Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure. b. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. c. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. d. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. e. The replacement chain (common life) approach and the equivalent annual annuity (EAA) approach must be used to evaluate independent projects with unequal lives; however, neither approach may be used to evaluate mutually exclusive projects with unequal lives.
Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure. b. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. c. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. d. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. e. The replacement chain (common life) approach and the equivalent annual annuity (EAA) approach must be used to evaluate independent projects with unequal lives; however, neither approach may be used to evaluate mutually exclusive projects with unequal lives.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?
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Step 1: Introduction to Capital budgeting:
VIEWStep 2: 1. Monte Carlo Simulation is the Most Frequently Used Procedure:
VIEWStep 3: 2. Risk-Adjusted Discount Rates and Subjectivity:
VIEWStep 4: 3. Corporate WACC and Risk Scaling:
VIEWStep 5: 4. Correlation with Economy Affects Discount Rate:
VIEWStep 6: 5. Evaluation Approaches for Projects with Unequal Lives:
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