Investment Project analysis

Question 1

Define a relevant cash flow for a project

Answer 1

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

Question 2

Define a stand alone principle

Answer 2

Assumption that evaluation of a project may be based on the projects incremental cash flows. Looks at projects independently

Question 3

Define incremental cash flows

Answer 3

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.

Question 4

Define irrelevant cash flows

Answer 4

Exists regardless of taking/not taking project

Question 5

Define a sunk cost

Answer 5

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

Question 6

Define opportunity costs

Answer 6

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

Question 7

Give an example of an opportunity cost

Answer 7

Asset owned that will be used in projects: If not used you will sell so the opportunity cost = market value

Question 8

Name two side effects for a project and are they included or not?

Answer 8

Erosion, Synergy - you include side effects in evaluating a project

Question 9

Define erosion

Answer 9

When a new product reduces cash flow of existing products. (relevant when it would not have been lost anyways)

Question 10

Define synergy

Answer 10

Occurs when new product increases cash flows of existing products

Question 11

How does NWC work for a project?

Answer 11

It is considered part of incremental cash flow and the firm supplies it at the beginning of a project, recovering it at the end

Question 12

Formula for NWC

Answer 12

Current assets- current liabilities

Usually cash + inventory + receivables - payables

Question 13

Why are financing costs not included in evaluating a project

Answer 13

Dividends/principal repaid. We only consider cashflows generated by assets of a project

Question 14

Define pro forma statements

Answer 14

Projecting future years operations needs estimates

Question 15

What is the formula for operating cash flow

Answer 15

Net income + depreciation - Increase (+decrease) in NWC

Question 16

What is the formula for a project cash flow

Answer 16

Operating cash flow - project capital spending

Question 17

What is an increase in NWC in relation to project cash flows

Answer 17

negative - cash outflow

Question 18

What is an decrease in NWC in relation to project cash flows

Answer 18

positive - cash inflow

Question 19

Why is depreciation added to find operating cash flow

Answer 19

its a non cash item

Question 20

Define reducing balance method of depreciation

Answer 20

Method allowing for the accelerated write off of assets under various classifications - depends on residual value of previous year

Question 21

Define straight line depreciation

Answer 21

Method allowing for linear write off of assets over their lifetime. - Divide value of asset by no. of years of life

Question 22

After depreciation what does the difference between the sale price and book value tell you about tax

Answer 22

Sale price < book value - company obtains tax savings

Sale price> book value - salvage company pays tax difference

Question 23

Define forecasting risk

Answer 23

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

Question 24

Define scenario analysis

Answer 24

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

Question 25

Explain paralysis of analysis in relation to scenario analysis

Answer 25

Looking at more and more possibilities but still won’t tell you what to do.

Question 26

Explain sensitivity analysis

Answer 26

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

Question 27

What are the benefits and weakness of sensitivity analysis

Answer 27

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

Question 28

Define simulation analysis

Answer 28

Mixed scenario and sensitivity analysis