Finance Final Exam 2303

What are real options?

" " to distinguish them from financial options like an option to purchase shares of Boeing stock, " " because they offer the right but not the obligation to take the future action to increase cash flows.

what is an opportunity cost?

the loss of potential gain from other alternatives when one alternative is chosen.

What are the several types of real options?

1. Abandonment 2. Timing 3. Expansion 4. Output Flexibility 5. Input Flexibility

How many types of real options are there ?

5

Which of the following is not a relevant cash flow when conducting capital budgeting ?

A (sunk cost) has already been incurred therefore whether or not you accept or reject a project, this cost wont change and therefore is not relevant

A company has a WACC of 8% for its average asset. Assets for the company represent a wide range of risks. Low risks projects have a WACC of 4%. Average risk projects have WACC of 8%. Higher risk projects have WACC 14%. The company would accept which project?

A higher risk project with an expected with an expected return of 15% You only accept projects with expected return > WACC.

what three techniques are used to assess stand alone risk?

A. Sensitivity Analysis B. Scenario Analysis C. Monte Carlo Situation

What are externalities?

ARE defined as the effects on a project on other parts of the firm or the environment. The three types are- Negative within Firm, Positive within firm and Environmental.

Which of the following would not create an incremental cash flow and therefore SHOULD NOT be included in Capital Budgeting for deciding whether or not to accept/reject a project?

Apple spent 120,000 on research and development of a recent product and whether or not the company approves or denies the project, the cost will not recovered. (this is a sunk cost)

Negative within-firm externalities

Cannibalization: the situation when a new project reduces cash flows that the firm would have otherwise had

What two types of projects can be distinguished?

Expansion projects and Replacement Projects

What is abandonment?

Is where the project can be shut down if its cash flows are low.

If a company uses the bonus depreciation method, that company can write off assets slower than they could under straight line depreciation and as a result, the NPV of the project will be lower than if the company used straight line depreciation? (True or False)?

False, Bonus D is 100% of the asset today, where as straight line you dont get to dispense anything today, you get to dispense the asset equally over 1 year through the end of the project. Therefore Bonus Increases NPV because savings at tax occur at the Beginning

The change in Net Operating working Capital is always Positive?(True or False)

False, The cash affect From (NOWC) Net Operating Working Capital is always equal and opposite. So if NOWC increases, then cash decreases.

Cash flows such as investment in buildings, equipment and working capital needed for project are obviously __________________________, as sales revenues and operating costs associated with this project.

Incremental Cash Flows

Which of the following are true regarding bonus depreciation?

It is the spreading out of an asset over time. Therefore no matter what method you use, the cash impact over the total cash flows (all of them) is always the same. depending on which method you use the timing of that depreciation impacts your cash flow.

Which type of risk is most relevant ?

Market risk is the most relevant risk for capital projects, because management's primary goal is shareholder wealth maximization.

Real options are valuable, but this value is not captured by conventional __________________________________. THEREFORE, a projects real options must be considered separately.( fill in the blank)

NPV analysis

is a sunk cost an incremental cost?

Negative

Positive Within-Firm Externalities

New project is complementary to old one and the cash flows increase

Suppose Home Depot spent 2 million to investigate a potential new store and obtain permits to build it. That 2 million would be a __________ _________ - the money is gone , and it wont come back whether or not the new store is built.

Sunk Cost

why should sunk costs not be included in a capital budgeting analysis?

Sunk cost is cash outlay (cash outflows) and it cannot be received in future whether the project is accepted or rejected. Sunk costs are not incremental costs and they are not relevant in the capital budgeting analysis why? because these sunk costs have no effect on future cash flows.

Because sunk costs were incurred in the past and cannot be recovered regardless of whether the is accepted and rejected, they are not relevant in the capital budgeting analysis?(True or False)?

TRUE

However, capital budgeting projects are not passive investments—managers can often take positive actions after the investment has been made that alter the cash flow stream.(True or False)?

TRUE

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 other are left at at their base case scenarios? (True or False)?

