Business Finance
University of Phoenix Fundamentals of Corporate Finance Questions

University of Phoenix

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I have a few discussion questions I need answered. with no plagiarism, Sources sited and at lest 150 words each.

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9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 350 Project Analysis and Evaluation 11 IN THE SUMMER OF 2013, the movie R.I.P.D., starring Ryan Reynolds and Jeff Bridges, was dead on arrival at the box office. The R.I.P.D. slogan was “To protect and serve the living,” but many critics and movie-goers disagreed. One critic said “Expect a sad afterlife for it on cable.”Others were even more harsh, saying “Unfortunately, the interesting drabness of the afterlife’s police department is paired with the colorless paucity of the film’s heavies” and “Less a bad movie than simply not a movie, R.I.P.D. gives every indication of having been a sloppy first-draft script.” Looking at the numbers, Universal Pictures spent close to $130 million making the movie, plus millions more for marketing and distribution. Unfortunately for Universal Pictures, R.I.P.D. did not allow the executives to rest peacefully, pulling in only $33.6 million worldwide. In fact, about four of 10 movies lose money at the box office, though DVD sales often help the final tally. Of course, there are movies that do quite well. Also in 2013, the Lions Gate movie Hunger Games: Catching Fire raked in about $425 million in the U.S. at a production cost of $130 million. So, obviously, Universal Pictures didn’t plan to lose $100 or so million on R.I.P.D., but it happened. As this particular box office bomb shows, projects don’t always go as companies think they will. This chapter explores how this can happen, and what companies can do to analyze and possibly avoid these situations. For updates on the latest happenings in finance, visit Learning Objectives After studying this chapter, you should understand: LO1 LO2 LO3 LO4 How to perform and interpret a sensitivity analysis for a proposed investment. How to perform and interpret a scenario analysis for a proposed investment. How to determine and interpret cash, accounting, and financial break-even points. How the degree of operating leverage can affect the cash flows of a project.!/4/490/2@0:100 1/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance LO5 How capital rationing affects the ability of a company to accept projects. In our previous chapter, we discussed how to identify and organize the relevant cash flows for capital investment decisions. Our primary interest there was in coming up with a preliminary estimate of the net present value for a proposed project. In this chapter, we focus!/4/490/2@0:100 2/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. on assessing the reliability of such an estimate and on some additional considerations in project analysis. Page 351 We begin by discussing the need for an evaluation of cash flow and NPV estimates. We go on to develop some useful tools for such an evaluation. We also examine additional complications and concerns that can arise in project evaluation. 11.1 Evaluating NPV Estimates As we discussed in Chapter 9, an investment has a positive net present value if its market value exceeds its cost. Such an investment is desirable because it creates value for its owner. The primary problem in identifying such opportunities is that most of the time we can’t actually observe the relevant market value. Instead, we estimate it. Having done so, it is only natural to wonder whether our estimates are at least close to the true values. We consider this question next. THE BASIC PROBLEM Suppose we are working on a preliminary discounted cash flow analysis along the lines we described in the previous chapter. We carefully identify the relevant cash flows, avoiding such things as sunk costs, and we remember to consider working capital requirements. We add back any depreciation; we account for possible erosion; and we pay attention to opportunity costs. Finally, we double-check our calculations; when all is said and done, the bottom line is that the estimated NPV is positive. Now what? Do we stop here and move on to the next proposal? Probably not. The fact that the estimated NPV is positive is definitely a good sign; but, more than anything, this tells us that we need to take a closer look. If you think about it, there are two circumstances under which a DCF analysis could lead us to conclude that a project has a positive NPV. The first possibility is that the project really does have a positive NPV. That’s the good news. The bad news is the second possibility: A project may appear to have a positive NPV because our estimate is inaccurate. Notice that we could also err in the opposite way. If we conclude that a project has a negative NPV when the true NPV is positive, we lose a valuable opportunity. PROJECTED VERSUS ACTUAL CASH FLOWS There is a somewhat subtle point we need to make here. When we say something like “The projected cash flow in Year 4 is $700,”what exactly do we mean? Does this mean that we think the cash flow will actually be $700? Not really. It could happen, of course, but we would be surprised to see it turn out exactly that way. The reason is that the $700 projection is based on only what we know today. Almost anything could happen between now and then to change that cash flow. Loosely speaking, we really mean that if we took all the possible cash flows that could occur in four years and averaged them, the result would be $700. So, we don’t really expect a projected cash flow to be exactly right in any one case. What we do expect is that if we evaluate a large number of projects, our projections will be right on average. FORECASTING RISK The key inputs into a DCF analysis are projected future cash flows. If the projections are seriously in error, then we have a classic GIGO (garbage in, garbage out) system. In such a case, no matter how carefully we arrange the numbers and manipulate them, the resulting answer can still be grossly misleading. This is the danger in using a relatively sophisticated!/4/490/2@0:100 3/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. technique like DCF. It is sometimes easy to get caught up in number crunching and forget the underlying nuts-and-bolts economic reality. Page 352 The possibility that we will make a bad decision because of errors in the projected cash flows is called forecasting risk (or estimation risk). Because of forecasting risk, there is the danger that we will think a project has a positive NPV when it really does not. How is this possible? It happens if we are overly optimistic about the future, and, as a result, our projected cash flows don’t realistically reflect the possible future cash flows. forecasting risk The possibility that errors in projected cash flows will lead to incorrect decisions. Also known as estimation risk. Forecasting risk can take many forms. For example, Microsoft spent several billion dollars developing and bringing the Xbox One game console to market. Technologically more sophisticated than its competition, the Xbox One was the best way to play against competitors over the Internet and included other features, such as the Kinect motion detector. However, Microsoft sold only four million Xboxes in the first four months of sales, which was at the low end of Microsoft’s expected range and noticeably fewer than the 6.6 million Sony PS4s sold. Since the Xbox was arguably the best available game console at the time, why didn’t it sell better? A major reason given by analysts was that the Xbox cost $100 more than the PS4. So far, we have not explicitly considered what to do about the possibility of errors in our forecasts; so one of our goals in this chapter is to develop some tools that are useful in identifying areas where potential errors exist and where they might be especially damaging. In one form or another, we will be trying to assess the economic “reasonableness” of our estimates. We will also be wondering how much damage will be done by errors in those estimates. SOURCES OF VALUE The first line of defense against forecasting risk is simply to ask, “What is it about this investment that leads to a positive NPV?”We should be able to point to something specific as the source of value. For example, if the proposal under consideration involves a new product, then we might ask questions such as the following: Are we certain that our new product is significantly better than that of the competition? Can we truly manufacture at lower cost, or distribute more effectively, or identify undeveloped market niches, or gain control of a market? These are just a few of the potential sources of value. There are many others. For example, in 2004, Google announced a new, free e-mail service: Gmail. Why? Free e-mail service is widely available from big hitters like Microsoft and Yahoo! and, obviously, it’s