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19 Cards in this Set
- Front
- Back
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How do you determine a project's incremental cash flow?
Ch. 11 |
Business cash flow with the project minus business can flow without the project.
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Should you subtract interest expenses or dividends when calculating cash flow?
Ch. 11 |
No
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Should you include sunk costs in cash flow analysis?
Ch. 11 |
No
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Why is it important to include inflation when estimating cash flows?
Ch. 11 |
1. Nominal r > real r. The cost of capital, r, includes a premium for inflation.
2. Nominal CF > real CF. This is because nominal cash flow incorporates inflation. 3. If you discount real CF with the higher nomimal r, then the NPV estimate will be too low. 4. Nominal CF should be discounted with nominal r, and real CF should be discounted with real r. It is more realistic to find the nominal CF than it is to reduce the nominal r to a real r. |
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What does "risk" mean in capital budgeting?
Ch. 11 |
Uncertainty about a project's future probability. Measured by o'NPV, o'IRR.
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What are the three types of relevant risk in capital budgeting?
Ch. 11 |
1. Stand-alone risk
2. Corporate risk 3. Market (or beta) risk |
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What is Stand-Alone Risk?
Ch. 11 |
The project's risk if it were the firm's only asset and there were no shareholders.
Ignores both firm and shareholder diversification. Measured by the o' of NPV, IRR, or MIRR. |
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What is Corporate Risk?
Ch. 11 |
Reflects the project's effect on the firm's earnings stability.
Considers firm's other assets (diversification within firm). Measured by the beta of the firm. |
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What is Market Risk?
Ch. 11 |
Reflects the project's effect on a well-diversified stock portfolio.
Takes account of stockholders' other assets. Measured by the project's market beta. |
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What is sensitivity analysis?
Ch. 11 |
Shows how changes in a variable, such as unit sales, affect NPV or IRR.
Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. Answers "what if" questions. |
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What are the advantages and disadvantages of sensitivity analysis?
Ch. 11 |
Advantages:
1. Gives some idea of stand-alone risk 2. Identifies dangerous variables 3. Gives some breakeven information Disadvantages: 1. Does not reflect diversification 2. Says nothing about the likelihood of change in a variable 3. Ignores relationships among variables |
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What is scenario analysis?
Ch. 11 |
Examines several possible situations, usually worst case, most likely case, and best case.
Provides a range of possible outcomes. |
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What are the problems associated with scenario analysis?
Ch. 11 |
1. Only considers a few possible outcomes.
2. Assumes that inputs are perfectly correlated (all "bad) values occur together; all "good" values occur together) 3. Focuses on stand-alone risk, although subjective adjustments can be made |
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What is simulation analysis?
Ch. 11 |
A computerized version of scenario analysis that uses continuous probability distributions. Computer selects values for each variable based on given probability distributions.
End result: Probability distribution of NPV and IRR based on sample of simulated values (shown graphically). |
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What are the advantages and disadvantages of simulation analysis?
Ch. 11 |
Advantages:
1. Reflects the probability distributions of each input 2. Shows range of NPVs, the expected NPV, o'NPV, and CV-NPV 3. Gives an intuitive graph of the risk situation Disadvantages: 1. Difficult to specify probability distributions and correlations 2. If puts are bad, output will be bad. |
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What are the disadvantages of sensitivity analysis in general?
Ch. 11 |
1. Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a project's expected return is sufficient to compensate for its risk.
2. Sensitivity, scenario, and simulation analyses all ignore diversification. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting. |
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Should subjective risk factors be considered in sensitivity analyses?
Ch. 11 |
Yes - a numerical analysis may not capture all of the risk factors inherent in the project.
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What is a real option?
Ch. 11 |
Real options exist when manager can influence the size and risk of a project's cash flows by taking different actions during the project's life in response to changing market conditions.
Alert managers always look for real options in projects. Smarter managers try to create real options. |
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What are some types of real options?
Ch. 11 |
1. Investment timing options
2. Growth options (option to expand, abandon, wait) 3. Abandonment options 4. Flexibility options |
