Chapter 11: Project Analysis and Evaluation Flashcards
There are two circumstances under which a discounted cash flow analysis could lead us to conclude that a project has a positive NPV
1) The first possibility is that the project really does have a positive NPV
2) The second possibility: a project may appear to have a positive NPV due to inaccuracies in our estimates.
What exactly does “the projected cash flow in Year 4 is $700,” mean?
Loosely speaking, we really mean that if we took all the possible cash flows that could occur in four years and averaged them, the result would be $700
GIGO
(garbage in, garbage out)
Forecasting risk aka estimation risk
The possibility that errors in projected cash flows lead to incorrect decisions.
It is a basic principle of economics that positive NPV investments are rare in a _____ competitive environment
highly
Base case
When investigating a new project. Naturally, we begin by estimating NPV based on our projected cash flows
Scenario Analysis
The determination of what happens to NPV estimates when we ask what-if questions.
Worst-case scenario
To calculate, we need to assign the least favourable value to each item
This means low values for items such as units sold and price per unit and high values for costs
Similarly, the true worst case would involve some incredibly remote possibility of ___________
total disaster
The absolutely best thing that could happen would be something absurdly unlikely, such as launching
a new diet soda and subsequently learning that our (patented) formulation also just happens to cure the common cold
Sensitivity Analysis
Investigation of what happens to NPV when only one variable is changed.
The basic idea with a sensitivity analysis is to freeze all the variables except one and see how sensitive our estimate of NPV is to changes in that one variable
If our NPV estimate turns out to be very sensitive to relatively small changes in the projected value of some component of projected cash flow, the forecasting risk associated with that variable is ______
high
Graphically looking at sensitivity analysis
The steeper the resulting line is, the greater the sensitivity of the estimated NPV to the projected value of the variable being investigated.
For sensitivity analysis and scenario analysis,
Management experience and judgment must still come into play.
Simulation Analysis
aka Monte Carlo simulation
A combination of scenario and sensitivity analyses.
With scenario analysis, we let all the different variables change, but we let them take on only a small number of values.
With sensitivity analysis, we let only one variable change, but we let it take on a large number of values.
Implicitly, we assumed that once a project is launched, its basic features cannot be changed.
For this reason, we say that our analysis is static (as opposed to dynamic).
Managerial options or real options
Opportunities that managers can exploit if certain things happen in the future.
Contingency Planning
Taking into account the managerial options that are implicit in a project.
There is no limit to the number of possible future scenarios or contingencies that we could investigate
THE OPTION TO EXPAND
If we truly find a positive NPV project, there is an obvious consideration. Can we expand the project or repeat it to get an even larger NPV? Our static analysis implicitly assumes that the scale of the project is fixed.
THE OPTION TO ABANDON
At the other extreme, the option to scale back or even abandon a project is also quite valuable
For example, if a project does not break even on a cash flow basis, it can’t even cover its own expenses. We would be better off if we just abandoned it. Our DCF analysis implicitly assumes that we would keep operating even in this case.
THE OPTION TO WAIT
Implicitly, we have treated proposed investments as if they were go or no-go decisions. In reality, there is a third possibility: the project can be postponed, perhaps in hope of more favourable conditions
THE TAX OPTION
Investment decisions may trigger favourable or unfavourable tax treatment of existing assets.
This can occur because capital cost allowance calculations are usually based on assets in a pooled class
Strategic options
Options for future, related business products or strategies.
How sensitive is OCF to a change in sales units
equation
Change in OCF / Change in quantity
How sensitive is PV to a change in sales units
equation
Change in NPV / change in quantity