free! The answer is that Google’s mail service is integrated with its acclaimed search engine, thereby giving it an edge. Also, offering e-mail lets Google expand its lucrative keyword-based advertising delivery. So, Google’s source of value is leveraging its proprietary Web search and ad delivery technologies. A key factor to keep in mind is the degree of competition in the market. A basic principle of economics is that positive NPV investments will be rare in a highly competitive environment. Therefore, proposals that appear to show significant value in the face of stiff competition are particularly troublesome, and the likely reaction of the competition to any innovations must be closely examined. To give an example, in 2008, demand for flat screen LCD televisions was high, prices were high, and profit margins were fat for retailers. But, also in 2008, manufacturers of the screens, such as Samsung and Sony, were projected to pour several billion dollars into new production facilities. Thus, anyone thinking of entering this highly profitable market would do well to reflect on what the supply (and profit margin) situation will look like in just a few years. And, in fact, the high prices did not last. By 2014, television sets that had been selling for well over $1,000 only two years before were selling for around $300–$400.!/4/490/2@0:100 4/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. It is also necessary to think about potential competition. For example, suppose home improvement retailer Lowe’s identifies an area that is underserved and is thinking about opening a Page 353 store. If the store is successful, what will happen? The answer is that Home Depot (or another competitor) will likely also build a store, thereby driving down volume and profits. So, we always need to keep in mind that success attracts imitators and competitors. The point to remember is that positive NPV investments are probably not all that common, and the number of positive NPV projects is almost certainly limited for any given firm. If we can’t articulate some sound economic basis for thinking ahead of time that we have found something special, then the conclusion that our project has a positive NPV should be viewed with some suspicion. Concept Questions 11.1a What is forecasting risk? Why is it a concern for the financial manager? 11.1b What are some potential sources of value in a new project? 11.2 Scenario and Other What-If Analyses Excel Master It! Excel Master coverage online Our basic approach to evaluating cash flow and NPV estimates involves asking what-if questions. Accordingly, we discuss some organized ways of going about a what-if analysis. Our goal in performing such an analysis is to assess the degree of forecasting risk and to identify the most critical components of the success or failure of an investment. GETTING STARTED We are investigating a new project. Naturally, the first thing we do is estimate NPV based on our projected cash flows. We will call this initial set of projections the base case. Now, however, we recognize the possibility of error in these cash flow projections. After completing the base case, we thus wish to investigate the impact of different assumptions about the future on our estimates. One way to organize this investigation is to put upper and lower bounds on the various components of the project. For example, suppose we forecast sales at 100 units per year. We know this estimate may be high or low, but we are relatively certain it is not off by more than 10 units in either direction. We thus pick a lower bound of 90 and an upper bound of 110. We go on to assign such bounds to any other cash flow components we are unsure about. When we pick these upper and lower bounds, we are not ruling out the possibility that the actual values could be outside this range. What we are saying, again loosely speaking, is that it is unlikely that the true average (as opposed to our estimated average) of the possible values is outside this range. An example is useful to illustrate the idea here. The project under consideration costs $200,000, has a fiveyear life, and has no salvage value. Depreciation is straight-line to zero. The required return is 12 percent, and!/4/490/2@0:100 5/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance the tax rate is 34 percent. In addition, we have compiled the following information:!/4/490/2@0:100 6/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. With this information, we can calculate the base-case NPV by first calculating net income: Page 354 Operating cash flow is thus $30,000 + 40,000 – 10,200 = $59,800 per year. At 12 percent, the five-year annuity factor is 3.6048, so the base-case NPV is: Thus, the project looks good so far. SCENARIO ANALYSIS The basic form of what-if analysis is called scenario analysis. What we do is investigate the changes in our NPV estimates that result from asking questions like: What if unit sales realistically should be projected at 5,500 units instead of 6,000? scenario analysis The determination of what happens to NPV estimates when we ask what-if questions. Once we start looking at alternative scenarios, we might find that most of the plausible ones result in positive NPVs. In this case, we have some confidence in proceeding with the project. If a substantial percentage of the scenarios look bad, the degree of forecasting risk is high and further investigation is in order. We can consider a number of possible scenarios. A good place to start is with the worst-case scenario. This will tell us the minimum NPV of the project. If this turns out to be positive, we will be in good shape. While we are at it, we will go ahead and determine the other extreme, the best case. This puts an upper bound on our NPV. To get the worst case, we assign the least favorable value to each item. This means low values for items like units sold and price per unit and high values for costs. We do the reverse for the best case. For our project, these values would be the following: With this information, we can calculate the net income and cash flows under each scenario (check these for yourself):!/4/490/2@0:100 7/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance What we learn is that under the worst scenario, the cash flow is still positive at $24,490. That’s good news. The bad news is that the return is –14.4 percent in this case, and the!/4/490/2@0:100 8/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. NPV is −$111,719. Because the project costs $200,000, we stand to lose a little more than half of the original investment under the worst possible scenario. The best case offers an attractive 41 percent return. Page 355 The terms best case and worst case are commonly used, and we will stick with them; but they are somewhat misleading. The absolutely best thing that could happen would be something absurdly unlikely, such as launching a new diet soda and subsequently learning that our (patented) formulation also just happens to cure the common cold. Similarly, the true worst case would involve some incredibly remote possibility of total disaster. We’re not claiming that these things don’t happen; once in a while they do. Some products, such as personal computers, succeed beyond the wildest expectations; and some turn out to be absolute catastrophes. For example, in April 2010, BP’s Gulf of Mexico oil rig Deepwater Horizon caught fire and sank following an explosion, leading to a massive oil spill. The leak was finally stopped in July after releasing over 200 million gallons of crude oil into the Gulf. BP’s costs associated with the disaster have already exceeded $43 billion, not including opportunity costs such as lost government contracts. Nonetheless, our point is that in assessing the reasonableness of an NPV estimate, we need to stick to cases that are reasonably likely to occur. Instead of best and worst, then, it is probably more accurate to use the words optimistic and pessimistic. In broad terms, if we were thinking about a reasonable range for, say, unit sales, then what we call the best case would correspond to something near the upper end of that range. The worst case would simply correspond to the lower end. Not all companies complete (or at least publish) all three estimates. For example, Almaden Minerals, Ltd., made a press release with information concerning its Elk Gold Project in British Columbia. Here is a table of the possible outcomes given by the company:!/4/490/2@0:100 9/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. As you can see, the NPV is projected at C$28.7 million in the base case and C$67.9 million in the best case. Unfortunately, Almaden did not release a worst-case analysis, but we hope the company also examined this possibility. Page 356 As we have mentioned, there are an unlimited number of different scenarios that we could examine. At a minimum, we might wan ...
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Final Answer


