Week 1 Flashcards
Net Present Value(NPV)
Difference between an investment’s market value and its cost
What is the formula of NPV?
PV of all future cash flows at investor required rate of return MINUS initial investment
What are mutually exclusive investments?
Situation where taking one investment prevents taking the other
Problems of Cash Flow Analysis
Based on estimated future cash flows
Forecasting Risk(Estimation risk)
What is Forecasting Risk(Estimation risk)?
The possibility that errors in projected cash flows will lead to incorrect decisions
What is Scenario Analysis?
Asking what-if questions to determine its effect on NPV
Why is Scenario Analysis performed?
Estimates the degree of forecasting risk by detecting key components that influence the success/failure of an investment.
Sensitivity Analysis
A variation of scenario analysis that pinpoints the area where forecasting risk is especially severe.
Why is Sensitivity Analysis performed?
To investigate what happens to NPV when only one variable is changed.
Drawback of Sensitivity Analysis
Only tells us good or bad possibilities and points out where forecasting errors occur - doesn’t tell us what actions to take
High forecasting risk occurring if estimated NPV is highly sensitive to unpredictable variables - such as unit sales.
What is Simulation Analysis and its purpose?
Combination of scenario and sensitivity analysis.
Purpose: to let all items vary at the same time.
Drawback of Simulation Analysis
Same as scenario and sensitivity analysis - no guidance on what to do.
Break-Even analysis
Tool used to analyse the relationship between sales, volume and profitability.
Accounting Break-even
The level of sales that results in zero-project net income(the most widely used measure).
What does Break-Even tell us?
Its answers the question: How bad do sales get before we start losing money?
Variable Costs and Formula
Costs that vary directly with output:
Formula:
Total Variable Cost = Variable Cost per unit * Quantity
Fixed Costs
Costs that do not change when the quantity changes during a particular time period.
Total Costs Formula
Total Costs = Fixed Costs + Total Variable Costs
Incremental/marginal revenue
The change in revenue that occurs when there is a unit change in output.
Why is accounting break-even important?
Helps estimate the feasibility of the investment.
Easy to understand and calculate.
Reduce total earnings if a project doesn’t reach accounting break-even
Cash Break-Even
The sales level that results in zero operating cash flow
Financial Break-even
The sales level that results in a zero NPV
Operating Leverage
The degree to which a firm or project relies on its fixed costs.
Operating Leverage characteristics
Capital Intensive projects have a high degree of operating leverage such as heavy investment into plant and equipment.
Fixed costs act like a lever - small % change in operating revenue leads to large % change in OCF and NPV.
