Chapter 12 Finance
sunk cost
A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.
positive within-firm
A cell phone company recently gave customers the ability to buy applications that they can download to their cell phones Allowing customers to use these applications increased cell phone sales. This is an example ofa externality.
NPVs; capital budgeting
A failure to handle conceptual issues in cash flow estimation can lead to calculating incorrect project ____, which will lead to bad ____ ____ decisions.
comparing actual results with those predicted by the project's sponsors and explaining why any differences occurred
A final aspect of the capital budgeting process is the post-audit, which involves
scenario anaylsis
A risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case situation
scenario analysis
A risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation.
monte carlo simulation
A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes.
Yes, because the firm could sell the warehouse if it didn't use it for the new project.
Alexander Industries owns a warehouse that it is not currently using. It could sell the warehouse for $300,000 or use the warehouse in a new project. Should Alexander Industries include the value of the warehouse as part of the initial investment in the new project?
best-case scenario
An analysis in which all of the input variables are set at their best reasonably forecasted values.
base-case scenario
An analysis in which all of the input variables are set at their most likely values.
worst-case scenario
An analysis in which all of the input variables are set at their worst reasonably forecasted values.
sunk cost
An outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted is known as
incremental cash flows
Cash flows that will occur if and only if the firm takes on a project
expand
Clemens Inc. is considering a $100 million investment in a new line of soft drinks. However, $100 million is a huge investment for Clemens; if things turn bad, it could wipe out the company. A few senior managers have suggested a smaller investment of $20 million to see if the market is as strong as they hope it is. If demand is strong and the opportunity is still available, Clemens will increase its investment at a later date. This example describes a real option to
market, or beta, risk
Considers both firm and stockholder diversification. It is measured by the project's beta coefficient.
passive; increase; increase; decrease
DCF analysis doesn't always lead to proper capital budgeting decisions because capital budgeting projects are not investments like stocks and bonds. Managers can often take positive actions after the investment has been made to alter a project's cash flows. These opportunities are real options that offer the right but not the obligation to take some future action. Types of real options include abandonment, investment timing, expansion, output flexibility, and input flexibility. The existence of options can projects' expected profitability, their calculated NPVs, and their risk.
passive
DCF techniques were originally developed to value securities such as stocks and bonds. These are ______ investments - once the investment has been made, most investors can take no actions that influence the cash flows they produce.
increase
When a firm a exhausts its retained earnings and must raise capital from external sources, its weighted average cost of capital (WACC) will
stand-alone risk
When dealing with , diversification is totally ignored.
timing
Which type of real option allows a firm to postpone a project until it can gather more information?
market
_____ risk is theoretically the most relevant of the three because it is the one reflected in stock prices
real option
creates value for a company because it gives the company the right but not the obligation to take future action to increase its cash flows
externalities
Effects on the firm or the environment that are not reflected in the project's cash flows.
subjectively
How do managers typically deal with within-firm risk and beta risk when they are evaluating a potential project?
lower its risk, increase its expected profitability, and raise it calculated NPV
If the firm has the option to abandon a project during its operating life, this abandonment option can:
read
In estimating its optimal capital budget, we assumed that DDI can obtain financing for all of its profitable projects. This assumption is reasonable for large, mature firms with good track records. However, smaller firms, new firms, and firms with dubious track records may have difficulties raising capital, even for projects that the firm concludes would have highly positive NPVs.
The development of a $500 million satellite communications system
Monte Carlo simulation example
NPV
Rational expansion decisions require detailed assessments of the forecasted cash flows, along with a measure of the risk that forecasted sales might not be realized. That information can then be used to determine the risk-adjusted ____ associated with each potential project
read
Note that the base-case results are the same in our sensitivity and scenario analyses, but in the scenario analysis, the worst case is much worse than in the sensitivity analysis and the best case is much better. In scenario analysis, all of the variables are set at their best or worst values, while in sensitivity analysis, only one variable is adjusted, and all the others are left at their base-case values.
read
Note too that it might be necessary for the firm to arrange things so that it has the possibility of abandonment when it is making the initial decision about a project. This might require contractual arrangements with suppliers, customers, and its union, and there might be some costs to obtaining these advance permissions. Any such costs could be compared with the value of the option as we calculated it, and this could enter into the initial decision.
read
Opportunities for such actions are called real options—"real" to distinguish them from financial options like an option to purchase shares of Boeing stock, and "options" because they offer the right but not the obligation to take the future action to increase cash flows. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.
