# fm12 3 - accruals thus increasing its net operating working...

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Answers and Solutions: 12 - 3 12-3 Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV. 12-4 Capital budgeting analysis should only include those cash flows which 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. 12-5 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
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Unformatted text preview: accruals, thus increasing its net operating working capital. Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the project’s life, inventories are depleted and receivables are collected. Thus, there is a decrease in NOWC, which is treated as an inflow. 12-6 Simulation analysis involves working with continuous probability distributions, and the output of a simulation analysis is a distribution of net present values or rates of return. Scenario analysis involves picking several points on the various probability distributions and determining cash flows or rates of return for these points. Sensitivity analysis involves determining the extent to which cash flows change, given a change in one particular input variable. Simulation analysis is expensive. Therefore, it would more than likely be employed in the decision for the \$200 million investment in a satellite system than in the decision for the \$12,000 truck....
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