Chapter 10

Sunk Cost

-cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted/rejected -not affected by the accept/reject decision

Replacement Decisions

-decisions made by all companies to determine when older, worn assets should be replaced with newer assets to continue normal operations -** identify relevant cash flows, then find net present value of the project

Depreciation in regards to Capital Budget

-depreciation is a noncash expense, so there is not a cash outflow associated with the recognition of depreciation expense each year -Depreciation is a tax deductible expense -affects the taxable income of a firm, and thus the amount of taxes paid by the firm, which is a cash flow

Externalities

-effect accepting a project will have on the cash flows in other parts of the firm -not incremental cash flows and should not be included in the analysis of the new capital budgeting project

Scenario Analysis Steps

-financial analyst ask operating managers to pick a bad set of circumstances and a good set of circumstances -NPVs under bad and good conditions are then calculated and compared to the expected (base case (NPV)

Analyzing a product's stand-alone risk

-first determine the uncertainty in the existing project cash flows -3 techniques used to assess stand alone risks 1. sensitivity analysis 2. scenario analysis 3. Monte Carlo Simulation

Amount of taxes paid

-is a cash flow -depreciation is a noncash expense -when depreciation changes, taxable income changes -taxes paid is a cash flow

Incremental Cash flows in regards to replacement decisions

-more complicated than expansion projects -have to consider cash flows from both the old and new asset

Modified Accelerated Cost Recovery System (MACRS)

-new accelerated cost recovery -allows greater accelerated depreciation over longer periods of time -allows companies to write off assets faster in earlier years

Opportunity Costs

-return on the best alternative use of an asset -highest return that will not be earned if funds are invested in a particular project -included as part of overall investment cost

Inflation in regards to Capital Budget

-should be recognized in capital budgeting decisions -if not taken into consideration for expected cash flows, calculated NPV and IRR will be artificially low -use expected inflation which is reflected by revenue and cost figures (annual net cash flow forecasts -required rate of return should not be adjusted for inflation expectations

Sensitivity Analysis Steps

1. base-case situation developed using expected values for each input 2. each variable is changed by specific percentage points above and below the the expected value, holding other things constant 3. new NPV is calculator for each of these values 4. set of NPVs is plotted against the variable that was changed

2 rules for relevant cash flows

1. capital budgeting decisions must be based on cash flows AFTER taxes, not accounting income 2. only incremental cash flows-that is, cash flows that change if the project is purchased are relevant to accept/reject decisions

Key differences in domestic and foreign capital budgeting analysis

1. cash flow estimation is generally must more complex for overseas investments -many firms set up a separate subsidiary in each foreign country they operate in -relevant cash flows of these subsidiaries are earnings and dividends that can be repatriated (returned) to the parent company 2. these cash flows must be converted into the currency of the parent company -subject to future exchange rates 3. earnings and dividends normally are taxed by both the foreign and home-country 4. foreign government might restrict the amount of cash that can be repatriated to the parent company

3 Categories of a project's incremental cash flows

1. cash flows that occur ONLY at the start of a project's life (Period 0) are part of the initial investment outlay 2. Cash Flows that continue throughout the project's life (Period 1 through n) are part of the supplemental operating cash flows 3. Cash flows that occur ONLY at the end of the project's life (Period n) and that are associated with the disposal, or termination of the project are part of the terminal cash flow

Financial Staff's role in the forecasting process

1. coordinating the efforts of the other departments 2. ensuring that everyone involved with the forecast uses a consistent set of economic assumptions 3. making sure that no biases are included in the forecast

Ways companies can take steps to reduce the potential loss from expropriation

1. financing the subsidiary with capital raised in the country in which the asset is located 2. structuring operations so that the subsidiary has value only as a part of the integrated corporate system 3. obtaining insurance against economic losses from expropriation from a source sick as the Overseas Private Investment Corporation (OPIC)

Monte Carlo Simulation Steps

1. get probability distribution of each uncertain cash flow variable and they must be specified 2. value from probability distribution is randomly chosen to compute the project's outflow (these values used to determine the project's NPV) 3. computer simulation is a process that repeats 500 times to get 500 NPVs -provides decision maker with a better idea of various outcomes that are possible

Replacement Decisions involve comparing two mutually exclusive projects

1. retaining the old assets 2. buying a new asset -if choosing between 2 mutually exclusive alternatives with significantly different lives, an adjustment would be necessary to make the results of the capital budgeting analysis for two projects comparable

Terminal Cash Flow includes.....

