chapter 11

Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included.

Capital budgeting analysis should only include those cash flows which will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis.

Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the analysis? If we do not, will this bias our results? If it does, would the NPV be biased up or down? Explain.

Daily cash flows would be theoretically best, but they would be costly to estimate and probably no more accurate than annual estimates because we simply cannot forecast accurately at a daily level. Therefore, in most cases we simply assume that all cash flows occur at the end of the year. However, for some projects it might be useful to assume that cash flows occur at mid-year, or even quarterly or monthly. There is no clear upward or downward bias on NPV since both revenues and costs are being recognized at the end of the year. Unless revenues and costs are distributed radically different throughout the year, there should be no bias.

What are some differences in the analysis for a replacement project versus that for a new expansion project?

In replacement projects, the benefits are generally cost savings, although the new machinery may also permit additional output. The data for replacement analysis are generally easier to obtain than for new products, but the analysis itself is somewhat more complicated because almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers. Similarly, differences in depreciation and any other factor that affects cash flows must also be determined.

In theory, market risk should be the only "relevant" risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk?

It is often difficult to quantify market risk. On the other hand, we can usually get a good idea of a project's stand-alone risk, and that risk is normally correlated with market risk: The higher the stand-alone risk, the higher the market risk is likely to be. Therefore, firms tend to focus on stand-alone risk, then deal with corporate and market risk by making subjective, judgmental modifications to the calculated stand-alone risk.

is a risk analysis technique in which a computer is used to simulate probable future events and thus to estimate the profitability and risk of a project.

Monte Carlo simulation analysis

Operating cash flows, rather than accounting profits, are used in project analysis. What is the basis for this emphasis on cash flows as opposed to net income?

Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapters we focused on dividends and free cash flows, which represent cash flows, rather than on earnings per share, which represent accounting profits.

How do simulation analysis and scenario analysis differ in the way they treat very bad and very good outcomes? What does this imply about using each technique to evaluate project riskiness?

Scenario analysis analyzes a limited number of outcomes. Although the base case scenario may be the most likely, or expected outcome, the bad and good scenarios are frequently worst case and best case scenarios, that is, when everything goes bad together, or everything goes right together. It is unlikely that everything will go wrong all at once, or everything will go right all at once and so scenario analysis can tend to overestimate the riskiness of a project. Simulation analysis, on the other hand, allows the variables being simulated to either vary together or independently, as the modeler sees fit. With enough runs of the simulation, this procedure should provide a reasonably accurate description of the possible outcomes. Note, however, that if the project is big and its failure could threaten the viability of the firm, then evaluating a worst case scenario may very well be important! A simulation may only identify that worst case outcome infrequently and with a scenario analysis you can specify the worst case and see if it drags the company down.

Why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward?

Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV.

Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm's capital budget.

Stand-alone risk is the project's risk if it is held as a lone asset. It disregards the fact that it is but one asset within the firm's portfolio of assets and that the firm is but one stock in a typical investor's portfolio of stocks. Stand-alone risk is measured by the variability of the project's expected returns. Corporate, or within-firm, risk is the project's risk to the corporation, giving consideration to the fact that the project represents only one in the firm's portfolio of assets, hence some of its risk will be eliminated by diversification within the firm. Corporate risk is measured by the project's impact on uncertainty about the firm's future earnings. Market, or beta, risk is the riskiness of the project as seen by well-diversified stockholders who recognize that the project is only one of the firm's assets and that the firm's stock is but one small part of their total portfolios. Market risk is measured by the project's effect on the firm's beta coefficient.

Why are interest charges not deducted when a project's cash flows are calculated for use in a capital budgeting analysis?

The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting analysis would "double count" the cost of debt financing.

Explain how net operating working capital is recovered at the end of a project's life and why it is included in a capital budgeting analysis.

When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net operating working capital. Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the project's life, inventories are depleted and receivables are collected. Thus, there is a decrease in NOWC, which is treated as an inflow.

