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.