True
Opportunity costs should be included in the capital budgeting analysis.
read
Our conclusions regarding risk analysis are as follows: It is very difficult, if not impossible, to quantitatively measure projects' within-firm and beta risks. Most projects' returns are positively correlated with returns on the firm's other assets and with returns on the stock market. This being the case, because stand-alone risk is correlated with within-firm and market risk, not much is lost by focusing just on stand-alone risk. Experienced managers make many judgmental assessments, including those related to risk, and they work them into the capital budgeting process. Introductory students like neat, precise answers, and they want to make decisions on the basis of calculated NPVs. Experienced managers consider quantitative NPVs, but they also bring subjective judgment into the decision process. If a firm does not use the types of analyses covered in this book, it will have trouble. On the other hand, if a firm tries to quantify everything and let a computer make its decisions, it too will have trouble. Good managers understand and use the theory of finance, but they apply it with judgment.
sensitivity analysis
Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant.
market; corporate; stand-alone
Risk analysis focuses on three issues. (1) The effect of a project on the firm's beta coefficient is known as risk. (2) The project's effect on the probability of bankruptcy is known as risk. (3) The risk of the project independent of both the firm's other projects and investors' diversification is known as risk.
Corporate, or within-firm, risk
Risk considering the firm's diversification, but not stockholder diversification. It is measured by a project's effect on uncertainty about the firm's expected future returns.
sunk costs were incurred in the past and cannot be recovered regardless of whether the project is accepted or rejected
Sunk costs are not relevant in the capital budgeting analysis because
False
T or F: Decision tree analysis is more commonly used in valuing securities than real assets.
opportunity costs
The best return that could be earned on assets the firm already owns if those assets are not used for the new project.
terminal cash flow
The cash flow at the end of the life of the project
risk-adjusted cost of capital
The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital.
cash flow; incremental cash flows; inflation
The most critical step in capital budgeting analysis is ____ ____ estimation. The key is to focus on only ___ ___ ___ . Factors that complicate the analysis are sunk costs, opportunity costs, externalities, changes in net operating working capital, and salvage values. Adjustments to the analysis must be made for ________ . We concentrate on expansion project analyses here but there are similarities when analyzing replacement projects.
stand-alone risk
The risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns.
cannibalization
The situation when a new project reduces cash flows that the firm would otherwise have had.
abandonment, timing, expansion, output flexibility, input flexibility
There are several types of real options, including
costs
Therefore, it is critical that the company perform a financial analysis to determine whether a potential store's expected cash flows will cover its _____
complementary
a new project also can be ____ to an old one, in which case cash flows in the old operation will be increased when the new one is introduced
sensitivity analysis
a risk analysis technique that measures changes in the IRR and NPV as individual variables are changed
cannibalization
an example of externality that can have a negative effect on a firm
The NPV when sales and other input variables are set equal to their most likely (or base-case) values.
base-case npv
higher
because of the time value of money, dollars received earlier have a _____ present value than dollars received later
incremental
cash flows such as investments in buildings, equipment, and working capital needed for the project are obviously _____, as are sales revenues and operating costs associated with the project
required
companies have an incentive to do things to protect the environment even though those actions are not
midyear
for projects with highly predictable cash flows, it might be useful to assume that cash flows occur at
differentials
for replacement projects, we must find cash flow _____ between the new and old projects, and these differentials are the incremental cash flows that we analyze
uncertainty, failure, separating operating results, responsibility
four disadvantages of the post-audit
flexibility
government rules and regulations constrain what companies can do, but firms have some _____ in dealing with the environment
bankrupt
if the bad conditions materialize, the company will not go ___ - this is just one project for a large company
high
if the project has high stand-alone risk and if its returns are highly correlated with returns on the firm's other assets and with returns on most other stocks in the economy, the project will have a ___ degree of all three types of risk
high; negative
if the project is highly successful, the combination of high sales price, low production costs, and high unit sales will result in a very ___ NPV. However, if things turn out badly, the NPV will be a ______
riskier; risk
if we were comparing two projects, the one with the steeper sensitivity lines would be ____, other things held constant, because relatively small changes in the input variables would produce large changes in the NPV. thus, sensitivity analysis provides useful insights into a project's _____
future
in capital budgeting, we are concerned with ______ incremental cash flows- we want to know if the new investment will produce enough incremental cash flow to justify the incremental investment
capacity; operating costs
in some instances, replacements add ____ as well as lower ____ ____
negative
in some respects, we can think of the sale of fixed assets at the end of the project as a ______ capital expenditure - instead of using cash to purchase fixed assets, the company is selling the assets to generate cash
estimated; uncertainty; uncertain
in the real world, cash flows are not just handed to you -rather, they must be ____ based on information from various sources. Moreover, ____ surrounds the forecasted cash flows, and some projects are more _____ and thus riskier than others.