INCREMENTAL CF EXAMPLE assume an existing machine generates revenues of $1,000 per year and expenses of $600 per year. A machine being considered as a replacement would generate revenues of $1,000 per year and expenses of $400 per year. On an incremental basis, the new machine would not increase revenues at all, but would decrease expenses by $200 per year. Thus, the annual incremental cash flow is

a before-tax savings of $200.

is a way of structuring a set of sequential decisions that depend on the outcomes at specific points in time.

a decision tree

incorporates the risk of the project's cash flows.

a risk adjusted discount rate

divides the analysis into different phases.

a staged decision tree analysis

is one that has already occurred and is not affected by the capital project decision.

a sunk cost

Net operating working capital changes are the increases in current operating assets resulting from

accepting a project less the resulting increases in current operating liabilities, or accruals and accounts payable.

Accounting income, on the other hand, reports

accounting data as defined by Generally Accepted Accounting Principles (GAAP).

is a cash flow that a firm must forgo to accept a project.

an opportunity cost

real options are also called embedded options because they are a par of

another project

The cost of capital to the firm reflects the

average risk of the firm's existing projects.

OPPORTUNITY COST EX: cannibalization occurs when a project's product reduces the company's sales of similar products. An expansion project is one in which new sales are generated. A replacement project is one in which an existing machine is replaced with a more efficient one—new sales might not be created, but cash flows improve

because of the more efficient machine

Each path in the staged decision tree analysis, that depends on a decision is called a

branch

allow a company to change the capacity of their output in response to changing market conditions.

capacity options

is the risk that a project contributes to a company after taking into consideration the cash flows of the company's other projects; because projects are not perfectly correlated, corporate risk usually will be less than stand-alone risk.

corporate (within firm) risk

The decisions in the staged decision tree analysis are represented on the decision trees by circles and are called

decision nodes

capacity options includes the option to contract or

expand production

A net operating working capital change must be financed just as a firm must

finance its increases in fixed assets

low/high discount rates also apply to a

firm's divisions

project cash flow is the

free cash flow generated by the project.

allow a company to expand if market demand is higher than expected

growth market

new projects that are riskier than existing projects should have a

higher risk-adjusted discount rate

are those cash flows that arise solely from the asset that is being evaluated.

incremental cash flows

growth market includes the opportunity to expand into different geographic markets and the opportunity to

introduce complementary or second-generation products.

give companies the option to delay a project rather than implement it immediately.

investment timing options

Project cash flow, which is the relevant cash flow for project analysis, represents the actual flow of cash, which includes

investments in capital and working capital, but does not include interest expenses or noncash charges like depreciation (except to the extent that depreciation affects taxes)

projects with less risk should have a

lower risk-adjusted discount rate

is the risk that a company contributes to a well diversified portfolio.

market (beta) risk

growth market also includes the option to abandon a project if

market conditions deteriorate too much.

Risk differences are difficult to quantify, thus risk adjustments are

often subjective in nature

real options are also called managerial options because they give

opportunities to managers to respond to changing market conditions.

At a staged decision tree analysis, each phase a decision is made either to

proceed or t stop the project

Salvage values and their tax effects must be included in

project cash flow estimation

real options are referred to as real options because they deal with

real as opposed to financial assets.

occur when managers can influence the size and risk of a project's cash flows by taking different actions during the project's life.

real options

A project's cost of capital is its

risk-adjusted discount rate for that project

is the market value of an asset after its useful life.

salvage value

is a shorter version of simulation analysis that uses only a few outcomes.

scenario analysis

Often the outcomes considered are optimistic, pessimistic and most likely.

scenario analysis (simulation analysis)

indicates exactly how much NPV or other output variables such as IRR or MIRR will change in response to a given change in an input variable, other things held constant.

sensitivity analysis

is sometimes called "what if" analysis because it answers this type of question.

sensitivity analysis

is the risk a project would have if it was held in isolation

stand alone risk

real options are sometimes called strategic options because they often deal with

strategic issues

are not relevant to capital budgeting decisions

sunk costs

This option to wait allows a company to reduce the

uncertainty of market conditions before it decides to implement the project.