Ch 10 Flashcards
Standalone principal
Evaluation of the project based on the projects incremental cash flow’s
Treat the project as a mini firm
Incremental cash flow’s (relevant cash flows)
The difference between firms future cash flow’s with a project and without the project
The incremental cash flow’s for project evaluation consist of any and all changes in the firms future cash flow’s that are a direct consequence of taking the project
Ignore sunk costs
Side effects
A firm can have a side effect or spillover effect on other parts of the firm’s existing operations
Erosion; the proportion of cash flows from a project come at the expense of a firm existing operation
Net working capital (NWC)
Current assets - current liabilities
Pro forma financial statements
Financial statements a project operating flows net working capital, capital spending and cash flows in the future
Scenario analysis
Impact on NPV by changing various cash flow assumptions (optimistic and pessimistic)
Arithmetic average return
Return earned in an average year over a multi year period.
“What was a return in an average year over particular?”
Best for shorter periods like one year
Geometric average return
Average compound return earned per year over multi year period
“what was your average compound return per year over particular period?”
Best for longer periods like 10 years
Efficient Capital Market
Market in which security prices reflects available information.
Efficient market forms
Strong form: rules out insider info
Semi-strong: rules out usefulness of analysts because market price reflects all info. Value in insider info
Weak form: price of stock reflects its own past prices. No point in analyzing past prices to id incorrectly prices stocks
Sensitivity analysis
Impact to NPV when only one variable is changed (sales numbers change)
Simulation Analysis (Monte Carlo)
Combining both scenario and sensitivity analysis
The impact on NPV of allowing a wide variety of all the variables used in NPV calculation
Cash flow is discounted at a risk-free rate because we won’t know the risk until the simulation is finished
Coefficient of variation
SD/avg return
Used to look at the dispersion of returns relative to the average return
Value at Risk (VaR)
Statistical measure of maximum loss used by banks to manage risk exposure
Calculate by using lower tail of normal distribution, we look at 2.5% of the time risk is less than 23.49%
Loss=$100 x .02349 = 23.49
Annual 2.5% VaR is $23.49
Efficient markets hypothesis
The hypothesis is that actual capital markets such as the TSX are efficient
NPV=0 because prices are not too low or too high due to High competition among investors.
