Chapter 13, Problem 1Q

Define each of the following terms:

1. a. Project cash flow; accounting income
2. b. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalization; expansion project; replacement project
3. c. Net operating working capital changes; salvage value
4. d. Stand-alone risk; corporate (within-firm) risk; market (beta) risk
5. e. Sensitivity analysis; scenario analysis; Monte Carlo simulation analysis
6. f. Risk-adjusted discount rate; project cost of capital
7. g. Decision tree; staged decision tree; decision node; branch
8. h. Real options; managerial options; strategic options; embedded options
9. i. Investment timing option; growth option; abandonment option; flexibility option

Summary Introduction

To discuss: Project cash flow and accounting income.

Explanation of Solution

Project cash flows is a part of financial planning for project, understanding the inflows and outflows of cash so one can be created by project. These cash flows are divided into three parts; they are initial investment for project, terminal or final cash flow and operating cash flow over life of the project.

Accounting income is the difference between total expenses and total revenues. It is the change in net profits over a period excluding any receipts from or expenses to owners.

Summary Introduction

To discuss: Incremental cash flow, opportunity cost, sunk cost, cannibalization, externality, expansion project and replacement project.

Explanation of Solution

Incremental cost is the difference between cash flows of an organization which comes by undertaking project and without task the challenge. It is revenue – expense – initial cost.

Sunk cost is a cost that has already been occurred and cannot be recovered. It is also known as standard cost. It is the past opportunity cost that are irrecoverable and irrelevant to future decisions.

Opportunity cost is an economic concept of profits/value that a company offers up with the aid of taking an alternative action. It is benefit not going to be achieved due to a particular decision. It is also called as alternative cost.

Externality is nothing but third party effect arising from consumption and production of goods and services for which no appropriate compensation is paid. It is defined as negative or positive consequences of economic activity on third party.

Cannibalisation is the lack of product sale due to access of newly launched product. It is negative impact a new product has no sales performance of company’s existing product.

Expansion projects are those projects which help to expand the size of the firm by introducing new class of assets.

Under replacement projects, the existing assets are replaced with similar assets.

Summary Introduction

To discuss: Net operating working capital changes and salvage value.

Explanation of Solution

Net operating working capital measures a company’s capability to pay all operating capital liabilities with its operational assets. It is a metric that indicates company leverage and current assets. It is the difference between current assets and current liabilities.

Salvage value is also known as scrap value or residual value. It is nothing but the estimated value of an asset at the end of its useful life.

Summary Introduction

To discuss: Stand-alone risk, corporate risk and market risk.

Explanation of Solution

Stand-alone risk is the risk related to single asset or units of the company.

Corporate within the firm risk is the risk that a company project could have on its earnings.

Market/ beta risk is the risk that investment value may also change because of market factors as exchange rate, interest rate. It affects the overall performance of financial market.

Summary Introduction

To discuss: Sensitivity analysis, Monte Carlo simulation analysis and scenario analysis.

Explanation of Solution

Sensitivity analysis is the technique which measures the effect of variation in a certain variable.

Scenario analysis is a kind of examination/ evaluation which provides a variety of possible outcomes, through an exam of various possible situations.

Monte Carlo simulation analysis is a mathematical technique used to measure the risk probability that various consequences in a process which aren’t easily predicted.

Summary Introduction

To discuss: Risk adjusted discount rate, project cost of capital.

Explanation of Solution

Risk adjusted discount rate is the measure of present value of cash for investments involving high risk. It gauges how much threat is related in earning a particular return for investor.

Project cost of capital is the minimum required rate of return on project given the risk.

Summary Introduction

To discuss: Decision tree, decision node, staged decision tree and branch.

Explanation of Solution

A decision tree is a way of structuring a set of sequential decisions, which is based on the consequences at specific points in time. A staged decision tree analysis divides the analysis into various phases.

At each phase a selection is made either to proceed or to stop the project. These decisions are denoted on the decision trees through circles and are known as decision nodes. Each path that relies upon on a decision is known as a branch.

Summary Introduction

To discuss: Real options, managerial options, strategic options and embedded options.

Explanation of Solution

Real options occur when mangers can affect the size and risk of a project’s cash flows by way of taking different actions during the project’s life. They are known to as real options because they deal with real as opposed to financial assets.

They are also referred to as managerial alternatives because they give opportunities to managers to response to change market conditions. Sometimes they are called strategic alternatives due to fact they often cope with strategic issues. Finally, they are caked as embedded options because they are a part of another project.

Summary Introduction

To discuss: Investment timing option, growth option, abandonment option and flexibility option.

Explanation of Solution

Investment timing option gives firms the option to delay a project instead of implement it immediately. This choice to wait permits an organization to reduce the uncertainty of market conditions before it comes to put to implement the project.

Capacity option allows a firm to change the capability in their output in response to changing marketplace conditions. This includes the option to contract or expand production.

Growth option permits a firm to expand if market place demand is better than expected. This includes the opportunity to expand into different geographic markets and the possibility to introduce complementary or second-generation products. It also includes the option to abandon a task if marketplace situations become worse too much.