week 18

Question 1

what are incremental cash flows

Answer 1

consist of any and all changes in the firms current and future cash flows that are a direct consequence of taking the project
any cash flow that exists regardless of if the project is undertaken is irrelevant

Question 2

how do you evaluate a proposed project

Answer 2

use estimated financial statements to forecast future operations
compute cash flow based from firm based on financial statements
evaluate project using techniques discussed in previous lectures

Question 3

what are the common pitfalls of accepting a project

Answer 3

sunk costs
opportunity costs
side effects
changes in net working capital
financing costs
tax effects

Question 4

what are sunk costs

Answer 4

a cost that has already occurred and cannot be recovered whether we decide to accept the project or not
not incremental to cash outflows

Question 5

what are opportunity costs

Answer 5

the most valuable alternative opportunity that is forgone if a particular investment is undertaken
are incremental cash flows

Question 6

what are side effects

Answer 6

negative or positive
both can are incremental cash flows

Question 7

what is net working capital

Answer 7

the investment in NWC represents an incremental cash outflow
when the project is approaching its end all investment in NWC is recovered

Question 8

how do you calculate NWC

Answer 8

cash + inventory + recievables - payables

Question 9

what are financing costs

Answer 9

the goal of project evaluation is to estimate cash flow generated by the proposed project which is cash flow from assets (CFFA)
companies usually finance entire companies at once
taxes are a cash outflow, all cash flows should be after tax numbers

Question 10

how do you calculate CFFA

Answer 10

CFs to creditors + CFs to shareholders

Question 11

which common pitfalls have incremental cash flows

Answer 11

opportunity costs
side effects
NWC
tax effects

Question 12

how do you evaluate a proposed project

Answer 12

get pro-forma financial statements
compute future cash flow from statements
evaluate using decision rules

Question 13

how do you calculate operating cash flow (OCF)

Answer 13

EBIT + depreciation - taxes
net income + depreciation

Question 14

how do you calculate cash flow from assets (CFFA)

Answer 14

OCF - net capital spending - changes in NWC

Question 15

what are the three methods to calculate OCF

Answer 15

bottom up - EBIT + D - T x EBIT
top down - (S-C) - (S-C-D) x T
tax shield - (S-C)(1-T) + DxT

Question 16

how can you avoid NPV mistakes

Answer 16

sources of value
forecasting risk

Question 17

what are sources of value

Answer 17

able to articulate why this project creates value
positive NPV projects are rare in highly competitive arenas
if project has large positive NPV, need to understand where it is coming from
no good reasons for large positive NPV, estimates may be inaccurate or optimistic

Question 18

what is forecasting risk

Answer 18

mistakes in forecasting cash flows or discount rate
estimate sensitivity of NPV to changes in cash flow estimates, more sensitive have greater forecasting risk
use scenario and sensitivity analysis

Question 19

what is scenario analysis

Answer 19

examines NPV under several possible situations to assess the impact of cash flows which differ from forecasts
worst case - low revenues, high costs
best case - high revenues, low costs

Question 20

what is sensitivity analysis

Answer 20

shows how changes in an input variable affect NPV
each variable is fixed except one
focus in the effect of specific variables on NPV
answers what if questions

Question 21

what are the additional considerations in capital budgeting

Answer 21

managerial actions - managers can modify a project after it starts, real options, can underestimate project NPV by ignoring options
capital rationing - firms have limited resources and cant undertake positive NPV projects