Cash Flow Estimation and Risk Analysis
Terms in this set (14)
Should financing effects be included in cash flows
No, dividends and interest expense should not be included in the analysis. Financing effects have already been taken into account by discounting cash flows at the WACC
The effect on other projects' CFs
What are the 3 types of project risk?
What is stand-alone risk?
The project's total risk, if it were operated independently.
What is corporate risk?
The project's risk when considering the firm's other projects, i.e., diversification within the firm.
What is market risk?
The project's risk to a well-diversified investor.
Which type of risk is most relevant?
Market risk is the most relevant risk for capital projects, because management's primary goal is shareholder wealth maximization.
Which risk is the easiest to measure?
Stand-alone risk is the easiest to measure. Firms often focus on stand-alone risk when making capital budgeting decisions.
What is sensitivity analysis?
Sensitivity analysis measures the effect of changes in a variable on the project's NPV.
Advantages of sensitivity analysis
Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables.
Disadvantages of sensitivity analysis
Does not reflect the effects of diversification.
Does not incorporate any information about the possible magnitude of the forecast errors.
If the project had a high correlation with the economy, how would corporate and market risk be affected?
The project's corporate risk would not be directly affected. However, when combined with the project's high stand-alone risk, correlation with the economy would suggest that market risk (beta) is high.
Is this project likely to be correlated with the firm's business? How would it contribute to the firm's overall risk?
We would expect a positive correlation with the firm's aggregate cash flows.
As long as correlation is not perfectly positive (i.e., ρ not equal to 1), we would expect it to contribute to the lowering of the firm's overall risk.
What subjective risk factors should be considered before a decision is made?
Numerical analysis sometimes fails to capture all sources of risk for a project.
If the project has the potential for a lawsuit, it is more risky than previously thought.
If assets can be redeployed or sold easily, the project may be less risky than otherwise thought.