Week 5

Capital Budgeting

Process of analysing investment oppurtunities and deciding which to accept

Incremental Cash flows

Costs as a result of taking the project on

Incremental increase in NWC

represents cashflows that must be included in investment appraisal process

Networking Capital

Current assets - current liabilities

Inflation

Cashflows must be adjusted to accounting for inflation

Individual cashflows

are inflated using specific rates

Discount nominal cash flows

with costs of nominal capital

Discount real cashflows

with costs of real cashflows

Sensitivity analysis 

Breaks npv down into components assumptions and shows effect of changing assumption on NPV

Sensitivity analysis tells us 

• Backups

  • Too many negative npvs means more investigation needs to be done

• Influential variables

  • Identifies influential variables that need to be estimated w/more accuracy

Sensitivity analysis shows us

• most important assumptions that need more resources and time invested in them

• effects of errors in npv estimates for project

Scenario Analysis

• Same as sensitivity just more realistic

• Focus on diff future scenarios

• Considers effect of changing multiple parameters project

In scenario analysis, more than one cashflow

is varied at a time

Simulation Analysis

Monte Carlo simulation estimates thousands of possible npv outcomes using probability and constraints to variables

Results of Monte Carlo Simulation

Range of npv outcomes with a probability for how likely it is to get a positive npv

Paralysis of analysis

You have to make a decision on if you should accept or not accept a project

Convertible Bonds

Some bonds can be exchanged for common stock of the issuers

Callable bonds

Some bonds can be redeemed before maturity date

Conventional Bonds

Fixed amt is paid to holder of bond every 6 months and redemption relies on maturity date

What type of risk is gov bonds

Default riskDe

Default risk

Fear borrower will not be able to repay the bond

What are zero coupon bonds

Bonds that pay no coupon payments, only a lump sum at maturity

What are Coupon paying bonds

Bonds that pay coupon payments periodically until maturity, at which point the principal is repaid

Some bonds never pay coupon payment, explain

These are called perpetuities

They have no maturity time

Bond perpetuity formula

P = C / r

Bonds usually used to obtain long term finance: Explain why government would use them

1. Public spending

2. Refinance debt

Bonds usually used to obtain long term finance: Explain why corporations would use them

1. Fun acquisitions 

2. Fund investment