L3- Capital Budgeting Flashcards
Define Sensitivity analysis
What is the formula for the total return on a company’s capital? Managers try to determine what else may happen and the implications of these possible surprise events
DO MORE ON SENSITIVITY ANALYSIS
Annual Cash flow equation (base case npv)
annual revs - (VC% * annual revs) - FCs
Cost of Capital (base case npv)
rfr + beta*(market return - rfr)
PV of future cash flow (base case NPV)
Annual CF/cost of capital * [1 - 1/1.cost of capital)^n]
NPV equation (base case NPV)
PV of future CF- Investment cost
What is the purpose of carrying out a sensitivity analysis?
To evaluate the impact of changes in each underlying modelling assumption on the NPV
Why is sensitivity analysis important in decision-making?
It helps identify which variables have the greatest impact on the NPV, allowing for better risk assessment and more informed decision-making.
What should be done if the sensitivity analysis reveals troubling numbers?
Evaluate whether it is worth spending more time on research to narrow the range of uncertainty for critical variables.
How can narrowing the range of uncertainty impact decision-making?
Increases the likelihood that NPV will not go into negative territory making project more predictable, reducing risk
Drawback on Sensitivity analysis
it assumes the variables vary independently
Why is the assumption of independent variable variation in sensitivity analysis unrealistic?
Unexpected changes in one variable, like an increase in investment cost, are often accompanied by similar changes in other costs, such as variable and fixed costs.
What is the solution to the drawback of sensitivity analysis?
Scenario analysis, which incorporates realistic scenarios that account for the covariance between variables.
How may we interpret a scenario analysis
we may do some research of how likely
a recession scenario really is, and whether we can mitigate some of the
negative impact of such an event.
How does scenario analysis differ from sensitivity analysis?
Sensitivity analysis examines the impact of changes in individual variables independently, while scenario analysis evaluates multiple variables together, considering their correlations.
What is Monte Carlo Simulation
an advanced version of the scenario analysis, where we embed correlations between variables into a simulation model
and repeat the simulation many times, to obtain a frequency plot of the NPV outcome.
How to interpret the output of the Monte Carlo simulation
we may look at the likelihood that we end up with a loss-making investment, and the
various mitigating measures that can be taken to avoid these losses.
Why is Monte Carlo simulation valuable for investment decisions
It allows for a detailed risk assessment by showing the range of possible outcomes and their probabilities, helping to identify and address potential risks.
What is the advantage of using market information to generate present values?
It eliminates the need for elaborate variable estimates by using readily available market data.
For what type of businesses is using market information particularly useful?
Businesses involved in trading commodities with available market values.
Why is market information not universally applicable for generating present values?
Market values are available for only a relatively narrow range of goods
CHECK NPV FORMULA FOR GOLD EXAMPLE
What is the expected return for an investor holding gold?
a return that is equal to the cost of capital for an investment with the
same level of risk as gold market investment.
What must be true for the price of gold over time if you hold it?
P(t)= [E(P)t+n))]/(1+r)^n
REDO ADJUSTING FOR NPV FORMULA
What are the two main ways companies make positive NPV investments?
–By “accident” – being in the right place at the right time.
–By exploiting a competitive advantage.
How can being in the right place at the right time lead to positive NPV investments?
Companies may benefit from unexpected growth in certain industries, such as tech companies developing technologies that significantly impact consumer habits.
What are some examples of competitive advantages that lead to positive NPV investments?
–Economies of scale, where large operators have cost advantages over smaller entrants.
–Patent rights or exclusive rights granting a monopoly on certain products.
–Unique brand recognition that differentiates the company from competitors
How do economies of scale contribute to a competitive advantage?
Larger operators can produce goods or services at lower costs compared to smaller entrants, giving them a cost advantage.
Why do patent rights or exclusive rights create a competitive advantage?
They grant a monopoly on specific products, preventing competitors from offering the same products
How does unique brand recognition lead to positive NPV investments?
A strong, recognizable brand can attract loyal customers and justify premium pricing, boosting profitability.
What would happen if competitive advantage did not exist?
All companies would make at most zero NPV investments, meaning no economic rent
What is the key reason behind a positive NPV?
A positive NPV must be attributed to some competitive advantage.
What is economic rent in the context of competitive advantage?
Economic rent comes from selling goods or services at a higher price (price premium), producing them at a lower cost (cost discount), or using brand recognition to sell more than competitors.
How should NPV calculations reflect competitive advantage
NPV calculations should highlight how competitive advantage leads to economic rent through price premiums, cost discounts, or both.
Why is it essential to trace economic rent to competitive advantage?
To understand how the company generates value above its competitors and ensures sustainable profitability.
