Chapter 9 - Making Capital Investment Decisions

relevant

first step in estimating cash flow is to determine the ___ cash flows

sensitivity analysis

investigation of what happens to NPV when only one variable is changed; identifies critical variables

contingency planning

what actions are we going to take if X happens

sunk cost

costs that have already occurred and are not affected by accepting or rejecting a project - NOT RELEVANT TO CASH FLOW

Accelerated Cost Recovery System (ACRS) of 1981

depreciation method under the U.S. tax law allowing for accelerated write-off of property under various classifications

scenario analysis

determination of what happens to NPV estimates when we ask what-if questions; gauges potential for disaster; combination of factors changed

incremental

direct consequence of taking a project under consideration

base case

estimated NPV based on our project cash flows

pro forma

financial statements projecting future years operations

sensitivity benefits

1. Identifies the variable that has the most effect on NPV 2. Reduces a false sense of security by giving a range of values for NPV instead of a single value

sensitivity drawbacks

1. May increase the false sense of security among managers if all pessimistic estimates of NPV are positive 2. Does not consider interaction among variables

soft rationing steps

1. Try to get a larger allocation 2. Generate as large a NPV as possible within the existing budget --> Choose projects with the largest benefit-cost ratio (profitability index)

risk analysis goals

1. assessing the degree of financing risk 2. identifying critical components

operating cf sources

1. cash outflows from investment in plant/equip at beginning 2. sales and expenses throughout 3. salvage value

NWC investment

1. credit sales are made 2. inventory is purchased 3. cash is kept for unexpected expenditures

True

NPV positive investments are NOT that common (T or F)

increase

___ in depreciation expense will increase CF from operations

synergy

___ will increase the sales of existing products (positive spillover effect)

aftertax

always interested in ___ cash flow

what-if analysis

assesses degree of forecasting risk & identifies most critical components

tax shield approach

ocf = (Sales - Costs) x (1 - T_c) + Depreciation * T_c

cash flow

operating cash flow - change in NWC - capital spending

managerial (real) options

opportunities that managers can exploit if certain things happen in the future; modifications to project

strategic options

options for future, related to business products or strategies; testing the water

forecasting (estimation) risk

possibility that errors in projected cash flows will lead to incorrect decisions

stand alone

principle that assumes that evaluation of a project may be based on a project's incremental cash flow

NPV

provides the most consistently correct projected total cash flow

Tax Reform Act of 1986

reformed ACRS

cash inflow

sales - increase in accounts receivable

capital rationing

situation that exists if positive NPV projects cannot obtain the necessary financing

hard rationing

situation that occurs when a business cannot raise financing for a project under any circumstances

soft rationing

situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting; typically internal

depreciation tax shield

tax saving that results from the depreciation deduction

underestimate

tend to ______ NPV by ignoring options

what-if questions

the basic approach to evaluating cash flow and NPV estimates involves asking....

opportunity cost

benefit lost due to taking on a particular project

option to expand, abandon, wait

broad classes of contingency planning

erosion

cash flows of a new project that come at the expense of a firm's existing projects; only relevant when sales would not otherwise be lost

net working capital (nwc)

completely recovered at end of project

cash ouflow

costs - decrease in inventory - increase in accounts payable

operating

EBIT - Taxes + depreciation

net income

EBIT - taxes

depreciation

noncash deduction; only important to cash flow because it reduces tax bill