Chapter 11
Cash Flow Estimation
and Risk Analysis
MINI CASE
Shrieves Casting Company is considering adding a new line to its product mix, and the
capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated
MBA. The production line would be set up in unused space in Shrieves’ main plant. The
machinery’s invoice price would be approximately $200,000; another $10,000 in shipping
charges would be required; and it would cost an additional $30,000 to install the
equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a
special tax ruling which places the equipment in the MACRS 3-year class. The machinery
is expected to have a salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for four years at
an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit
can be sold for $200 in the first year. The sales price and cost are expected to increase by
3% per year due to inflation. Further, to handle the new line, the firm’s net operating
working capital would have to increase by an amount equal to 12% of sales revenues. The
firm’s tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent.
a. Define “incremental cash flow.”
Answer: This is the firm’s cash flow with the project minus the firm’s cash flow without the
project.
a. 1. Should you subtract interest expense or dividends when calculating project cash
flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we
apply the 10 percent cost of capital discount rate, hence including financing flows
would be "double counting." Put another way, if we deducted capital costs in the
table, and thus reduced the bottom line cash flows, and then discounted those CFS by
the cost of capital, we would, in effect, be subtracting capital costs twice.
a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
Mini Case: 11 - 1
, Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and
presumably also expensed for tax purposes. Since, it is a sunk cost, it should not be
included in the analysis.
a. 3. Now assume that the plant space could be leased out to another firm at $25,000 a
year. Should this be included in the analysis? If so, how?
Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this
project, it would forgo the 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.
Note that the opportunity cost cash flow must be net of taxes, so it would be a
$25,000(1 - t) = $25,000(0.6) = $15,000 annual outflow.
a. 4. Finally, assume that the new product line is expected to decrease sales of the
firm’s other lines by $50,000 per year.Should this be considered in the
analysis? If so, how?
Answer: If a project affects the cash flows of another project, this is an "externality" which
must be considered in the analysis. If the firm's sales would be reduced by $50,000,
then the net cash flow loss would be a cost to the project. Note that this annual loss
would not be the full $50,000, because Shrieves would save on cash operating costs if
its sales dropped. Note also that externalities can be positive as well as negative.
b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis?
Answer: Get the depreciation rates from table 11-2 in the book. Note that because of the half-
year convention, a 3-year project is depreciated over 4 calendar years:
YEAR RATE BASIS = DEPRECIATION
1 0.33 $240 $ 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
$240
Mini Case: 11 - 2
Cash Flow Estimation
and Risk Analysis
MINI CASE
Shrieves Casting Company is considering adding a new line to its product mix, and the
capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated
MBA. The production line would be set up in unused space in Shrieves’ main plant. The
machinery’s invoice price would be approximately $200,000; another $10,000 in shipping
charges would be required; and it would cost an additional $30,000 to install the
equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a
special tax ruling which places the equipment in the MACRS 3-year class. The machinery
is expected to have a salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for four years at
an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit
can be sold for $200 in the first year. The sales price and cost are expected to increase by
3% per year due to inflation. Further, to handle the new line, the firm’s net operating
working capital would have to increase by an amount equal to 12% of sales revenues. The
firm’s tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent.
a. Define “incremental cash flow.”
Answer: This is the firm’s cash flow with the project minus the firm’s cash flow without the
project.
a. 1. Should you subtract interest expense or dividends when calculating project cash
flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we
apply the 10 percent cost of capital discount rate, hence including financing flows
would be "double counting." Put another way, if we deducted capital costs in the
table, and thus reduced the bottom line cash flows, and then discounted those CFS by
the cost of capital, we would, in effect, be subtracting capital costs twice.
a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
Mini Case: 11 - 1
, Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and
presumably also expensed for tax purposes. Since, it is a sunk cost, it should not be
included in the analysis.
a. 3. Now assume that the plant space could be leased out to another firm at $25,000 a
year. Should this be included in the analysis? If so, how?
Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this
project, it would forgo the 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.
Note that the opportunity cost cash flow must be net of taxes, so it would be a
$25,000(1 - t) = $25,000(0.6) = $15,000 annual outflow.
a. 4. Finally, assume that the new product line is expected to decrease sales of the
firm’s other lines by $50,000 per year.Should this be considered in the
analysis? If so, how?
Answer: If a project affects the cash flows of another project, this is an "externality" which
must be considered in the analysis. If the firm's sales would be reduced by $50,000,
then the net cash flow loss would be a cost to the project. Note that this annual loss
would not be the full $50,000, because Shrieves would save on cash operating costs if
its sales dropped. Note also that externalities can be positive as well as negative.
b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis?
Answer: Get the depreciation rates from table 11-2 in the book. Note that because of the half-
year convention, a 3-year project is depreciated over 4 calendar years:
YEAR RATE BASIS = DEPRECIATION
1 0.33 $240 $ 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
$240
Mini Case: 11 - 2
