Capital Budgeting

Question 1

What is capital budgeting

Answer 1

When you give value to an investment opportunity and decide whether to invest in it or not

Question 2

There is uncertainty with estimates related to npv. Does the estimate cover all parameters e.g. economy falling to recession. You have to understand to what extent NPV estimate is affected by all parameters. Done through analysis. Describe the 3

Answer 2

Break even analysis: determine the values of parameter that give NPV equal to 0
Analysis assumes parameters are independent but in reality they all correlate with each other

Sensitivity analysis: determines how sensitive NPV is to one variable while the other variables stay fixed. The more volatile the NPV is with one variable, the larger the risk associated with that variable so focus on that variable

Scenario analysis: examines NPV under different scenarios e.g. high revenues, low costs or high costs and low revenues

Question 3

Advantages and disadvantages of sensitivity analysis

Answer 3

Advantages
Identifies dangerous variables, provides some break even information and provides indication of stand alone risk
Disadvantages
Doesn’t reflect diversification, says nothing about likelihood of change in variable, indicates where errors may be but not what to do with them, ignores relationship amongst variable

Question 4

Disadvantages of scenario analysis

Answer 4

Considers only a few possible outcomes
Assumes perfectly correlated inputs ( all bad values occur together and all good values occur together)

Question 5

What are the additional considerations you should have for capital budgeting

Answer 5

Managerial options and capital rationing

Question 6

Explain managerial options

Answer 6

Managers have the right to modify a project even after it starts.

They gave options to expand if economy is in a blooming state ( expansion of products, new products, new geographic markets)

Option to abandon if economy in recession
Can be forever or temporary suspension

Option to wait