Chapter 10 & 11

Question 1

Relevant cash flows

Answer 1

• The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur!) if the project is accepted.
• Change in the firm’s overall future cash flow that comes as a direct
  consequence of the decision to take the project.
• These cash flows are called incremental cash flows.

Question 2

Stand-alone principle

Answer 2

The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows.

Question 3

Common types of cash flows

Answer 3

Sunk costs
Opportunity costs
Side effects
Changes in net working capital
Financing costs
Taxes

Question 4

Sunk costs

Answer 4

A cost already paid or have already incurred the liability to pay

Question 5

Opportunity cost

Answer 5

The most valuable alternative that is given up if a particular investment is undertaken

Question 6

Side effects

Answer 6

Incremental cash flows for a project include all the resulting changes in the firm’s future cash flows.
Erosion: negative impact on the cash flows of an existing product from the introduction of a new product.

Question 7

Net working capital

Answer 7

The project may also entail NWC requirement. NWC typically can be recovered fully (at book value) at the end.

Question 8

Operating cash flow (OCF)

Answer 8

OCF = EBIT + depreciation - taxes
OCF = net income + depreciation (when there is no interest expense)

Question 9

Cash Flow from Assets (CFFA)

Answer 9

Cash Flow from Assets (CFFA) = OCF - net capital spending (NCS) - changes in NWC

Question 10

Pro forms financial statement

Answer 10

Financial statements projecting future years’ operations.
Unit sales (Q)
Revenues (P)
Variable costs (VC)
Total fixed costs (FC)
Total investment required (NFA)
Investment in NWC

Question 11

Depreciation

Answer 11

Depreciation is a non-cash expense, it is only relevant because it affects taxes.
Depreciation tax shield = D * T
D=depreciation expense
T=marginal tax rate

Straight-line depreciation = initial cost / number of years

Question 12

OCF Bottom-up approach

Answer 12

OCF = NI + depreciation
Only works only when there is no interest expense

Question 12

OCF Tax shield approach

Answer 12

OCF = (sales-costs)(1-T) + depreciation*T

Question 12

OCF Top-down approach

Answer 12

OCF = Sales - Costs - Taxes
Do not subtract non-cash deductions

Question 13

Equivalent Annual Cost (EAC)

Answer 13

The present value of project’s costs calculated on an annual basis.

Question 14

Forecasting risk

Answer 14

The possibility that errors in projected cash flows will lead to incorrect decisions.

Question 15

Scenario and what-if analyses

Answer 15

Scenario analysis: investigation of impacts on NPV by changes in assumptions about a group of variables
▪ Best case – high revenues, low costs
▪ Worst case – low revenues, high costs
▪ Measures of the range of possible outcomes

we examine many variables taking on few different values, in combination.

Question 16

Sensitivity analysis

Answer 16

Subset of scenario analysis where we are looking at the effect of specific variables on NPV.
The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay its estimation.

we examine one variable taking on many different values, one variable at a time.

Question 17

Simulation analysis

Answer 17

Expanded sensitivity and scenario analysis. Simulation can estimate thousands of possible outcomes based on conditional probability distributions and constrains for each of the variables.
The output is a probability distribution for NPV with an estimate of the
probability of obtaining a positive net present value.

combination of the two: we examine many variables taking on many different values, in combination.

Question 18

Break-even analysis

Answer 18

Form of sensitivity analysis. Variable that leads to NPV=0

▪ Total variable costs = quantity × cost per unit
▪ Fixed costs are constant, regardless of output, over some time period.
▪ Total costs = fixed + variable = FC + VC*Q

Question 19

Average vs marginal cost

Answer 19

Average cost: TC/number of units ; will decrease as number of units increases

Marginal cost: the cost to produce one more unit, same as variable cost per unit

Question 20

3 types of break-even analysis

Answer 20

• Accounting Break-even
  Where NI = 0
  Q = (FC + D)/(P – VC)
• Cash Break-even
  Where OCF = 0
  Q = (FC + OCF)/(P – VC); (ignoring taxes)
• Financial Break-even
  Where NPV = 0
• Cash BE < Accounting BE < Financial BE

Question 21

Operating leverage

Answer 21

The degree or which a firm or project relies on fixed costs.
Degree of operating leverage (DOL) = 1 + (FC/OCF)

Question 22

Capital rationing

Answer 22

The situation that exists if a firm has positive NPV projects but cannot find the necessary financing. 2 kinds of capital rationing:
* Soft rationing: the firm itself sets constraints on its various divisions, necessary funds are available at the firm level motivated by maintaining control and keeping track of spending.
* Hard rationing: the firm cannot raise financing for a positive NPV project under any circumstances in its essence, this is due to capital market imperfection