1. salvage or disposal value that can be either positive (selling the asset) or negative (paying for removal) 2. tax impact associated with the disposal of the project 3. because we assume the firm will return to the operating level that existed prior to the acceptance of the project, any changes in net working capital that occurred at the beginning of a project's life will be reversed at the end

In general a project's stand-alone risk depends on both

1. sensitivity of its NPV to changes in key variables 2. range of likely values of these variables, as reflected in the probability distribution ***Sensitivity considers 1st, Scenario considers both factors

3 Reasons why corporate risk is important

1. undiversified stockholders, including the owners of small businesses, are primarily concerned about the diversification associated with a particular firm 2. studies of the determinants of required rates of return generally find that investors, even those who are well diversified, give some consideration to corporate risk when they establish required returns 3. Firms stability important to employees and investors, a struggling firm will have a hard time finding capital and good employees -these factors affect price of stock and make corporate risk significant

Expansion project

a project that is intended to increase sales -invest in new assets

Incremental (marginal) cash flow

change in a firm's net cash flow attributable to an investment project -cash flows that change if the project is purchased and must be included in the capital budgeting evaluation

Supplemental operating cash flows

changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes the asset

Net Working Capital

difference between current assets and current liabilities -required change in assets -spontaneous change in liabilities -if change is positive (Expansion Products), then additional financing, over and above the cost of the project, is needed to fund the increase

Risk-adjusted discount rate

discount rate (required rate of return) that applies to a particular risky stream of income -equal to risk free rate of interest plus a risk premium appropriate to the level of risk associated with a particular project's income stream -discount rates recognize that projects with different risks should be evaluated by different required rates of return

Most important step in the analysis of a capital project

estimating its cash flows

Working Capital Accounts

firm's short term assets and liabilities

If project risk is not considered in capital budgeting analysis.....

incorrect decisions are possible -Ex: high risk project being accepted when it should've been rejected

Initial Investment Outlay

incremental cash flows associated with a project that will occur only at the start of a project's life -EX: purchase price of the new project, shipping and installation costs -if capital budgeting decision is a replacement decision, then the initial investment must also take into consideration the cash flows associated with disposal of old or replaced asset

Risk adjustments are.....

necessarily judgmental and somewhat arbitrary

Terminal Cash Flow

net cash flow that occurs at the end of the life of a project, including cash flows associated with 1. final disposal of the project 2. returning the firm's operations to where they were before the project was accepted

Relevant cash flows are determined by.....

net differences between new cash flows and old cash flows because cash flows from new project replace cash flows from old (replaced) project

Operating cash flow=

net income + depreciation OR return ON capital + return OF capital

Beta (market) Risk

part of a project's risk that cannot be eliminated by diversification -measured by a project's beta coefficient

Repatriation of Earnings

process of sending cash flows from a foreign subsidiary back to a parent company

Stand-alone Risk

risk an asset would have if it were a firm's only asset -measured by the variability of the asset's expected returns -easier to estimate than other two risks

Scenario Analysis

risk analysis technique in which "good" and "bad" sets of financial circumstances are compared with a most likely, or base case, situation -only considers a few discrete outcomes (NPVs) for project even though there are more possibilities

Sensitivity analysis

risk analysis technique in which key variables are changed and the resulting changes in the NPV and the IRR are observed -help provide insight of riskiness of a product

Monte Carlo Simulation

risk analysis technique in which probable future events are simulated on a computer -generating a probability distribution that indicates the most likely outcome -different from scenario analysis because the probability distribution of each uncertain cash flow variable must be specified

Political Risk

risk of expropriation (seizure) of a foreign subsidiaries asset by the host country or of unanticipated restrictions on the cash flows to the parent company

Corporate (within-firm) Risk

risk that does not take into consideration the effects of stockholders' diversification -measured by a project's effect on the firm's earnings variability -effect a project has on the total company's overall risk`

Project Required Rate of Return r(proj.)

risk-adjusted required rate of return for an individual project

Rate of return for a foreign project might be different from.....

that of an equivalent domestic project because foreign projects might be either riskier or less risky -higher risk could come from exchange rates and political risks

Cash flows relevant to the analysis of a foreign investment are.....

the cash flows that the subsidiary legally can send back to the parent

Relevant Cash Flows

the specific cash flows that should be considered in a capital budgeting decision

Depreciable Basis of an asset

total amount that can be depreciated during the asset's life -includes the purchase price and any additional expenditures required to make an asset operational (shipping and installation) -FULL cost of asset is used to determine annual depreciation expenses

Exchange Rate Risk

uncertainty associated with the price at which the currency from one country can be converted into the currency of another country -different values in different currencies -foreign currency cash flows that are to be turned over to the parent company must be converted into US dollars by translating them at EXPECTED future exchange rates

Cash flows associated with the new asset.....

will take the place of the cash flows associated with the old asset -must compute increase or decrease in cash flows that results from the replacement of the old asset with the new asset

Change in net working capital that results from the acceptance of a project is.....

an incremental cash flow that must be considered in capital budgeting analysis -also included as part of the initial investment outlay because the change occurs at the start of the project's life

Best-Case Scenario

analysis in which all of the input variables are set at their best reasonably forecasted values

Base (most likely) Case

analysis in which all of the input variables are set at their most likely values

Worst-case scenario

analysis in which all of the input variables are set at their worst reasonably forecasted value

Replacement Analysis

analysis involving the decision as to whether to replace an existing asset with a new asset

Pure Play Method

approach used for estimating the beta of a project in which a firm identifies companies whose only business is the one product in question (Pure Play Firms), determines the beta for each firm, then averages the betas to find an approximation of its own project's beta