Finance Final Exam Chapter 11

Scenario analysis

the determination of what happens to NPV estimates when we ask what-if questions.

Hard rationing

the situation that occurs when a business cannot raise financing for a project under any circumstances. DCF analysis breaks down because companies will not take a project that exceeds the required return. Occurs when a company experiences financial distress or bankruptcy.

Sensitivity analysis

investigation of what happens to NPV when only one variable is changed. A variation on scenario analysis that is useful in pinpointing the areas when forecasting risk is especially severe. Freeze all of the variables except for one and then see how sensitive our estimate of NPV is to changes in that variable. (Ex: changed only fixed costs)

Base case

our estimated NPV based on our projected cash flows.

Forecasting risk

the possibility that errors in projected cash flows will lead to incorrect decisions. Also known as elimination risk.

Capital rationing

the situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

base, worse, best

What cases need to be calculated?

garbage in, garbage out

If projections of future cash flows are in error, it is called a GIGO, meaning "______________________, _____________________".

Soft rationing and hard rationing

What are the different types of capital rationing?

Simulation analysis

a combination of scenario and sensitivity analysis. Limited in practice, but computer software will likely make it more common in the future.

soft rationing

the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. The corporation isn't short of capital and management can raise money if needed. Companies must 1) try to get a larger allocation or 2) generate as large of an NPV as possible using PI.