Ch. 12 - Cash Flow Estimation and Risk Analysis

The price that the company receives for a fixed asset at the end of the project is often referred to as its _________.

salvage value

For example, the 2017 _________ allows firms to deduct, in many cases, all of the project's up-front fixed asset expenses at the time the costs are incurred. However, the GAAP guidelines still require the company to depreciate these costs over time.

Tax Cuts and Jobs Act (TCJA)

Unless we say otherwise, we will assume that the projects we examine will be eligible for this bonus depreciation, in which case, the full cost of the purchased asset will be _________ at the time of the purchase. Consequently, the book value of the asset will be zero after the time of purchase.

deducted (fully depreciated)

Note, however, for projects with highly predictable cash flows, it might be useful to assume that cash flows occur at midyear (or even quarterly or monthly). But for most purposes, we assume _________ flows.

end-of-year

Incremental cash flows are flows that will occur if and only if some _________ event occurs.

specific

Two types of projects can be distinguished: _________ projects, where the firm makes an investment, such as a new Home Depot store, and _________ projects, where the firm replaces existing assets, generally to reduce costs.

expansion

replacement

Replacement analysis is complicated by the fact that almost all of the cash flows are _________, found by subtracting the new cost numbers from the old numbers. Thus, the fuel bill for a more efficient new truck might be $10,000 per year versus $15,000 for the old truck. The $5,000 savings is the incremental cash flow that would be used in the replacement analysis.

incremental

A _________ is an outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted.

sunk cost

Because sunk costs were incurred in the past and cannot be recovered regardless of whether the project is accepted or rejected, they are not relevant in the _________.

capital budgeting analysis

Not handling sunk costs properly can lead to _________ decisions.

incorrect

Another issue relates to opportunity costs associated with assets the firm _________

already owns

Therefore, the $2 million must be charged to the _________, and a failure to do so would artificially and incorrectly increase the new project's NPV.

new project

Another potential problem involves _________, which are defined as the effects of a project on other parts of the firm or the environment.

externalities

The three types of externalities—_________, _________, and _________—are explained next.

negative within-firm externalities, positive within-firm externalities, and environmental externalities

_________ is the situation when a new project reduces cash flows that the firm would otherwise have had.

cannibalization

However, a new project also can be complementary to an old one, in which case cash flows in the old operation will be _________ when the new one is introduced.

increased

The most common type of negative externality is a project's impact on the _________.

environment

We are interested only in _________ costs. The $150 is not an incremental cost; it is a sunk cost. Therefore, it should not enter into the analysis.

incremental

For replacement projects, we must find cash flow differentials between the new and old projects, and these differentials are the _________ cash flows that we analyze.

incremental

Three separate and distinct types of risk are involved:

1. Stand-alone risk

2. Corporate, or within-firm, risk

3. Market, or beta, risk

_________ risk is theoretically the most relevant of the three because it is the one reflected in stock prices. Unfortunately, market risk is also the most difficult to estimate, primarily because new projects don't have "market prices" that can be related to stock market returns.

Market

The _________ is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital.

risk-adjusted cost of capital

Three techniques are used to assess stand-alone risk:

(1) sensitivity analysis,

(2) scenario analysis, and

(3) Monte Carlo simulation.

_________ measures the percentage change in NPV that results from a given percentage change in an input, other variables held at their expected values.

Sensitivity analysis

The _________ is the NPV when sales and other input variables are set equal to their most likely (or base-case) values.

base-case NPV

A _________ is the risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation.

Scenario Analysis

Often the best and worst cases are defined as having a _________ probability of conditions being that good or bad, with a _________ probability for the base-case conditions.

25%

50%

When we divide the standard deviation by the expected NPV, we calculate the _________ which is a measure of stand-alone risk.

coefficient of variation

_________, so named because this type of analysis grew out of work on the mathematics of casino gambling, is a sophisticated version of scenario analysis.

Monte Carlo simulation

Monte Carlo simulation is technically more complex than _________ analysis, but simulation software makes the process manageable.

scenario

The problem is that to measure diversification's effects on risk, we need the correlation coefficient between a project's returns and returns on the firm's other assets, which requires _________ that obviously do not exist for new projects. Experienced managers generally have a "feel" for how a project's returns will relate to returns on the firm's other assets.

historical data

It is very difficult, if not impossible, to quantitatively measure projects' within-firm and _________ risks.

beta

Most projects' returns are _________ correlated with returns on the firm's other assets and with returns on the stock market. This being the case, because stand-alone risk is correlated with within-firm and market risk, not much is lost by focusing just on stand-alone risk.

positively

If a firm does not use the types of analyses covered in this book, it will have trouble. On the other hand, if a firm tries to quantify everything and let a computer make its decisions, it too will have trouble. Good managers understand and use the theory of finance, but they apply it with _________.

judgment

If a company is choosing between two projects and those projects

(1) have significantly different lives,

(2) are mutually exclusive, and

(3) can be repeated, the "regular" NPV method may not indicate the better project.

A _________ is 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.

replacement chain (common life) approach

A _________ is 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.

equivalent annual annuity (EAA) method

The replacement chain and _________ methods always result in the same decision, so it doesn't matter which one is used. The EAA is a bit easier to implement.

EAA

However, the _________ method is often easier to explain to senior managers. Also, it is easier to make modifications to the replacement chain data to deal with anticipated productivity improvements and asset price changes.

replacement chain

or those reasons, we generally use the replacement chain method when we work with _________, but when engineers are involved, we show both results.

non-engineers

As a general rule, the unequal life issue never arises for _________ projects, but it can be an issue when we compare mutually exclusive projects with significantly different lives. However, the issue arises if and only if the projects will be repeated at the end of their initial lives. Thus, for all independent projects and those mutually exclusive projects that will not be repeated, there is no need to adjust for unequal lives.

independent