FIN 310 Ch. 9

sensitivity analysis answers...

"what if" questions

how to calculate relevant cash flows

(corporate CFs WITH the project) - (corporate CFs WITHOUT the project)

problems w/ scenario analysis

-considers only a few possible outcomes -assumes perfectly correlated inputs -focuses on stand-alone risk, although subjective adjustments can be made

sensitivity analysis weaknesses

-does not reflect diversification -says nothing about the likelihood of change in a variable -ignores relationships among variables

2 disadvantages of both sensitivity and scenario analysis

-neither provides a decision rule -ignores diversification

sensitivity analysis strengths

-provides indication of stand-alone risk -identifies dangerous variables -gives some breakeven info

If any, which of the following does NOT have the potential to increase the net present value of a proposed investment? A. The ability to immediately shut down a project should the project become unprofitable B. The ability to wait until the economy improves before making the investment C. The option to increase production beyond that initially projected D. All of the above have the potential to increase the NPV of a proposed investment

All of the above have the potential to increase the NPV of a proposed investment

Which of the following statements is TRUE? A. Opportunity costs are those values that have already been incurred, cannot be recouped, and should not be considered in an investment decision. B. Under hard capital rationing, a business enforces limits on investment budgets because it prefers not to raise financing from the capital markets. C. Managerial real options can be very valuable but difficult to measure, and ignoring them will underestimate a project's true Net Present Value. D. Forecasting risk is more troublesome when NPV estimates are particularly large.

Managerial real options can be very valuable but difficult to measure, and ignoring them will underestimate a project's true Net Present Value.

net salvage CF =

SP - ((SP - BV) x (T)) selling price - (selling price - book value) x (marginal tax rate)

Which of the following statements is FALSE? A. Sensitivity analysis helps determine the reasonable range of expectations for a project's outcome. B. The impacts of estimation errors and forecasting risks are small when NPVs are large and negative. C. Under intense competition, positive NPV projects are rare. D. The error of commission, or Type 1 error NPV estimation, is the risk that a project will be accepted when its true NPV is negative.

Sensitivity analysis helps determine the reasonable range of expectations for a project's outcome.

Which of the following should not be included in the analysis of a proposed investment? A. The current market value of an existing building to be used in the project. B. The amount paid 4 years ago for an existing building to be used in the project. C. The expected after-tax salvage value at the end of a project of an existing building to be used in the project. D. The net working capital balance remaining at the end of the project.

The amount paid 4 years ago for an existing building to be used in the project.

Which of the following statements is FALSE? A. Since errors of commission are often readily apparent, managers have a tendency to be cautious when evaluating new projects B. Errors of omission can result in lost potential value as much as errors of commission can destroy value. C. Type 1 errors occur when managers reject projects whose true NPVs are positive D. Errors in projected cash flows create large forecasting risks when their net present values are particularly small in magnitude.

Type 1 errors occur when managers reject projects whose true NPVs are positive

Which of the following statements is FALSE?? A. The impacts of estimation errors and forecasting risks are small when NPVs are large and positive. B. Under intense competition, positive NPV projects are as common as negative NPV projects. C. Scenario analysis helps determine the reasonable range of expectations for a project's outcome. D. Sensitivity analysis helps identify the variable within a project that presents the greatest forecasting risk.

Under intense competition, positive NPV projects are as common as negative NPV projects.

capital rationing occurs when...

a firm or division has limited resources

stand-alone principle

allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

hard rationing

capital will never be available for this project

sensitivity analysis shows how...

changes in an input variable affect NPV or IRR

pro forma financial statements project...

future operations

Sensitivity analysis: A. looks at the most reasonably optimistic and pessimistic results for a project. B. helps identify the variable within a project that presents the greatest forecasting risk. C. is generally conducted prior to scenario analysis just to determine if the range of potential outcomes is acceptable. D. illustrates how an increase in operating cash flow caused by changing both the revenue and the costs simultaneously will change the net present value for a project.

helps identify the variable within a project that presents the greatest forecasting risk.

relevant cash flows

include only CFs that will ONLY occur if the project is accepted

main focus of the relevant cash flows analysis

incremental cash flows

book value =

initial cost - accumulated depreciation

after-tax salvage =

salvage - T(salvage - book value)

the PI is a useful tool when faced w/...

soft rationing

If the salvage value is different from the book value of the asset, then there is a

tax effect

soft rationing

the limited resources are temporary