1. Topic 7: Capital Budgeting Practice Instructor ： Zou Ying Eighth Edition

2. Topic Covered  1. What is capital budgeting?  2. Evaluating project cash flows  3. Risk and risk analysis  4. Practical methods of capital budgeting  5. Summary Instructor ： Zou Ying

3. What is Capital Budgeting? Instructor ： Zou Ying Capital ： operating assets used in production. Budget ： a plan that details projected cash flows during some future period. Capital budget ： an outline of planned investments in operating assets.  Capital budgeting ： the whole process of evaluating and analyzing projects and deciding which ones to include in the capital budget.

4. What is Capital Budgeting? Instructor ： Zou Ying  Capital budgeting is the decision process that managers use to identify those projects that add to the firm’s value, and so such it is the most important task faced by financial managers and their staffs. Define the firm’s strategic direction. Long-term decisions; involve large expenditures, reducing flexibility. Instructor ： Zou Ying

5. What is Capital Budgeting? Instructor ： Zou Ying Very important to firm’s future ：  If it invests too much ：  If it does not invest enough ： Capital budgeting projects are created by the firm. The primary idea of this topic ： Firms must screen projects for those that add value. Instructor ： Zou Ying

6. The Capital Budgeting Process  Generate investment proposals consistent with the firm’s strategic objectives.  Estimate after-tax incremental operating cash flows for the investment projects.  Assess risk of cash flows.  Determine r = WACC for project.  Select projects based on a value-maximizing acceptance criterion.  Reevaluate implemented investment projects continually and perform postaudits for completed projects.  Generate investment proposals consistent with the firm’s strategic objectives.  Estimate after-tax incremental operating cash flows for the investment projects.  Assess risk of cash flows.  Determine r = WACC for project.  Select projects based on a value-maximizing acceptance criterion.  Reevaluate implemented investment projects continually and perform postaudits for completed projects. The project’s risk adjusted cost of capital Instructor ： Zou Ying

7. What is the difference between independent and mutually exclusive projects? Projects are:  independent, if the cash flows of one are unaffected by the acceptance of the other.  mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. Instructor ： Zou Ying

8. Estimating After-Tax Incremental Cash Flows  Cash (not accounting income) flows  Operating (not financing) flows  After-tax flows  Incremental flows  Cash (not accounting income) flows  Operating (not financing) flows  After-tax flows  Incremental flows Basic characteristics of relevant project flows Instructor ： Zou Ying

9.  Ignore sunk costs  Include opportunity costs  Include project-driven changes in working capital net of spontaneous changes in current liabilities  Include effects of inflation  Ignore sunk costs  Include opportunity costs  Include project-driven changes in working capital net of spontaneous changes in current liabilities  Include effects of inflation Principles that must be adhered to in the estimation Estimating After-Tax Incremental Cash Flows Instructor ： Zou Ying

10. Tax Considerations and Depreciation u Depreciation u Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both.  Generally, profitable firms prefer to use an accelerated method for tax reporting purposes (MACRS). Instructor ： Zou Ying

11. Depreciation and the MACRS Method  Everything else equal, the greater the depreciation charges, the lower the taxes paid by the firm.  Depreciation is a noncash expense.  Assets are depreciated (MACRS) on one of eight different property classes.  Generally, the half-year convention is used for MACRS. Instructor ： Zou Ying

12.  Certain property is subject to depreciation. Depreciation allows one to deduct a certain amount of the value or basis of depreciable property per taxable year. A person with depreciable property must know when to start depreciating his/her property. The tax code explains how to do this through, what is called, the applicable convention.depreciationapplicable convention  In tax accounting the half-year convention is the default applicable convention used for federal income tax purposes.tax accounting Wikipedia says Half-year Convention

13.  Like other conventions, the half-year convention affects the depreciation deduction computation in the year in which the property is placed into service. Using the half- year convention, a taxpayer claims a half of a year's depreciation for the first taxable year, regardless of when the property was actually put into service. It is assumed that the property being depreciated was placed into service at the mid-point of the year. To compensate for this computation, the taxpayer is entitled to another half-year of depreciation at the end of the normal recovery period. § 168(d)(4) of the Federal Income Tax Code defines half-year convention as a convention which treats all property placed in service during any taxable year (or disposed of during any taxable year) as placed in service (or disposed of) on the mid-point of such taxable year. Wikipedia says Half-year Convention