Fundamentals of Corporate Finance
What are the differences in the calculation of net present value and internal rate of return?
The net present value is a method of evaluating the profitability of a proposed investment by
discounting the stream of anticipated cash flows of the proposed investment to their present
value, while the internal rate of return assesses the profitability of a project by calculating the
percentage rate of return that will result to a net present value of zero for those cash flows.
Therefore, the major differences in the two calculations are as follows;

The calculation of the net present value results in a dollar value that will be produced by
a project while the internal rate of return results to a percentage return that a project
should create.
NPV focuses on surpluses of a project while IRR concentrates on the break-even level of
a project’s cash flow.
The discount rate and cash flows used in the NPV method is very hard to derive. This
difficulty is not experienced in IRR calculations since discount rate is the rate of return
that is derived from the cash flows or one that results to a zero NPV (Drew, Christensen
& Bianchi, 2013).

What are the various tools for analyzing capital investments? What are the decision
criteria, advantages and disadvantages of each? Which one would you recommend that
your boss use in analyzing a new business opportunity? Why?
Net present value
It as a tool that evaluates an investment by discounting its future cash flows to a current value
through a predetermined the decision criteria for this method is to accept a project if its net
present value is positive and reject if negative. The advantage of NPV is that it has no serious
flaws in its decision criteria. The drawback of this tool is that it is very difficult to come up with
the discount rate and cash flows used in this method (Ross, Westerfield & Jordan, 2008).
Internal Rate of Return
When assessing an investment, this tool calculates the rate that will discount an investments’
NPV to zero. The criteria for this tool is to accept a project when its IRR exceeds the required
return and reject if IRR is less than the required return. The advantage is that IRR is a simple
method to use esp...

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