Risk analysis for capital budgeting Flashcards
What is sensitivity analysis?
Investigation of what happens to NPV when only one variable is changed with respect to changes in different variables. Also known as what-if analysis
What are variable costs?
Costs that change when the quantity of output changes
What are fixed costs?
Costs that do not change when the quantity of output changes during a particular time period
How can we find total costs?
TC = VC + FC
What is a marginal (incremental) cost?
The change in costs that occurs when there is a small change in output
What is a marginal (incremental) revenue?
The change in revenue that occurs when there is a small change in output
What is accounting break even?
The sales level that results in zero project net income
What can profit before tax also be interpreted as?
EBIT
Why do we use accounting break even?
- Relatively easy to calculate
- Helps reduce forecasting risk
- A project does not break even in an accounting sense reduces total earnings
- A project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense
What is the cash break-even?
The sales that result in a zero operating cash flow
What is the financial break even?
The sales that result in a zero NPV
What is operating leverage?
The operating leverage is the relationship between a companies fixed costs and variable costs. When fixed costs are high relative to variable cost, the company’s operating leverage is also high
What is the degree of operating leverage
Measures how well a company generates profit using it’s fixed costs. The percentage change in operating cash flow relative to the percentage change in quantity sold
What are the implications of operating leverage?
Operating leverage magnifies both profits and losses. This is because fixed costs act as a lever in the sense that a small percentage change in operating revenue can be magnified into a large percentage change. In operating cash flow and net present value the higher degree of operating leverage. The greater is the potential danger from forecasting risk.
What is the goal of management regarding operating leverage?
One way of coping with highly uncertain projects is to keep the degree of operating leverage as low as possible. This will generally have the effect maintaining the breakeven point at its minimum level.
What is capital rationing?
Capital rationing refers to the situation that existed. The firm has positive net present value projects, but cannot find a necessary financing.
What is soft rationing?
Soft rationing refers to the situation that occurs when units in a business allocated a certain amount of financing for capital budgeting. For example, different levels of investment across different sectors
What is hard rationing?
Hard rationing refers the situation occurs what a business cannot raise financing for a project under any circumstances
under capital rationing, what is the best metric for deciding whether to invest or not?
Under capital rationing, we should follow the profitability index as it accounts for the cost of the initial investment. Whereas the net present value does not.
What are the advantages of capital rationing?
- Ensure a budget is followed
- Optimal utilisation of resources
- More effective and efficient project management
What are the disadvantages of capital rationing?
Applying capital rationing = focus on short-term rather than long-term growth
