finace 3 quiz
Negative side effects to sunk and opportunity cost
- costs to other projects
disadvantages of payback
-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -biased against long term projects, such as research and development, and new projects
IRR
-most important alternative to NPV -widely used in practice -intuitively appealing -independent of interest rates
IRR Decision Rule:
Accept the project if the IRR is greater than the required return
Scenario Analysis cases
Best case - high revenues, low costs Worst case - low revenues, high costs Base case - most likely event
IRR - Disadvantages
Can produce multiple answers Cannot rank mutually exclusive projects
Analysis of potential projects
Capital Budgeting
Determines firm's strategic direction
Capital Budgeting
Difficult/impossible to reverse
Capital Budgeting
Large expenditures
Capital Budgeting
Long-term decisions
Capital Budgeting
NWC effect from sunk and opportunity cost
Changes in net working capital
Straight-line method
D = (Initial cost - salvage) / number of years Very few assets are depreciated straight-line for tax purposes
advantages of payback
Easy to understand Biased towards liquidity
Why do we have to consider changes in NWC separately?
GAAP requires that sales be recorded on the income statement when made, not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet Finally, we have to buy inventory to support sales, although we haven't collected cash yet
most important diadvantage of PAYBACK
IGNORES CASH FLOWS BEYON CUTOFF DATE
What does MACRS stand for?
Modified Accelerated Cost Recovery System
Rationale for the NPV Method
NPV = PV inflows - Cost
Conflicts Between NPV and IRR
NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, always use NPV
what happens to NPV if rate of return decreases
NPV increases
MACRS
Need to know which asset class is appropriate for tax purposes Multiply percentage given in table by the initial cost Depreciate to zero
IRR is unreliable in the following situations
Non-conventional cash flows Mutually exclusive projects
When considering Net Working Capital, a project will generally need all of the following, except:
Only long-term assets to get the project started.
advantages of IRR
Preferred by executives Intuitively appealing Easy to communicate the value of a project Considers all cash flows Considers time value of money
Profitablity Index
Present value of Cash flows (after initial investment)/ Initial Investment.
Based upon the following graph; sensitivity analysis, which variable should Simmons Corporation be most concerned about?
Price
2 things a positive npv does to a firm
Project is expected to add value to the firm Will increase the wealth of the owners
NPV=0 means
Project's inflows are "exactly sufficient to repay the invested capital and provide the required rate of return"
An analysis of the change in a project's NPV when a single variable is changed is called _____ analysis.
Sensitivity
The subset of scenario analysis where we are looking fat the effect of specific variables on NPV
Sensitivity
Which type of analysis identifies the variable, or variables, that are most critical to the success of a particular project?
Sensitivity
what type of analysis is monte carlo
Simulation
When reviewing a graph of data from sensitivity analysis, the ____________ the line, the ____________ the sensitivity of the estimated Net Present Value.
Steeper, greater.
Computing Depreciation - 2 methods
Straight-line method MACRS (modified accelerated cost recovery system) method
Mutually Exclusive
The acceptance of one project precludes accepting the other.
Independent
The cash flows of one project are unaffected by the acceptance of the other.
incremental cash flows
The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted
Which one of the following will be used in the computation of the best-case analysis of a proposed project?
The lowest variable cost per unit that can reasonably be expected
True or False: If a substantial percentage of the scenarios look bad, the degree of forecasting risk is high and further investigation is in order.
True
Fixed costs:
are constant over the short-run regardless of the quantity of output produced.
positive side effects to sunk and opportunity cost
benefits to other projects
opportunity cost
costs of lost options
Sunk costs
costs that have accrued in the past
Sensitivity analysis determines the:
degree to which the net present value reacts to changes in a single variable.
The main focus of sensitivity analysis is to:
determine the one variable that has the highest level of risk.
IRR Definition
discount rate that makes the NPV = 0
Financing costs regarding sunk and opportunity cost
don't include interest as its already factored in discount rate Taxes
It is recommended that at a minimum, we might want to investigate _________ scenarios in all, including the base case.
five
Best case
high revenues, low costs
To get the worst case scenario, we assign the least favorable value to each item. This means to assign low values for items like units sold and price per unit and:
high values for costs.
NPV is a direct measurement of
how well this project will meet the goal of increasing shareholder wealth.
Forecasting risk is defined as the possibility that:
incorrect decisions will be made due to erroneous cash flow projections.
The base case values used in scenario analysis are the values considered to be the most:
likely to occur.
Worst case
low revenues, high costs
Base case
most likely event
NPV= what for shareholder
net gain in shareholder wealth
Depreciation
non-cash expense; consequently, it is only relevant because it affects taxes
Combining scenario analysis with sensitivity analysis can yield a crude form of _____ analysis.
simulation
what happens when salvage value differs from book value of the asset
there is a tax effect - company must pay tax on the gain
Variable costs can be defined as the costs that:
vary directly with sales.
When you assign the lowest anticipated sales price and the highest anticipated costs to a project, you are analyzing the project under the condition known as:
worst-case scenario analysis.