Questions and Answers on Incremental Cash Flow - Paper Example

Define "incremental cash flow."

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Incremental cash flow refers to the additional operating finances that an organization receives through the undertaking of a new project. A positive incremental cash flow is a situation in which after undertaking the project the organizations cash flow will increase whereas negative cash flow refers to the decrease in cash flow after undertaking the project (Ball et al., 2016).

Should you subtract interest expense or dividends when calculating project cash flow? Why or why not?

The interest expense and the dividends should not be included in the cash flow statement because it would result in double counting since the cost of capital is accounted for in the capital discount rate.

Why is it important to include inflation when estimating cash flows?

It is important when calculating the cash flow to consistently consider inflation by stating the cash flow in current dollars at the time the projections are made. For instance, if the cash flows are in nominal terms nominal discount rates should be used to account for inflation which increases the accuracy of the cash flows and reduces the error caused by inflation (Ball et al., 2016).

What does the term "risk" mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?

Risk refers to the uncertainty in finance regarding the future events and it influences the profitability of the project in the future in capital budgeting. Risk in projects can be quantified by assessing the historical data of an investment especially if it is an expansion decision because past events can be used to quantify the future events (Ball et al., 2016).

What are the three types of risk that are relevant in capital budgeting? How is each of these risk types measured, and how do they relate to one another?

Stand-alone risk

This refers to the total project risk if it was carried out independently by ignoring both the organization diversification among projects and it is measured by the project standard deviation of the NPV and also profitability measures such as IRR can also be used to estimate stand-alone risk (Paquin et al., 2016).

Within-firm risk

This is the total risk of the project in relation to other projects being undertaken by the organization. In this case, within-firm risk considered the organization diversification and it refers to the contribution of a project to the entire organization risk. Within-firm risk is measured by the projects beta which refers to the regression slope line by plotting the returns of the project against the returns of the firm (Paquin et al., 2016).

Market risk

Market risk refers to the riskiness of a project to a much diversified investor hence, it considers the risk that can be incurred by the investors by plotting the returns of the project against the returns of the market (Paquin et al., 2016).

How is each type of risk used in the capital budgeting process?

The primary management goal in many organizations is the maximization of the shareholder wealth and the ability of risks to affect many organization stakeholders such as suppliers, employees, creditors, investors and customers makes it have an important role in capital budgeting. Decisions in capital budgeting should be made by considering all the possible risks and projects that have the greatest risks should be avoided or receive less investment in capital (Campbell et al., 2016).

What is sensitivity analysis?

Sensitivity analysis refers to the measure of effects and changes in a specific variable in a project such as revenue. To carry out a sensitivity analysis an organization should set all variables at a fixed rate except one after which it is changed by specific percentages and the resulting NPV (Ding & VanderWeele, 2016).

What is the primary weakness of sensitivity analysis? What is its primary usefulness?

The prominent disadvantages of sensitivity analysis is that it does not show the effects of diversification and it does not include the information regarding the possible forecast errors magnitudes. Ignoring the relationships between variables. For instance, the unit sales and the sales price makes it a poor indicator of risk (Ding & VanderWeele, 2016).

Assume that Sidney Johnson is confident in her estimates of all the variables that affect the project's cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Johnson believes there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). What is scenario analysis? Explain it in the context of this information (detailed calculations are

Not necessary).

Scenario analysis refers to the examination of several situations that are possible in most cases the best case and the worst case. Scenario analysis is important because it provides a number of possible outcomes (Ding & VanderWeele, 2016).

Using the spreadsheet model to develop scenarios the following were deduced;

Scenario Probability Unit Sales Unit Price NPV

Best Case 25% 1600 $240 $278,965

Base Case 50% 1250 $200 $88,030

Worst Case 25% 900 $160 ($48,514)

Expected NPV = $101,628

Standard Deviation = $75,684

Coefficient Of Variation =

Std Dev / Expected NPV = 0.74

References

Ball, R., Gerakos, J., Linnainmaa, J. T., & Nikolaev, V. (2016). Accruals, cash flows, and operating profitability in the cross section of stock returns. Journal of Financial Economics, 121(1), 28-45.

Campbell, J. L., Cecchini, M., Cianci, A., Ehinger, A. C., & Werner, E. M. (2016). Do Mandatory Risk Factor Disclosures Predict Future Cash Flows and Stock Returns? Evidence from Tax Risk Factor Disclosures.

Ding, P., & VanderWeele, T. J. (2016). Sensitivity analysis without assumptions. Epidemiology (Cambridge, Mass.), 27(3), 368.

Paquin, J. P., Gauthier, C., & Morin, P. P. (2016). The downside risk of project portfolios: The impact of capital investment projects and the value of project efficiency and project risk management programmes. International Journal of Project Management, 34(8), 1460-1470.