Chapters 7 - 8 Flashcards
what is risk
risk arises when there are several possible outcomes, and based on past relevant experience, probabilities can be assigned to the possible outcomes
what is uncertainty
arises when there are several possible outcomes and no info, so probabilities cannot be quantified
what is joint probability
two worst probabilities multiplied together
problems with probability
the expected NPV may never occur
assigning probabilities is highly subjective
EV’s do not evaluate the full range of probabilities
what is sensitivity analysis
method of analysing the uncertainty surrounding a capital expenditure project and enables an assessment of how responsive the projects NPV is
sensitivity formula
project NPV / present value of project variable x 100
weaknesses of sensitivity analysis
method require that only one variable change at a time
looking at factors in isolation is unrealistic as they are interdependent
does not provide a decision rule
3 things a shorter replacement cycle means
lower operating costs
higher residual value when the asset is disposed of
increased capital expenditure ( as its purchased more frequently)
2 things a longer replacement cycle means
reduced capital expenditure
asset may cost more to operate as it gets older
residual value will be lower
formula for equivalent annual cost
NPV of costs over replacement cycle / annuity factor for life of asset
drawback of EAC
fails to recognise the asset may not work as well as it gets older
what is the equivalent annual benefit (AEB)
expressed the NPV from a project as an annuity, ie a constant cash flow per year
formula for AEB
NPV of project / Annuity Factor
what kind of leases minimise risk to the lessee
one where the lessor is responsible for servicing and maintenance
what kind of leases are purely a source of finance
lessee is responsible for maintenance and servicing
benefits of a lease to a lessee
if they cant get a bank loan to buy it
loan covenants may make it harder to borrow in the future
what is capital rationing
arises when there is insufficient capital to invest in all available projects which have positive NPVs
what is hard capital rationing
when investors are unwilling to invest more equity
when businesses are too risky to loan to
capital markets are depressed
what is soft capital rationing
management are reluctant to issue more shares
management do not want to raise additional debt capital
what is a divisible project
a project that can be scaled down and done in part
formula for probability index
present values of cash flow / initial cash flow
critical value of PI
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