Chapter 11: Cash Flow Estimation and Risk Analysis
Project S has a cost of $1,000, and its expected revenues are $655 per year for 2 years. Project L has a cost of $2,000, and its expected revenues are $700 per year for 4 years. The projects are mutually exclusive, and they can be repeated. Assume that the projects' cost of capital is 10%. What is the NPV for the better project?
$249.82
incremental cash flows
a cash flow that will occur if and only if the firm takes on a project
sunk cost
a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected
replacement chain (common life) approach
a method of comparing projects with unequal lives that assumes that each project can be repeated as many times as necessary to reach a common life. the NPVs over this life are then compared, and the project with the higher common-life NPV is chosen
accounting beta method
a method of estimating a project's beta by running a regression of the company's return on assets against the average return on assets for a large sample of firms
equivalent annual annuity (EAA) method
a method that calculates the annual payments that a project will provide if it is an annuity. when comparing projects with unequal lives, the one with the higher equivalent annual annuity (EAA) should be chosen
scenario analysis
a risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation
Monte Carlo simulation
a risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes
Three separate types of risk should be considered in capital budgeting. Which of the following is NOT one of those risks? a. Consumer price risk b. Stand-alone risk c. Market risk d. Corporate risk
a. consumer price risk
best-case scenario
an analysis in which all of the input variables are set at their best reasonably forecasted values
worst-case scenario
an analysis in which all of the input variables are set at their worst reasonably forecasted values
base-case scenario
an analysis in which of all the input variables are set at their most likely values
pure play method
an approach used for estimating the beta of a project in which a firm (1) identifies several companies whose only business is to produce the product in question, (2) calculates the beta for each firm, and then (3) averages the betas to find an approximation to its own project's beta
externalities
an effect on the firm of the environment that is not reflected in the project's cash flows
half-year convention
assumes assets are used for half of the first year and half of the last year
market, or beta, risk
considers both firm and stockholder diversification. it is measured by the project's beta coefficient
T/F Although free cash flows rather than accounting income are useful for some purposes, in a capital budgeting analysis it is accounting income that should be discounted to find the NPV.
false
T/F An opportunity cost is an amount that a firm would receive if it does not make a given investment. An example would be the purchase price from a building that a firm owns and could sell if it does not make an investment that would call for the use of the building. Opportunity costs should not be reflected in a capital budgeting analysis.
false
T/F If a firm is choosing between two mutually exclusive and repeatable projects that have different lives, the project with the shorter life should normally be chosen.
false
T/F Two methods can be used when choosing between mutually exclusive and repeatable projects that have different lives: (1) the scenario analysis approach and (2) the equivalent annual annuity approach.
false
sensitivity analysis
percentage change in NPV resulting from a given percentage change in an input variable, other things held constant
corporate, or within-firm, risk
risk considering the firm's diversification but not stockholder diversification. it is measured by a project's effect on uncertainty about the firm's expected future returns
base-case NPV
the NPV when sales and other input variables are set at their most likely values
annual depreciation rates
the annual expense accountants charge against income for "wear and tear" of an asset. for tax purposes, the IRS provides that appropriate MACRS rates be used that are dependent on an asset's class life
opportunity cost
the best return that could be earned on assets the firm already owns if those assets are not used for the new project
risk-adjusted cost of capital
the cost of capital appropriate for a given project, given the riskiness of that projects. the greater the risk, the higher the cost of capital
stand-alone risk
the risk an asset would have if it were a firm's only asset and if investors owned only one stock. it measures by the variability of the asset's expected returns
project cost of capital (rp)
the risk-adjusted cost of capital for an individual project
cannibalization
the situation when a new project reduces cash flows that the firm would otherwise have had
class life
the specified life of assets under the MACRS system
T/F A project's incremental cash flow is the difference between the firm's cash flow
true
T/F A sunk cost is a cost that has been incurred and cannot be recovered regardless of whether a project is accepted or rejected. Sunk costs should not be reflected in a capital budgeting analysis.
true
T/F For replacement projects, we must find cash flow differentials between the new and old projects. These differentials are the incremental cash flows that we analyze in determining whether the replacement project should be done or not.
true
T/F If a project is negatively correlated with the firm's other projects, it might stabilize the firm's total earnings and thus be relatively safe.
true
T/F Of the three types of risk, market risk is theoretically the most relevant, but it is quite difficult to measure a new project's market risk. Stand-alone risk is easier to estimate, and it is usually positively correlated with market risk. Therefore, the focus of risk analysis for most projects is on stand-alone risk.
true
T/F Scenario analysis is similar to sensitivity analysis, but here the variables are typically set at "good," "normal," and "bad" levels, and then the NPV is calculated under each scenario. This analysis is designed to give management an idea of just how good or bad the results might turn out to be, along with the most likely (or expected) result. The spreadsheet model used to do a sensitivity analysis could be modified slightly and used for the scenario analysis.
true
T/F Three procedures are used to evaluate a project's stand-alone risk: sensitivity analysis, scenario analysis, and Monte Carlo simulation.
true
T/F To do a sensitivity analysis, one would set up a spreadsheet model that calculates a project's NPV, using as inputs unit sales, sale prices, fixed and variable costs, the tax rate, and the cost of capital. Input variables are then changed one at a time to determine their effects on the NPV. If small changes in the variables could result in a large decline in the NPV, then the project is judged to be relatively risky.
true