14. MACRS Sample Schedule Instructor ： Zou Ying

15. Depreciable Basis In tax accounting, the fully installed cost of an asset. This is the amount that, by law, may be written off over time for tax purposes. Depreciable Basis Depreciable Basis = Cost of Asset Capitalized Expenditures Cost of Asset + Capitalized Expenditures Instructor ： Zou Ying

16. Capitalized Expenditures  Capitalized Expenditures  Capitalized Expenditures are expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred.  Examples: Shipping and installation Instructor ： Zou Ying

17. Why is it important to include inflation when estimating cash flows?  Nominal r > real r. The cost of capital, r, includes a premium for inflation.  Nominal CF > real CF. This is because nominal cash flows incorporate inflation.  If you discount real CF with the higher nominal r, then your NPV estimate is too low.  Nominal CF should be discounted with nominal r, and real CF should be discounted with real r.  It is more realistic to find the nominal CF (i.e., increase cash flow estimates with inflation) than it is to reduce the nominal r to a real r. Instructor ： Zou Ying

18. What if you terminate a project before the asset is fully depreciated?  Cash flow from sale = Sale proceeds- taxes paid.  Taxes are based on difference between sales price and tax basis, where:  Basis = Original basis - Accum. deprec. Instructor ： Zou Ying

19. Incremental Cash Flow for a Project  Project’s incremental cash flow is:  Corporate cash flow with the project Minus  Corporate cash flow without the project. Instructor ： Zou Ying

20.  NO. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors.  They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs. Should you subtract interest expense or dividends when calculating CF? Instructor ： Zou Ying

21. Calculating the Incremental Cash flows  Initial cash outflow  Initial cash outflow -- the initial net cash investment.  Interim incremental net cash flows  Interim incremental net cash flows -- those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.  Terminal-year incremental net cash flows  Terminal-year incremental net cash flows -- the final period’s net cash flow. Instructor ： Zou Ying

22. Initial Cash Outflow a) Cost of “new” assets b)+ Capitalized expenditures c)+ (-)Increased (decreased) NWC d)- Net proceeds from sale of “old” asset(s) if replacement e)+ (-)Taxes (savings) due to the sale of “old” asset(s) if replacement f)= Initial cash outflow Instructor ： Zou Ying

23. Interim incremental net cash flows a) Net incr. (decr.) in operating revenue less (plus) any net incr. (decr.) in operating expenses, excluding depr. b)- (+) Net incr. (decr.) in tax depreciation c)= Net change in income before taxes d)- (+) Net incr. (decr.) in taxes e)= Net change in income after taxes f)+ (-) Net incr. (decr.) in tax depr. charges =Incremental net cash flow for period g)=Incremental net cash flow for period Instructor ： Zou Ying

24. Terminal-Year Incremental Cash Flows incremental net cash flow terminal period a) Calculate the incremental net cash flow for the terminal period b)+ (-) Salvage value (disposal/reclamation costs) of any sold or disposed assets c)- (+) Taxes (tax savings) due to asset sale or disposal of “new” assets d)+ (-) Decreased (increased) level of “net” working capital = Terminal year incremental net cash flow e) = Terminal year incremental net cash flow Instructor ： Zou Ying

25.  Uncertainty about a project’s future profitability.  Measured by  NPV,  IRR, beta.  Will taking on the project increase the firm’s and stockholders’ risk? What does “risk” mean in capital budgeting? Is risk analysis based on historical data or subjective judgment?  Can sometimes use historical data, but generally cannot.  So risk analysis in capital budgeting is usually based on subjective judgments. Instructor ： Zou Ying

26.  Stand-alone  Corporate risk  Market (or beta) risk Three types of risk relevant in capital budgeting Instructor ： Zou Ying

27. 投資案風險示意圖

28.  Stand-alone risk: assumes the project a company intends to pursue is a single asset that is separate from the company's other assets. It is measured by the variability of the single project alone. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk. Three types of risk relevant in capital budgeting Instructor ： Zou Ying

29.  Corporate risk: assumes the project a company intends to pursue is not a single asset but incorporated with a company's other assets. As such, the risk of a project could be diversified away by the company's other assets. It is measured by the potential impact a project may have on the company's earnings. Three types of risk relevant in capital budgeting Instructor ： Zou Ying

30.  Market (or beta) risk: looks at the risk of a project through the eyes of the stockholder. It looks at the project not only from a company's perspective, but from the stockholder's overall portfolio. It is measured by the effect the project may have on the company's beta. Three types of risk relevant in capital budgeting Instructor ： Zou Ying

