chapter 12 - capital structure Flashcards
What is scenario analysis? Why is it used? What
is the baseline scenario? Why do managers care
about worst-case scenarios more than other
scenarios?
Scenario analysis:
- Projecting cash flows under different possible states of the the world
Baseline scenario –
- Projected cash flows under the most likely outcome
- Bad scenario, good scenario
Worst-case scenario
- Managers often care about bad or worst-case scenarios
- What happens if the economy weakens or customers don’t buy the product?
- Make sure that one bad investment doesn’t bankrupt the company
How can using comparables improve forecast
accuracy? How can Monte Carlo simulations
improve forecast accuracy?
Generally use existing projects or comparables
The more similar a new investment is to an existing investment, the less risk in predicting future cash flows
If two projects have the same expected NPV, select the project with the less risky cash flows
Consider NPV under all scenarios
Weight different scenarios same/different?
Monte Carlo Simulation
Mathematical technique used to estimate scenarios by simulating different possible states of the world
What are the three types of project risk? Be
able to describe stand-alone risk, corporate risk,
and market risk. Which risk is most relevant for
corporations? Why?
What are the 3 types of project risk
Stand-alone risk
Corporate risk
Market risk
What is stand-alone risk
The project’s total risk, if it were operated independently.
Usually measured by standard deviation (or coefficient of variation).
However, it ignores the firm’s diversification among projects and investors’ diversification among firms.
What is corporate risk?
The project’s risk when considering the firm’s other projects, i.e., diversification within the firm.
Corporate risk is a function of the project’s NPV and standard deviation and its correlation with the returns on other firm projects.
What is market risk?
The project’s risk to a well-diversified investor.
Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder diversification.
Projects can have above, above-average, and
below-average risk
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How do we adjust decision criteria for differences in individual project risk
If the risk is above-average, adjust the discount
rate higher (require a higher WACC to accept the project, such as 12% instead of 10%)
What is real option analysis? Why does this
matter for deciding which projects to accept?
Real Option Analysis:
The analysis of capital budgeting projects for which managers can take positive actions after the investment has been made that alter the project’s cash flows.
Real options are valuable, but this value is not captured by conventional NPV analysis.
A project’s real options are considered separately.
What are the different types of real options?
Abandonment
Can stop the project and stop losses/recoup investment if project doesn’t work out
Investment Timing
Flexibility in when make investments
Expansion Potential
Additional projects after complete the current project
Output Flexibility – produce multiple projects
Input Flexibility – use different inputs/switch inputs if necessary
Market Switching – Switch consumers base
What are four other considerations that
managers may consider when deciding to
accept or reject a project?
Opportunity Cost
The best return that could be earned on assets if not used in a given project
Cannibalization
When a new investment/store takes sales away from an existing investment or store
Complementary
When a new investment/store increases sales at an existing investment or store;
Sunk Cost
A cash outlay that had already been incurred and that cannot be recovered regardless
NPV analysis: never include sunk costs
Projects should take all future costs into
consideration, but not sunk costs or prior costs
that can’t be recovered.
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