TRUE

It is very difficult, if not impossible, to quantitatively measure projects within-firm and beta risks ? (True or False)?

TRUE

Not handling sunk costs properly can lead to incorrect decisions?(True or False)

TRUE

Once we find the incremental cash flows, we use them in a "regular" NPV analysis to decide whether to replace the asset or to continue using it? (True or False)?

TRUE

if a project is negatively correlated with returns on most stocks, it might reduce the firm's beta and thus be correctly evaluated with a relatively low WACC. So in theory, we should be more concerned with within-firm and beta risk than with stand-alone risk.

TRUE

Replacement Projects

The firm replaces existing assets generally to reduce costs

a company that uses NPV Or IRR to determine the attractiveness of a project will be more likely to accept a project if it immediately expenses depreciation rather than using straightline depreciation?(True or False)

True, you are using 100% Bonus depreciation, you get a large tax benefit Today (at time 0) because you get to expense 100% of the cost of the asset today.

Which of the following would increase the NPV of a project?

When a company decides to use Bonus Depreciation over straight line depreciation. Reason being is that you get a major tax benefit today(tax savings treated as an inflow) therefore it increases the NPV or the value of the property today.

What is a sunk cost?

a cost that has already been committed and cannot be recovered, Regardless of whether the project under consideration is accepted.

What is cannibalization?

a situation that occurs when sales of a new product cut into sales of a firm's existing products

best-case scenario

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

worst-case scenario

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

What are incremental cash flows?

are the flows that will occur if and only some specific event occurs. In Capital Budgeting, the event is the firms acceptance of a project and the projects cash flows are ones that occur as a result of this decision.

Explain why net operating working capital is included in a capital budgeting analysis and how it is recovered at the end of a project's life.

is the difference current assets and current liabilities. It is the additional ( or separate) investment in capital budgeting analysis. It will be recoup at the end of the projects life.

What does a Scenario Analysis do?

it allows us to change more than one variable at a time, and it incorporates the probablities of changes in key variables.

What is Sensitivity Analysis ?

measure the percentage change in NPV that results from the a given percentage change in an input, other variables held at their expected values. most commonly used type of risk analysis, and it is used by most firms. begins with base case scenario

In capital budgeting you should ignore which of the following ?

remember, Ignore interest in your capital budgeting analysis when finding your cash flows. Interest is only factored in via WACC (as I/YR in your calculator), so do not subtract it from your earnings before interest and taxes.

What is Monte Carlo Situation?

sophisticated version of a scenario analysis analyzed under a large number of scenarios or runs. is more complex than scenario analysis, but it is made manageable by software

environmental externalitites

this is the most common type of negative externality is a projects impact on______ Government rules and regulations constrain what companies can do, but firms have some flexibility in dealing with the environment.

Why should companies use a projects free cash flow rather than accounting income when determining a projects NPV?

to see if the return on the cash invested in one project is better than the return on cash invested in one project is better than the return on cash invested in another project , while income is determined by many other variables that have nothing to do with cash.

what is Timing?

where a project can be delayed until; more information about demand and or costs can be obtained.

What is an Expansion Project?

where the firm makes an investment, such as new Home Depot Store.

What Is 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.

what is output flexibility?

where the output can be changed if market conditions change

what is expansion?

where the project can be expanded if the demand turns out to be stronger than expected.

stand alone risk

which is a products risk assuming: a. that is the only asset the firm has and B. that the firm is the only stock in each investors portfolio. this risk is measured by the variability of the projects expected return. Diversification is totally ignored.

Corporate, or within-firm, risk

which is the project risk to the corporation as opposed to its investors. this risk takes account the fact that the project is only one asset in the firms portfolio of assets: hence some of the risk will be eliminated by diversification within the firm. This type of risk is measured by the projects impact on the uncertainty about the firms future returns.

Market, or beta, risk

which is the riskiness of the project as seen by well diversified stockholder who recognizes A. that the project is only one of the firms assets and B. that the firms stock is but one part of his or her stock portfolio the projects risk is measured by its effect on the firms beta coefficient.

what is base case scenario?

which uses the most likely set of input values.