Finance 325 Chapter 11

Why might a financial manager be interested in the accounting break-even point?

Financial managers are often concerned with the contribution that a project will make to the firm's total accounting earnings. A project that does not break even in an accounting sense actually reduces total earnings. A project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense.

What is capital rationing? What types are there?

Firm or organizations limiting of new investment or restriction of new investment due to some budgetary decisions. > Soft rationing- The situation that occurs when in a business are allocated a certain amount of financing for capital budgeting. > Hard rationing- the situation that occurs when a business cannot raise financing for a capital budgeting.

What is forecasting risk? Why is it a concern for the financial manager?

Forecasting risk is the possibility that errors in projected cash flows will lead to incorrect decisions or it is the possibility that it will lead to bad decision because of errors in the projected cash flows. It is a concern for the financial manager because there is always a danger that Net Present Value would be positive which is not in reality.

How is operating leverage measured?

Operating leverage is measured by the percentage change in operating cash flow relative to the percentage change in quantity sold. It is calculated using the equation:- DOL=1+ FC/OCF Where: FC-fixed costs OCF-operating cash flow DOL- Degree of operating leverage

What is operating leverage?

Operating leverage is the degree to which a project or firm is committed to fixed production costs. In other words, the degree to which a firm or project relies on fixed costs. ( The ability to have low fix costs, so that you can afford to have higher variable cost.) Your fixed cost should be low , so you have a better operating leverage.

What are scenario, sensitivity, and simulation analysis?

Scenario-Process of analyzing future events, compared to our NPV figures. And often we look at both worst and best case scenarios in the project. Sensitivity- Looking at changing one particular variable to see how much its effects our outcome. Simulation- It is a combination of scenario and sensitivity analysis.

What is net income at the accounting break-even point? What about taxes?

The accounting break-even point is simply the sales level that results in a zero project net income. When net income is zero so are pretax income and of course, taxes, in accounting terms our revenues are equal to our costs, so there is no profit, which means there is no tax.

What are the implications of operating leverage for the financial manager?

The implications of operating leverage for the financial manager are:- >Higher the degrees of operating leverage the greater potential danger from forecasting risk. >Another is coping with highly uncertain projects are to keep the degree of operating leverage as low as possible.

What problems does capital rationing create for discounted cash flow analysis?

The problems capital rationing creates for discounted cash flow analysis are > Profitable projects cannot be funded. > NPV is not necessarily the appropriate criterion. > Bankruptcy is possibility.

What are some potential sources of value in a new project?

When a new project involves a new product under consideration some of the potential sources of value are (i) Low cost, (ii) Control over the market (iii) Identify undeveloped markets and (iv) Degree of competition