Chap 10 Flashcards
What is the capital budget?
A list of investment projects planned for the year
- We need some forewarning of future investment outlays
What do firms often do to begin the capital budgeting process?
- Firms begin the capital budgeting process by establishing consensus forecasts of economic indicators, such as inflation and growth in national income, as well as forecasts of particular items that are important to the firm’s business, such as housing starts or raw materials prices.
What is Brealey, Myers, and Allen’s second law? And do fudge factors work to decrease bias from optimism?
- Senior managers must be careful not to encourage bias, ex. thinking success depends on having the largest division rather than the most profitable.
- Adding a fudge factor to the discount rate in attempt to avoid bias does not work.
- Brealey, Myers, and Allen’s Second Law: The proportion of proposed projects having positive NPVs at the corporate hurdle rate is independent of the hurdle rate.
- Do NOT add fudge factors to the cost of capital
What is the purpose of a Post-Audit, and when does it occur?
- Most firms conduct post-audits shortly after the project begins
- Identify the problems that need fixing, check the accuracy of forecasts, and suggest questions that should have been asked before the project was undertaken.
- Post-audits help managers find thinks they should have considered, and fix them for the next round of projects.
What is the idea behind a sensitivity analysis and how does it work?
- Before deciding on a project, you should delve into all of the forecasts and identify the key variables that determine whether the project succeeds or fails
- With a sensitivity analysis, you are given optimistic and pessimistic estimates for some underlying variables. Figure out what happens to the net present value if the variables are set one at a time to their optimistic and pessimistic values.
What is the greatest problem to watch out for when doing a sensitivity analysis?
look for unidentified variables, unknown unknowns, are the greatest problems.
What are two limits to sensitivity analysis?
- Hard to tell what values to use for optimistic and pessimistic values. It’s hard to be accurate at the present moment.
- Underlying variables are likely to be interrelated with each other, sensitivity analysis changes only one variable
What is a Scenario Analysis?
- Consider alternative plausible scenarios if variables are related
- Scenario analysis allows you to look at different but consistent combination of variables
Give an example of a Scenario used in a Scenario Analysis
- Ex. Rise in oil price, may cause a recession, may stimulate inflation -> Include all these variables.
What is the idea of a Break-Even Analysis?
Looking at how bad sales can get before the firm actually ends up losing money.
Where is the Break-Even point on a graph between PV of outflows and PV of inflows?
The graph looks like two diagonal lines with different slopes, one being PV outflows and the other being PV inflows. The Break-Even point is where the two lines cross, where PV outflows = PV inflows.
What leads to a quicker Break-Even, accounting profits or economic profits?
Accounting profits will not lead to the same break-even, they will lead to a quicker breakeven because they do not consider present values.
What is operating leverage?
High fixed costs means they have high operating leverage
What are the two formulas to measure Degree of Operating Leverage?
Degree of Operating Leverage (DOL) =
(Percentage Change in Profits / Percentage Change in Sales)
DOL = 1 + (Fixed Costs/Profits)
What does DOL tell you about a change in sales?
How much a change in sales leads to a change in profits.
For example, a 1% change in sales leads to a (1 * DOL)% change in profits
What are the four steps behind the Monte Carlo Simulation?
Step 1: Modelling the Project
Step 2: Specifying Probabilities
Step 3: Simulate the Cash Flows
Step 4: Calculate the Present Value
What does the Monte Carlo simulation provide?
It provides a probability distribution for present values of cash flows for individual projects.
What is the most important part of a Monte Carlo Simulation?
Specifying the interdependencies is the hardest and most important part of a simulation. If all components of project cash flows were unrelated, simulation would rarely be necessary.
What are real options? Why are they important?
- If a project is going well they will expand it, if not they may cut back or abandon it.
- Options to modify projects are known as real options
- Projects that can be modified in these ways are more valuable than those that do not provide such flexibility. The more uncertain the outlook, the more valuable this flexibility becomes.
- Sensitivity analysis and Monte Carlo simulation do not recognize the opportunity to modify projects.
What is a decision tree?
- A decision tree is used to outline all of the possible real options and outcomes that follow them.
- Each square represents an action or decision by the company. Each circle represents an outcome revealed by fate
What are some examples of when expansion decision trees are used?
- When launching a new product, use a pilot program to iron out design problems and test the market.
- When designing a factory, allow for extra space to reduce the future cost of building a second production line.
- When building a highway, may build larger bridges so the road can be expanded in the future and you don’t have to rebuild the bridge
- When building production platforms (ex. Oil and Gas), allow for extra deck space.
What are production options? Ex.?
- Flexibility to change the way production is run. Ex. For Electric Utilities, switch between burning oil and burning natural gas when prices change.
What are timing options and what is the idea behind them?
- Figuring out when the best time to choose to invest in a project.
- The optimal date to choose an investment is one that maximizes it’s contribution to the value of your firm today.
- Examine alternative dates for making the investment and calculate it’s net future value at each of these dates. Then discount back to PV to see which is the best time to start a project.
What is the formula for calculating NPV of Investment if undertaken at a future date?
Net Present Value of Investment if Undertaken at Time T = (Net Future Value at Date t) / (1 + r)^t
What is a pro of using a Decision Tree?
Decision trees force the underlying strategy into the open. By displaying the links between today’s decisions and tomorrow’s decisions, they help the financial manager to find the strategy with the highest net present value.
What is the major con of a Decision Tree?
The trouble with decision trees is that they get so _FUCKING____ complex so _FUCKING____ quickly
A firm’s capital investment choices should reflect both bottom-up and top-down views of the business— what is top down and what is bottom up?
Bottom up: capital budgeting (plant and division managers)
Top down: strategic planning (higher level ee)
Are people over or under confident when they forecast?
Overconfident, therefore project risks are UNDERstated
Who does overoptimism affect?
Everyone, from government (majority) to private business
things usually cost more than we forecast
When doing a sensitivity analysis what are the most dangerous variables?
market share and unit variable cost
What happens when a company has a loss? What does this say about the tax outflow?
- this loss can be used to reduce the tax bill on the rest of the company’s business
- the tax outflow is negative, it is essentially an inflow or a “saving”
Does uncertainty increase with time?
yes; The farther out you look into the future, the more the actual price or market size may depart from your original forecast.
What do sensitivity analysis and Monte Carlo simulation lack in terms of opportunities to modify a project?
They do not recognize the opportunity to modify projects