31.  Stand-alone risk ： is important in capital budgeting, because  Is easier to estimate and measure than the other two risks;  Three types of risk are highly correlated, stand-alone risk is a good proxy for the other two risks.  Corporate risk  Market (or beta) risk Three types of risk relevant in capital budgeting Instructor ： Zou Ying

32. The project’s risk if it were the firm’s only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the variability of the project’s expected return (  or CV of NPV, IRR, or MIRR. Stand-Alone Risk Instructor ： Zou Ying

33. 0E(NPV) Probability Density Flatter distribution, larger, larger stand-alone risk. Such graphics are increasingly used by corporations. NPV Instructor ： Zou Ying

34. Reflects the project’s effect on uncertainty about the firm’s future earnings(corporate earnings stability). Considers firm’s other assets (diversification within firm). Depends on: project’s , and its correlation, , with returns on firm’s other assets. Measured by the project’s corporate beta. Corporate Risk: Instructor ： Zou Ying

35. Profitability 0 Years Project X Total Firm Rest of Firm 1.Project X is negatively correlated to firm’s other assets. 2.If r < 1.0, some diversification benefits. 3.If r = 1.0, no diversification effects.

36. Reflects the project’s effect on a well- diversified stock portfolio. Takes account of stockholders’ other assets. Depends on project’s and correlation with the stock market. Measured by the project’s market beta. Market Risk: Instructor ： Zou Ying

37.  Market risk is theoretically best in most situations.  However, creditors, customers, suppliers, and employees are more affected by corporate risk.  Therefore, corporate risk is also relevant.  Stand-alone risk is easiest to measure, more intuitive.  Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk.  If the project is highly correlated with the economy, stand-alone risk also reflects market risk. How is each type of risk used? Instructor ： Zou Ying

38.  Shows how changes in a variable such as unit sales affect NPV or IRR.  Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR.  Answers “what if” questions, e.g. “What if sales decline by 30%?” Instructor ： Zou Ying What is sensitivity analysis?

39. -30%$113$17 $85 -15%$100 $52 $86 0%$88 $88 $88 15%$76 $124 $90 30%$65 $159 $91 Change from Resulting NPV (000s) Base Level r Unit Sales Salvage Sensitivity Analysis In a sensitivity analysis, each variable is changed by several percentage points above and below the expected value,holding all other variables constant.

40. -30 -20 -10 Base 10 20 30 Value (%) 88 NPV (000s) Unit Sales Salvage r Instructor ： Zou Ying

41.  Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV.  Unit sales line is steeper than salvage value or r, so for this project, should worry most about accuracy of sales forecast. Instructor ： Zou Ying Results of Sensitivity Analysis

42.  Does not reflect diversification.  Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales won’t fall.  Ignores relationships among variables. Instructor ： Zou Ying The weaknesses of sensitivity analysis Why is sensitivity analysis useful?  Gives some idea of stand-alone risk.  Identifies dangerous variables.  Gives some breakeven information.

43.  Examines several possible situations, usually worst case, most likely case, and best case.  Provides a range of possible outcomes. Instructor ： Zou Ying What is scenario analysis?

44. Scenario ProbabilityNPV(000) Best scenario: 1,600 units @ $240 Worst scenario: 900 units @ $160 Best 0.25$ 279 Base0.5088 Worst 0.25-49 E(NPV) = $101.5  (NPV) = 75.7 CV(NPV) =  (NPV)/E(NPV) =0.75 Instructor ： Zou Ying

45. Only considers a few possible out-comes. Assumes that inputs are perfectly correlated--all “bad” values occur together and all “good” values occur together. Focuses on stand-alone risk, although subjective adjustments can be made. Instructor ： Zou Ying Problems with scenario analysis

46.  A computerized version of scenario analysis which uses continuous probability distributions.  Computer selects values for each variable based on given probability distributions.  NPV and IRR are calculated.  Process is repeated many times (1,000 or more).  End result: Probability distribution of NPV and IRR based on sample of simulated values.  Generally shown graphically. Instructor ： Zou Ying What is a simulation analysis?

