FIN 3113 Chapter 11

Capital rationing exists when a company has identified positive NPV projects but can't find:

the necessary financing

Basic approach to evaluating cash flow and NPV estimates involves asking:

what if questions.

When McDonald's decides to build a new restaurant at a particular location, which of the following competitors might also be tempted to locate new facilities in the same area?

Burger King & Wendy's

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:

Cannot be observed and is lower than its cost

Context of capital budgeting, what does sensitivity analysis do?

It examines how sensitive a particular NPV calculation is to changes in underlying assumptions.

2 main benefits of performing sensitivity analysis:

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

Legitimate reason for a project to have a positive NPV for Palmer Corporation:

Palmer can produce the product more cheaply, has a better distribution channel than its competitors, and has a better product than its competitors.

Opportunity cost in the context of a vacant building that a firm currently owns:

Potential rental income lost by using the empty building for a project.

When we estimate the best case, worst case and base case cash flows and calculate the corresponding NPVs, we are engaging in:

Scenario analysis & asking what if questions

In a competitive market, positive NPV projects are:

Uncommon

Possibility that errors in projected cash flows will lead to incorrect decisions is known as:

forecasting and estimation risk

West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.

reliability

In a simulation, the average NPV and spread of NPVs around the average are determined by:

repeated random drawings

When using _______ all of the variable except one are frozen in order to determine how sensitive the NPV estimate is to changes in that particular variable

sensitivity analysis

If Kellogg's introduces a new brand of cereal, it will most likely lead to _____ in its sales of existing cereals.

Erosion

Reasons why NPV is considered a superior capital budgeting technique

NPV considers time value of money & NPV considers all cash flows.

T/F: Opportunity costs are irrelevant costs when doing capital budgeting analysis

False

2 main drawbacks of sensitivity analysis:

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

Difference between scenario analysis and sensitivity analysis:

Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at a time

The Omega Division of Alpha Corporation thinks that he can convince the company to fund the additional money because Omega uses ______ rationing to control overall spending.

Soft

The Alpha Division of Beta Corporation has been allocated $4 million for capital spending but has identified $4.6 million in positive NPV projects. Alpha's manager doesn't believe she can convince the company to fund the additional $.6 million because Omega is using _________ rationing because of a severe downturn in the company's overall prospects.

hard

Evans Corporation estimated that the cash flows last year from a particular project would be $40,000, but the actual cash flow turned out to be $37,500. Evans Corporation should:

not expect cash flow estimations to be exactly right every time.