Chapter 9. Making Capital Investment Decisions

What is scenario analysis?

Determines the impact on NPV of a set of events relating to a specific scenario

OCF

EBIT + Depreciation - Taxes

Operating cash flow is a function of?

EBIT, Dep, Taxes

what is the difference between scenario analysis and sensitivity analysis?

scenario analysis considers a combo of factors for each scenario, while senstivity analysis focuses on only one variable at a time.

Suppose a project's operating cash flow is $150. The firm anticipates a $30 investment in net working capital and $80 in capital spending. What is the projects' cash flow?

$40 = $150-$30-$80

What is the deprecation tax shield if EBIT is $600, deprication is $1,800, and the tax rate is 30%?

$540 = 1,800 x .3

If a firm's variable cost per unit estimate used in its base case analysis is $50 per unit and they anticipate the upper and lower bounds to be +/- 10%, what is the "worst case" for variable cost per unit?

(1.10) * 50 = $55; the worse case for costs is the higher value

Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?

- there will be a tax savings if BV exceeds sales price - taxes are based on the diference between the bv and the sales price - BV= purchase price - accumulated dep

What are the two main benefits of performing sensitivity analysis?

-It reduces a false sense of security by giving a range of values for NPV instead of a single value. -It identifies the variable that has the most effect on NPV.

Side effects from investing in a project refer to cash flows from:

-beneficial spillover effects -eroson effects

Investment in net working capital arises when ____.

-cash is kept for unexpected expeduitures -credit sales are made -inv is purchased

On option on areal asset rather than a financial asset is known as?

-managerial option -real option

If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be

100% reversed

Project cash flow

= Project operating cash flow− Project change in net working capital− Project capital spending

Which of the following correctly describes the relationship between depreication, income, taxes, and investment cash flows?

As depreciation expense increases, net income and taxes will decrease, while investment cash flows will increase.

Capitol Rationing

Capital rationing is said to exist when we have profitable (positive NPV) investments available but we can't get the needed funds to undertake them.

Which of the following are considered relevant cash flows?

Cash flows from opportunity costs Cash flows from beneficial spillover effects Cash flows from erosion effects

opportunity cost

Cost of the next best alternative use of money, time, or resources when one choice is made rather than another Relevant

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

IRR, Payback period, NPV

Traditional NPV analysis

In our capital budgeting analysis thus far, we have more or less ignored the possibility of future managerial actions. Implicitly, we have assumed that once a project is launched, its basic features cannot be changed. For this reason, we say that our analysis is static (as opposed to dynamic).

The stand-alone principle assumes that evaluation of a project may be based on the project's ____cash flows.

Incremental cash flows

the difference between a firm's cash flows with a project versus without the project is called _____.

Incremental cash flows

ignored

Interest expenses incurred on debt financing are _____ when computing cash flows from a project.

What is a drawback of traditional NPV analysis?

It ignores managerial options ( abandon, expand, to wait) in investment decisions

What are the two main drawbacks of sensitivity analysis?

It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive. It does not consider interaction among variables.

Accounts receivable and accounts payable are included in project cash flows estimation as part of changes in?

NWC

The tax shield definition of OCF is:

OCF=(Sales − Costs) × (1 − Tc) + Depreciation × Tc where Tc is the corporate tax rate. Assuming that Tc = 34%, the OCF works out to be: OCF= ($200,000 − 137,000).66 +( 30,000 × .34)=$51,780

This is called the stand-alone principle.

Once we identify the effect of undertaking the proposed project on the firm's cash flows, we need only focus on the project's resulting incremental cash flows. (relevant)

One of the most important steps in estimating cash flows is to determine the _____ cash flows.

Relevant The first (and most important) step, therefore, is to decide which cash flows are relevant and which are not.

To investigate the impact on NPV of a change in one variable, you would employ?

Sensitivity analysis

When using ______ , all of the variables except one are frozen in order to determine how sensitive the NPV estitnate is to chnages in that paerticular variable.

Sensitivity analysis

Scenario Analysis

The basic form of what-if analysis is called scenario analysis. What we do is investigate the changes in our NPV estimates that result from asking questions like: "What if unit sales realistically should be projected at 5,500 units instead of 6,000?"

Net Working Capital

The difference between a firm's current assets and its current liabilites

Incremental cash flows

The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project.

Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?

The true operating cash flows from net sales for the life of a project.

Proforma financial statements

To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required, including any investment in net working capital.

In order to analyze the risk of a project's NPV estimate, we should establish ___ for each important estimate variable.

Upper and Lower bounds

Net Working Capital

Will be recovered at the end of the project

Eroson

Will reduce the sales of existing projects

The primary risk in estimation errors is the potential to?

make incorrect capital budgeting decisions

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

necessary financing

Sunk costs

previous cash outflows not relevant to the project decision.

managerial options

the option to Expand, to Abandon, to wait

In a competitive market, positive NPV projects are:

uncommon It is a basic principle of economics that positive NPV investments will be rare in a highly competitive environment. Therefore, proposals that appear to show significant value in the face of stiff competition are particularly troublesome, and the likely reaction of the competition to any innovations must be closely examined.

If a firm sells a fixed asset

Finally, we have to account for the long-term capital invested in the project. In this case, we invest $800,000 at Year 0. By assumption, this equipment will be worth $160,000 at the end of the project. It will have a book value of zero at that time. As we discussed above, this $160,000 excess of market value over book value is taxable, so the aftertax proceeds will be $160,000 × (1 − .34) = $105,600.

We underestimate NPV because of the option(s) to _____________.

abandon expand

Cash flows should always be considered on a(n) _______________ basis.

after-tax

Fixed Assets

assets that are relatively permanent, such as land, buildings, and equipment rent on production facility, cost of equip

Sunk costs

costs that are made in the past and cannot be recovered have already occurred and are not affected by accepting or rejecting a project