CAPITAL BUDGETING PROJECT ANALYSIS AND EVALUATION 1 What is the Stand Alone Principle and Value Additivity Stand Alone Principle the assumption that evaluation of a project may be based on the projects incremental cash flows Value Additivity when the value of a whole group of assets exactly equals the sum of the values of the individual assets that makes up a group of assets 2 What are relevant incremental cash flows and why are they used for capital budgeting analysis Relevant Cash Flows a change in the firm s overall future cash flow that comes about as a direct consequence of the decision to take that project Incremental Cash Flows the difference between a firms future cash flows with a project and those without the project 3 What is an opportunity cost Be able to identify in examples Opportunity Cost the most valuable alternative that is given up if a particular investment is undertaken Examples worked instead The opportunity cost of going to college is the money you would have earned if you If a gardener decides to grow carrots his opportunity cost is the alternative crop he could be growing instead 4 What is a sunk cost Be able to identify in examples Sunk Cost a cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision Examples Cost of Training employees Cost of Marketing Study Hiring Bonuses 5 Why are side effects of capital projects considered in capital budgeting analysis Erosion the cash flows of a new project that comes at the expense of a firm existing projects It is important to recognize that any sales lost as a result of erosion might be lost anyway because of future competition Relevant only when sales would not otherwise be lost 6 Why is net working capital included in capital budgeting analysis At what time s does this effect occur across the project s life A project will generally need some amount of cash on hand to pay any expenses that arise The firm supplies working capital at the beginning and recovers it towards the end 7 Are financing costs included in capital budgeting analysis If so how In analyzing a proposed investment we will NOT include interest paid or any other financing costs such as dividends or principles repaid because we are interested in the cash flow generated by the assets of the project 8 How and why are taxes considered in capital budgeting analysis Always interested in after tax cash flow because taxes are definitely a cash outflow Incremental cash flow means after tax incremental cash flows 9 What is a proforma financial statement Proforma Financial Statement financial statements projected future years operations 10 Explain the difference between depreciation as calculated on the income statement and depreciation as calculated for taxes What are the cash effects of each Accounting depreciation is a noncash deduction Depreciation has a cash flow consequence only because it influences the tax bill Depreciation calculated for tax purposes is the relevant method for capital investment decisions 11 When we calculate the bid price for a production project what does that price represent The bid price represents what the buyer is willing to pay for the project 12 How can a decision to buy a new piece of equipment be made if the two alternatives have different functional lives Be able to calculate if provided an example The goal is to choose the most cost efficient decision EAC the present value of a projects cost calculation on an annual basis Example Out of the textbook pg 328 329 Machine A Costs 100 and 10 per year to operate Needs to be replaced every 2yrs Machine B Costs 140 and 8 per year to operate Needs to be replaced every 3yrs 10 discount rate for both machines a A Present Value 100 10 1 1 10 1 1 2 117 36 b B Present Value 140 8 1 1 8 1 1 2 8 1 1 3 159 89 c A Calculate Annuity 1 1 1 10 2 10 1 7355 d B Calculate Annuity 1 1 1 10 3 10 2 4869 e A Calculate EAC 117 36 EAC x 1 7355 67 62 f B Calculate EAC 159 89 EAC x 2 4869 64 29 Machine B is the cheapest 13 Be able to calculate any of the cash items that should be considered in a capital budgeting problem given a detail example 14 In the context of capital budgeting what is forecasting risk Forecasting Risk the possibility that errors in projected cash flows will lead to incorrect decisions Also known as estimation risk 15 Describe scenario analysis Scenario Analysis the determination of what happens to NPV estimates when we ask Sensitivity Analysis investigation of what happens to NPV when only one variable is what if questions 16 What is sensitivity analysis changed 17 What is breakeven analysis Breakeven Analysis Analysis of the relationship between sales volume and profitability 18 Describe simulation analysis What is its biggest downfall Simulation Analysis A combination of scenario and sensitivity analysis Downfalls No simple decision rule tells us what to do Limited in practice CAPITAL MARKETS HISTORY 19 Why do we commonly use percentage rather than dollar returns Your return doesn t depend on how much you actually invest 20 Explain the relationship between risk and reward Generally the greater the risk the greater reward potential The lower the risk the lower the return 21 What information do financial markets provide us about returns When presented a year to year historical rates of return on five important financial investment The year to year percentage change in the consumer price index is computed Real returns are calculated using the CPI as the inflation rate 22 Rank large stocks small stocks corporate bonds government bonds and treasury bills according to historical risk and return You do not need to know historical numbers but should know relative levels of return and risk 1 Large Company Stocks contains 500 of the largest companies in the US 2 Small Company Stocks smallest 20 percent of the companies listed on the New York Stock Exchange 3 Long Term Corporate Bonds Based on high quality bonds with 20 years to maturity 4 Long Term US Government Bonds Bases on the US government bonds with 20 years to maturity 5 US Treasury Bills Based on treasury bills with a one month maturity 23 What security do we normally use to represent the risk free rate 24 What is risk Premium The excess return required from an investment in a risky asset over that required from a risk free investment 25 What statistic is commonly used as a measure of the total risk of an asset 26 What is the difference between the arithmetic and
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