better
in theory, capital budgeting analyses should deal with cash flows exactly when they occur; therefore, daily cash flows theoretically would be ____ than annual flows
cost
lost cash flows should be taken into account, and that means charging them as a ____ when analyzing the proposed new store
subjective; simulation; statistics
managers deal with risk in many different ways, ranging from almost totally ______ adjustments to highly sophisticated analyses that involve computer _____ and complex ______
new projects don't have market prices that can be related to stock market returns
market risk is also the most difficult to estimate, primarily because
Quantitative; qualitative
most decision makers do a _____ analysis of stand-alone risk and then consider the other two risk measures in a ____ manner
incorrect decisions
not handling sunk costs properly can lead to ____ _____
fixed assets; inventory; cash
once the project is completed, the company sells the project's ___ ____ and ____ and receives ____
regular
once we have found the incremental cash flows, we use them in "____" NPV analysis to decide whether to replace the asset or to continue using it
market; stand-alone; higher
risk is theoretically the most relevant of the three types of risk but it is the most difficult to estimate. Therefore, most decision makers quantitatively analyze stand-alone risk and qualitatively assess the other two risk measures. Techniques for measuring risk include sensitivity analysis, scenario analysis, and Monte Carlo simulation. The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the project's risk, the its cost of capital.
it allows us to change more than one variable at a time, and it incorporates the probabilities of changes in the key variables
scenario analysis allows for these extensions -
negative; less
taxes paid would be ____ (i.e., the firm would receive a tax credit) if the company sold the asset for ____ than its book value
exceeds
the company will also have to pay taxes if the asset's salvage value _____ its book value
differs
the expected NPV ____ from the base-case NPV
operating cash flows
the first bracketed term in the free cash flow equation [EBIT(1-T) + Dep. and amor] represents the project's
steeper: more
the larger the range, the ____ the variable's slope and the _____ sensitive the NPV is to changes in this variable.
sales projections, costs, taxes, depreciation
the marketing department may provide ___ _____, the company's engineers may estimate ____, and the accounting staff may provide information about _____ and ______
improve forecasts and improve operations
the post-audit has two main purposes
salvage value
the price that the company receives for a fixed asset at the end of the project is often referred to as its
stand-alone risk
the risk of a project without factoring in the impact of diversification
capital rationing
the size of the capital may be constrained, a situation called
subjective; justify
these adjustments are highly _____ and difficult to ____
stand-alone risk, corporate, or within-firm risk, and market, or beta risk
three separate and distinct types of risk
sensitivity analysis, scenario analysis, monte carlo simulation
three techniques are used to assess stand-alone risk
negative within-firm, positive within-firm, environmental
three types of externalities
historical data
to measure diversification's effects on risk, we need the correlation coefficient between a project's returns and returns on the firm's other assets, which requires _____ ____ that obviously do not exist for new projects
expansion; replacement
two types of projects can be distinguished: ____ projects, where the firm makes and investment, such as new Home Depot store, and _____ projects, where the firm replaces existing assets, generally to reduce costs
NPV; IRR
variables other than depreciation also could be varied and these changes would alter the calculated cash flows and thus the ___ and ___
equipment; WACC
we see that NPV is very sensitive to changes in the sales prices, fairly sensitive to changes in variable costs, a bit less sensitive to units sold and fixed costs, but not very sensitive to changes in the _____ cost or the ____
depreciation
what matters is the ____ rate that the firm's accountants use for tax purposes
timing
where a project can be delayed until more information about demand and/or costs can be obtained;
input flexibility
where the inputs used in the production process (say, coal versus natural gas for generating electricity) can be changed if input prices and/or availability change.
output flexibility
where the output can be changed if market conditions change; and
expansion
where the project can be expanded if demand turns out to be stronger than expected;
abandonment
where the project can be shut down if its cash flows are low;
business environment; judgment
while it is essential to understand the theory of finance, it is equally important to understand the ____ _____, including how competitors are likely to react to a firm's actions. a great deal of ____ goes into making good financial decisions
