c11: cash flow estimation + risk analysis

• estimating cash flows is The most important but also the most difficult step because there are Many variables involved such as Unit sales, sales prices, capital outlays, operating costs, etc
• incremental cash flows = company's cash flows with the project - company's cash flows without the project
• A project’s free cash flow can be broken down into the following components:

  • investment outlay cash flow
  • operating cash flow
  • nowc cash flow
  • salvage cash flow
• since depreciation is deducted each year throughout the life of the asset Adjustments for a project’s cash flow are as follows: Asset purchases represent negative cash flows and Depreciation must be added back when calculating a project’s cash flow
• Interest Expenses Are Not Included in Project Cash Flows
• The matching principle dictates that the project cash flows to be discounted should also be those available to all investors. so interest shouldn't be subtracted for cash flows to debtholders
• a sunk cost is on that has no bearing on the decision. examples include marketing or feasibility reports before a decision is made
• Project analysis focuses on expected cash flows, not accounting net income. it Uses the depreciation rates allowed by the Canada Revenue Agency (CRA), it Doesn't subtract interest. it Includes the investment in working capital. it Ignores sunk costs Identifies opportunities and externalities
• After-tax cash flows are the focus of a project analysis
• CCA tax shield = CCA amount * Tax rate
• Depreciation is not a cash expense but shields some earnings from taxes and thus indirectly increases cash flows
• the CRA classifies capital assets into more than 40 asset groups with given rates. the CCA rates are the maximum rate a company may claim per year for tax purposes
• Most CCAs are calculated on a declining basis: undepreciated capital cost (UCC)
• the half-year rule states that Only half of the capital cost can be claimed for CCA in the year of acquiring (the first year you get the asset)
• Net Acquisition = Capital cost of new assets - original capital cost. if net acquisition > 0, the half-year rule applies
• we'll terminate an asset pool when the last asset in an asset class is disposed of
• CCA recapture is generated if the disposition value > UCC remaining. (ie. a negative UCC balance results from the sale, and the extra CCA is fully taxable and must be added back to income)
• Terminal loss is generated if a positive UCC balance results and the balance is allowed to be deducted against income
• the Accelerated Investment Incentive Allows companies to deduct the capital cost immediately (or deduct more than normally allowed immediately). it also provides Greater tax savings and therefore greater free cash flows generated earlier for companies
• cca tax shield is the amount that we saved on tax. the higher the better.
• both fcf and npv = inital outlay + pv project cf's + pv ccats + pv ecf
• Cash flows for an expansion project involves purchasing new assets to expand existing capacity. they're easily identifiable because there are incremental cash flows
• Cash flows for a replacement project consists of purchasing new assets to replace existing ones. these are not as obvious, but, typically, cost savings/reduction would be an incremental cash flow for a replacement project
• sensitivity analysis Shows the changes in an input variable (like unit sales) affect NPV or IRR. it answers “what if” (“What if sales decline by 30%?). we use it to find out to which input variable is most sensitive on a project’s NPV or IRR
• Sensitivity analysis starts with a base-case situation which uses the expected/most-likely values for each input. Then each variable is changed by several percentage points above and below the expected value, with all other variables held constant, and a new NPV is calculated
• the set of NPVs in the sensitivity table is plotted against each input variable. The slope of each NPV line measures the sensitivity of the project’s NPV to this particular input variable. The steeper the slope, the more sensitive the NPV is to a change in the variable.
• npv break-even analysis is An application of sensitivity analysis that finds the level of an input where the an NPV produced is exactly zero. this is Helpful in determining how bad things can get before the project has a negative NPV
• scenario analysis Extends sensitivity analysis to deal with its weaknesses. it Allows more than one variable to change at a time to see the combined effects of all changes. it Examines several possible situations like the worst case, most likely case, and best case