Test 2 Concept Questions

Sensitivity Analysis

investigation of what happens to NPV when only one variable is changed

10.1a What are the relevant incremental cash flows for project evaluation?

Any and all changes in the firm's future cash flows that are a direct consequence of taking the project.

14.1a What is the primary determinant of the cost of capital for an investment?

Cost of capital depends primarily on the use of the funds, not the source.

11.6b What problems does capital rationing create for discounted cash flow analysis?

DCF analysis breaks down.

14.2b What are two approaches to estimating the cost of equity capital?

Dividend growth model approach, and SML/CAPM approach

10.2b Explain what erosion is and why it is relevant.

Erosion is the cash flows of a new project that come at the expense of a firm's existing projects.

11.1a 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.

14.4b Why do we multiply the cost of debt by (1 - Tc) when we compute the WACC?

Interest on debt is tax deductible and needs to be removed from WACC calculation to account only for the after tax cost of debt.

11.2b What are the drawbacks to the various types of what-if analysis?

Misleading, absurdly unlikely, incredibly remote possibility of total disaster

9.7a What are the most commonly used capital budgeting procedures?

Profitability index, NPV, IRR, payback period, accounting rate of return

10.3a What is the definition of project operating cash flow? How does this differ from net income?

Project Operating Cash Flow is defined as the operating cash flow required for the day to day operation of the project. Project operating cash flow = Project cash flow + Project change in net working capital + Project capital spending

10.1b What is the stand-alone principal?

The assumption that evaluation of a project may be based on the project's incremental cash flows.

14.3b How can the cost of debt be calculated?

The cost of debt can be calculated by observing the current interest rate the firm must pay on new borrowing or the interest rate on similarly rated bonds.

14.3a Why is the coupon rate a bad estimate of a firm's cost of debt?

The coupon rate measures what the firm's initial cost of debt is. It does not estimate the current cost or yield.

10.3b For the shark attractant project, why did we add back the firm's net working capital investment in the final year?

The firm's fixed assets will be worthless at the end of the project's life, but the firm will recover the $20,000 that was tied up in working capital.

14.2a What do we mean when we say that a corporation's cost of equity capital is 16 percent?

The investors require at least 16% return on their investment in the firm.

Capitol Rationing

The situation that exists if a firm has positive NPV projects but cannot obtain the necessary financing

14.1b What is the relationship between the required return on an investment and the cost of capital associated with that investment?

They are more or less interchangeable because they mean the same thing.

9.7b If NPV is conceptually the best procedure for capital budgeting, why don't you think multiple measures are used in practice?

To measure what aspect it lacks in

10.2c Explain why interest paid is not a relevant cash flow for project evaluation.

We are only interested in cash flows generated by the assets of the project.

14.4c Under what conditions is it correct to use the WACC to determine NPV?

We use WACC to determine NPV when an investment isn't as typically risky as other investments by the company.

Simulation Analysis

a combination of scenario and sensitivity analysis

9.2a Payback Rule

an investment is acceptable if its calculated payback period is less than some prespecified number of years

9.2a Payback Period

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

Scenario Analysis

the determination of what happens to NPV estimates when we ask what-if questions (best/worst case).

Hard Rationing

the situation that occurs when a business cannot raise financing for a project under any circumstances

Soft Rationing

the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting