chap 11 - Chapter 11 Cash Flow Estimation and Risk Analysis...

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After reading this chapter, students should be able to: Discuss difficulties and relevant considerations in estimating net cash flows, and explain the four major ways that project cash flow differs from accounting income. Define the following terms: relevant cash flow, incremental cash flow, sunk cost, opportunity cost, externalities, and cannibalization. Identify the three categories to which incremental cash flows can be classified. Analyze an expansion project and make a decision whether the project should be accepted on the basis of standard capital budgeting techniques. Explain three reasons why corporate risk is important even if a firm’s stockholders are well diversified. Identify two reasons why stand-alone risk is important. Demonstrate sensitivity and scenario analyses and explain Monte Carlo simulation. Discuss the two methods used to incorporate risk into capital budgeting decisions. Learning Objectives: 11 - 1 Chapter 11 Cash Flow Estimation and Risk Analysis LEARNING OBJECTIVES
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This chapter covers some important but relatively technical topics. Note too that this chapter is more modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip sections of the chapter. Assuming you are going to cover the entire chapter, the details of what we cover, and the way we cover it, can be seen by scanning Blueprints , Chapter 11. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 11 - 2 LECTURE SUGGESTIONS
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11-1 Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapter we focused on dividends, which represent cash flows, rather than on earnings per share. 11-2 Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis. 11-3 When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net operating working capital (NOWC). Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of
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This note was uploaded on 05/10/2010 for the course FMT 0438310384 taught by Professor Hung during the Spring '10 term at Aarhus Universitet, Aarhus.

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chap 11 - Chapter 11 Cash Flow Estimation and Risk Analysis...

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