Ch 11 - Cash Flow Estimation and Risk Analysis Flashcards
Understand and be able to explain the concepts of externalities (what I called
“internalities” in class), sunk costs, incremental cash flows and opportunity costs
- sunk costs- money that has been spent and can’t be recovered regardless if project is accepted or not. not relevant and not incremental cost
- project cash flows/ incremental cash flows- -differences between the cash flows the firm will have if it implements the project versus cash flows it will have if it rejects the project.
- opportunity costs- potential loss from a missed opportunity
- externalities- effects of a project on other parts of the firm or on the environment. 3 types: negative within-firm, positive within-firm and environmental
Understand how stand-alone, corporate and market risk are used in capital budgeting. In
particular, be able to calculate and use a project’s expected NPV, standard deviation of
NPV, and the coefficient of variation of NPV.
Understand and be able to explain the advantages and disadvantages of sensitivity analysis,
scenario analysis and simulation. Also, understand what information is needed for each
method.
Advantages:
- simulation analysis: reflects probability distributions, shows range & expected NPV, st. dev and CV, gives an intuitive graph of risk situation
- sensitivity-
- scenario- shows best and worse case scenario and then you can find expected value and st. dev to get a better idea.
Disadvantages:
- simulation: difficult to specify probability distributions and correlations, if inputs re bad, outputs are bad.
- sensitivity- doesn’t reflect diversification and ignores economies of scope and scale
- scenario: only considers few possible outcomes. assumes all bad values happen together and good values happen together
- none of them provide a decision rule and ignore diversification
Understand how to perform a decision-tree analysis, as in the chapter example, and be able
to explain what it gives us.
Understand and be able to explain/identify four types of real options, from the chapter.
- right to abandon a project because it involves real cash flows and real assets instead of financial assets in contrast to financial options
- abandonment- abandon a project if demand is low
- managerial options- opportunities for managers to respond to changing circumstances
- strategic options- large, strategic projects rather than routine maintenance projects
- embedded option - part of the project
project cash flows/ incremental cash flows
- differences between the cash flows the firm will have if it implements the project versus cash flows it will have if it rejects the project.
- capital budgeting uses project’s cash flow not net income. to see if the return on cash invested in one project is better than the return on cash invested in another project, while income is determined by many other variables that have nothing to do with cash.
- depreciation and other noncash charges should be added back because it has an impact on cash flow
- if inventories are used and not replaced, it affects net operating working capital
- don’t subtract interest expense when finding a project’s cash flows bc it can double interest costs
expansion and replacement projects
- expansion- firm makes an investment in their store. cash expenditures are incremental
- firm replaces existing assets generally to reduce costs
negative within-firm
positive within-firm
environmental
- an apple store being made near another one so the new one steals the old one’s customers. cannibalization- new business eats into the company’s existing business. ignoring can cause company to overestimate value of a project
- new model of nike shoes gets customers in the store and could buy nike clothing. new project can be complementary to an old one.
- most common negative one. plant emitting fumes that cause some bad will in its neighborhood. if they want to protect the environment, have to raise prices or suffer decline in earnings.
analysis of an expansion project
why is it important to include inflation when estimating cash flows?
nominal r > real r. the cost of capital, r, includes a premium for inflation.
- nominal CF > real CF because normal cash flows incorporate inflation
- if you don’t include inflation, you’ll underestimate the NPV
depreciation methods
- straight line- annual dep expenses equal basis/ project’s life
- half year convention- calcultes dep expenses like they are in service halfway through the year
firms are more profitable when using accelerated
-modified accelerated cost recover system (MACRS) - faster than straight line.
book value
salvage value
bonus depreciation
- original basis- accumulated depreciation
- market value at which a used asset can be sold
- allows projects to be depreciated more quickly than MACRS rates
impact of sunk, opportunity costs and externalities
- sunk- ignore
- opportunity- reduction in calculated annual cash flows
- externalities- deduction per year
risk analysis in capital budgeting
- determines if a project’s risk differs from that of an avg project in the company.
- if it does, the project’s cash flows should be discounted at a risk-adjusted cost of capital instead of company’s WACC
market risk
corporate risk
stand alone risk
- determines company’s required return on equity when using CAPM, important in determining intrinsic stock. most difficult to measure bc most new projects dont have market prices
- risk project contributes to company’s cash flows
- uncertainty of a project’s cash flows
most firms: estimate value using risk-adjusted cost of capital based on past projects, conduct quantitative analysis of project’s stand alone risk, consider corporate and market risk in qualitative way, and then assign a cost of capital
