Chapter 9 Connect (Exam 2)

Total number of inputs that change while doing sensitivity analysis?

1

Possibility that errors in projected cash flows will lead to incorrect decisions is known as:

estimation risk & forecasting risk

We underestimate NPV because of the options to

abandon and expand

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:

cannot be observed

Firms VC per unit estimate used in its base case analysis is $50 per unit and they anticipate the upper lower bounds to be +/- 10%, what is the "worst case" for VC per unit?

$55

In the context of capital budgeting, what does sensitivity analysis do?

It examines how sensitive a particular NPV calculation us to changes in underlying assumptions

Drawbacks of sensitivity analysis

May increase the false sense of security among managers if all pessimistic estimates of NPV are positive and it does not consider interaction among variables

Benefits of sensitivity analysis

Reduces a false sense of security by giving a range of values for NPV instead of a single value AND it identifies the variable that has the most effect on NPV

Scenario analysis vs sensitivity analysis

Scenario considers a combo of factors for each scenario while sensitivity focuses on only one variable at a time

Managerial options

The option to: abandon, wait, expand

True relative to capital rationing

hard rationing implies the firm is unable to raise funds for projects AND soft rationing is typically internal in that the firm allocates funds to divisions for capital projects

Reasons why NPV is considered a superior capital budgeting technique:

it properly chooses among mutually exclusive projects, considers time value of $, considers all cash flows, considers the riskiness of the project

The primary risk in estimation errors is the potential to

make incorrect capital budgeting decisions

When we estimate the bestcase, worst-case cash flows and calculate the corresponding NPVs, we are engaging in:

scenario analysis and asking what-if questions

A manager has estimated a positive NPV for a project. What could drive the result:

the cash flow estimates are inaccurate, project is a good estimate, overly optimistic management

Capital rationing exists when a company has identified positive NPV projects but can't (or won't) find:

the necessary financing

In a competitive market, positive NPV projects are:

uncommon

The basic approach to evaluating cash flow and NPV estimates involves asking

what-if questions