flow due to investment in net
working capital:
Particulars
Sales
NOWC
( 12% of
sales)
CF due to
NOWC

Year 0
$30,000

Year 1
$250,000
30,900

Year 2
$257,500
31,827

Year 3
$265,225
32,783

Year 4
$ 273,188
0

($30,000)

($900)

($927)

($956)

$32,783

Solution:
After tax salvage cash flow:
Salvage value

= $25,000

Tax on salvage value (40%)

= 10,000

Net after tax salvage cash flow = $15,000

Solution:
Calculation of net cash flow:
Particulars
Year0
Initial outlay ($240,000)
Operating
cash flows
CF due to
($30,000)
NOWC
Salvage
Cash Flows

Year 1

Year 2

Year 3

Year 4

$106,680

$120,450

$93,967

$88,680

($900)

($927)

($956)

$32,783
$15,000

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LESSON 7 MINI CASE

Net cash
Flows

($270,000)

$105,780

$119,523

$93,011

$136,463

NPV @ 10% = [(105,780x0.9091) + (119,523x0.8264) + (93011x0.7513) + (136,463x0.6830)]

270,000
= [358,021.179 270,000]
= $ 88021.79
Calculation of IRR
Trying at 23%
Year
0
1
2
3
4

Net cash flow

-270,000
105780
119523
93011
136463

PV @23%
1
0.8130
0.6610
0.5374
0.4369

PV
-270,000
85999.14
79004.7
49984
59620

Therefore NPV is 4607.84

Again trying at 24%
Year

Net cash flow

PV @23%

PV

-270,000

-270,000

105780

0.8065

85311.57

119523

0.6504

77737.75

93011

0.5245

48784.27

136463

0.4230

57723.85

FV @10%

FV

Therefore NPV is $ 442.561

Calculation of MIRR
Year

Net cash flow

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LESSON 7 MINI CASE

-270,000

-270,000

105780

1.3310

140793

119523

1.2100

144,622

93011

1.1000

102,312

136463

136463

Therefore FV is $ 524,189
PV $270,000
Therefore MIRR is 18.0%
Calculation of Payback period
Year

Net cash flow

Cumulative
cash flow

-270,000

-270,000

105780

-164220

119523

-44697

93011

48314

136463

184777

Therefore payback period is = 2+ 44697/93011

= 2.5 yrs.

Risk means uncertainty about a projects future profitability in capital budgeting. It is

measured by standard deviation of NPV, standard deviation of IRR and beta. Risk can be
based on sometimes on historical data but generally not. Therefore risk analysis in capital
budgeting is usually based on subjective judgements.

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LESSON 7 MINI CASE

1. The tree types of risk that are relevant in capital budgeting are:

Standalone Risk

Corporate Risk

Market Risk

2.
Standalone risk: it is easier to measure than either corporate risk or market risk. Standalone risk
is the projects total risk if it were operated independently. Standalone risk ignores both the
firms diversification among projects and investors diversification among firms. Standalone risk
is measured either by the project standard deviation of NPV or its coefficient of variance of NPV.
Corporate Risk: Corporate risk is important because it influences the firms ability to use low
cost debt, to maintain smooth operations over time and to avoid crises that might consume
managements energy and disrupt its employees, customers, suppliers and community. Within
firm risk is often called corporate risk, and it measured by the projects corporate beta, which is
the slope of the regression line formed by plotting returns on the project versus returns on the
firm.
Market risk is the riskiness of the project to a well-diversified investor; hence it considers the
diversification inherent in stockholders portfolios. It is measured by the projects market beta,
which is slope of the regression line formed by plotting returns on the project versus returns on
the market.

3. Market risk is theoretically best in most situations. However, creditors, customers, suppliers
and employees are more affected by corporate risk. Therefore, corporate risk is also relevant.
Standalone risk is easiest to measure, more intuitive. Core projects are highly correlated with
other assets, so standalone risk generally reflects corporate risk. If the project is highly correlated
with the economy, standalone risk also reflects market risk.

1. Sensitivity analysis is a technique that shows how much a projects NPV will change
in response to a given change in an input variable, such as sales when all other factors
are held constant.

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LESSON 7 MINI CASE

2. The primary weakness of sensitivity analysis is:

It does not reflect diversification

Says nothing about the likelihood of change in a variable i.e. a steep sales line is
not a problem if sales wont fall.

Ignores relationships among variables.

Sensitivity analysis is useful because it gives some idea of standalone risk, identifies
dangerous variables and gives some breakeven information.

Scenario analysis is a risk analysis technique in which the best and worst case NPVs are
compared with the projects base case NPV.

Worst case and best case NPV estimates probability of occurrence of each scenario and
then weight the NPVs calculated according to their relative probabilities to find the
expected NPV.

Solution:
Scenario
Best case
Base case
Worst case

Probability
25%
50%
25%

Unit sales
1600
1250
900

Unit price
$240
200
160

NPV
$278,965
$88,030
($48,514)

Expected NPV = $ 101,628

Standard Deviation = $ 73,684
Coefficient of variation= 0.74

Scenario analysis examines several possible scenarios, usually worst case, most likely
case, and best case. Thus it usually considers only 3 possible outcomes. Obviously the
world is much more complex and most projects have an almost infinite number of
possible outcomes.
Simulation analysis is a computerized version of scenario analysis which uses continuous
probability distribution.

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LESSON 7 MINI CASE

Advantages of simulation analysis are:

Reflects the probability distributions of each project.

Gives an intuitive graph of the risk situation

A disadvantage of simulation analysis is:

Difficult to specify probability distributions and correlation.

The coefficient of variance in the range of 0.2-0.4 falls into the high risk category.
Standalone risk is measured.

Since the project is judged to have above average risk, its differential risk adjusted, or
project, cost of capital would be 13 %. At this discount rate, its NPV would be
$60,541 so it would still be acceptable. If it were a low risk project, its cost of capital
would be 7%, its NPV would be $104,975, and it would be an even more profitable
project on a risk adjusted basis.

Yes a numerical analysis may not capture all the risk factors inherent in the project.

Real option is that option which involves tangible assets and physical actions instead of
financial instruments and cash flows.
Types of real options are

Abandonment options

Investment timing options

Growth options

Flexibility options.

References
Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: theory and

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LESSON 7 MINI CASE

practice (13th ed). Mason, Ohio: South-Western Cengage Learning.