Investment Project analysis Flashcards
Define a relevant cash flow for a project
Change in firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project - These are incremental cashflows
Define a stand alone principle
Assumption that evaluation of a project may be based on the projects incremental cash flows. Looks at projects independently
Define incremental cash flows
Difference between a firm’s future cash flows with a project and those without the project. These cash flows for a project consist of all changes in firm’s future cash flows that are a direct consequence of taking the project.
Define irrelevant cash flows
Exists regardless of taking/not taking project
Define a sunk cost
Sunk cost is a cash flow that has already occured and cannot be recovered. In evaluating a new project sunk costs are ignored ex: asset’s historical cost
Define opportunity costs
Lost revenues you forego making the proposed investment. In evaluating a new project you incorporate opportunity cost as these resources will not be used elsewhere
Give an example of an opportunity cost
Asset owned that will be used in projects: If not used you will sell so the opportunity cost = market value
Name two side effects for a project and are they included or not?
Erosion, Synergy - you include side effects in evaluating a project
Define erosion
When a new product reduces cash flow of existing products. (relevant when it would not have been lost anyways)
Define synergy
Occurs when new product increases cash flows of existing products
How does NWC work for a project?
It is considered part of incremental cash flow and the firm supplies it at the beginning of a project, recovering it at the end
Formula for NWC
Current assets- current liabilities
Usually cash + inventory + receivables - payables
Why are financing costs not included in evaluating a project
Dividends/principal repaid. We only consider cashflows generated by assets of a project
Define pro forma statements
Projecting future years operations needs estimates
What is the formula for operating cash flow
Net income + depreciation - Increase (+decrease) in NWC
What is the formula for a project cash flow
Operating cash flow - project capital spending
What is an increase in NWC in relation to project cash flows
negative - cash outflow
What is an decrease in NWC in relation to project cash flows
positive - cash inflow
Why is depreciation added to find operating cash flow
its a non cash item
Define reducing balance method of depreciation
Method allowing for the accelerated write off of assets under various classifications - depends on residual value of previous year
Define straight line depreciation
Method allowing for linear write off of assets over their lifetime. - Divide value of asset by no. of years of life
After depreciation what does the difference between the sale price and book value tell you about tax
Sale price < book value - company obtains tax savings
Sale price> book value - salvage company pays tax difference
Define forecasting risk
Possibility that errors in projected cash flows will lead to incorrect decisions - estimation risks. Is estimated NPV reliable? You must answer questions like the source of value of the NPV, why is a product better, why is NPV > 0
Define scenario analysis
Determination of what happens to NPV estimates when we ask what-if questions. Changes all variables to analyst best and worst case
Best and worst case must be reasonably likely
Explain paralysis of analysis in relation to scenario analysis
Looking at more and more possibilities but still won’t tell you what to do.
Explain sensitivity analysis
Investigation of what happens to NPV if one variable changes. Useful in pinpointing which forecasting error will do most damage looking at best and worst case scenario
What are the benefits and weakness of sensitivity analysis
If there are many NPV < 0 you know investigation is needed
Analysis identifies the influential variables - these must be estimated with more accuracy
Weakness: each variable is in isolation and it is still not conclusive
Define simulation analysis
Mixed scenario and sensitivity analysis