47. Simulation Example  Assume a:  Normal distribution for unit sales: Mean = 1,250 Standard deviation = 200  Triangular distribution for unit price: Lower bound= $160 Most likely= $200 Upper bound= $250 Instructor ： Zou Ying

48. Simulation Process  Pick a random variable for unit sales and sale price.  Substitute these values in the spreadsheet and calculate NPV.  Repeat the process many times, saving the input variables (units and price) and the output (NPV). Instructor ： Zou Ying

49. Simulation Results (1000 trials) Units PriceNPV Mean1260$202 $95,914 St. Dev.201$18 $59,875 CV0.62 Max1883 $248 $353,238 Min685$163 ($45,713) Prob NPV>097% Instructor ： Zou Ying Interpreting the Results  Inputs are consistent with specificied distributions.  Units: Mean = 1260, St. Dev. = 201.  Price: Min = $163, Mean = $202, Max = $248.  Mean NPV = $95,914. Low probability of negative NPV (100% - 97% = 3%).

50. Histogram of Results Instructor ： Zou Ying

51.  Advantages ：  Reflects the probability distributions of each input.  Shows range of NPVs, the expected NPV,  NPV, and CV NPV.  Gives an intuitive graph of the risk situation. Instructor ： Zou Ying The advantages and disadvantages of simulation analysis  Disadvantages ：  Difficult to specify probability distributions and correlations.  If inputs are bad, output will be bad: “Garbage in, garbage out.”

52.  Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a project’s expected return is sufficient to compensate for its risk.  Sensitivity, scenario, and simulation analyses all ignore diversification. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting. Instructor ： Zou Ying

53. About the discount rate  Any project’s cost of capital depends on the use to which the capital is being put—not the source.  Therefore, it depends on the risk of the project and not the risk of the company. Instructor ： Zou Ying

54. Risk,DCF and CEQ Page 227 Instructor ： Zou Ying

55. Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project? Instructor ： Zou Ying =6%+0.75×8%=12%

56. Risk,DCF and CEQ Instructor ： Zou Ying Now assume that the cash flows change, but are RISK FREE. What is the new PV?

57. Risk,DCF and CEQ Instructor ： Zou Ying

58. Risk,DCF and CEQ Instructor ： Zou Ying Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.

59. Risk,DCF and CEQ DEDUCTION FOR RISK Instructor ： Zou Ying The difference between the 100 and the certainty equivalent (94.6) is 5.4%…this % can be considered the annual premium on a risky cash flow

60. Instructor ： Zou Ying Risk,DCF and CEQ

61. Strengths of Payback: 1.Provides an indication of a project’s risk and liquidity. 2.Easy to calculate and understand. Weaknesses of Payback: 1.Ignores the TVM. 2.Ignores CFs occurring after the payback period. About payback period ： Instructor ： Zou Ying

62. NPV:Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative. Instructor ： Zou Ying

63. Rationale for the NPV Method NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. Instructor ： Zou Ying

64. Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. Instructor ： Zou Ying

65. Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example:WACC = 10%, IRR = 15%. Profitable. Instructor ： Zou Ying

66. NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. Instructor ： Zou Ying

67. Construct NPV Profiles Find NPV L and NPV S at different discount rates: r 0 5 10 15 20 NPV L 50 33 19 7 NPV S 40 29 20 12 5 (4) Instructor ： Zou Ying

68. NPV ($) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% r 0 5 10 15 20 NPV L 50 33 19 7 (4) NPV S 40 29 20 12 5 S L Instructor ： Zou Ying

69. NPV and IRR always lead to the same accept/reject decision for independent projects: r > IRR and NPV < 0. Reject. NPV ($) r (%) IRR IRR > r and NPV > 0 Accept. Instructor ： Zou Ying

70. Mutually Exclusive Projects r 8.7 r NPV % IRR S IRR L L S r NPV S, IRR S > IRR L CONFLICT r > 8.7: NPV S > NPV L, IRR S > IRR L NO CONFLICT Instructor ： Zou Ying

71. Two Reasons NPV Profiles Cross 1.Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. 2.Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPV S > NPV L. Instructor ： Zou Ying

72. Reinvestment Rate Assumptions  NPV assumes reinvest at r (opportunity cost of capital).  IRR assumes reinvest at IRR.  Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects. Instructor ： Zou Ying

73. Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?  Yes, MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs.  TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.

74. MIRR = 16.5% 10.080.060.0 0123 10% 66.0 12.1 158.1 MIRR for Project L (r = 10%) -100.0 10% TV inflows -100.0 PV outflows MIRR L = 16.5% $100 = $158.1 (1+MIRR L ) 3 Instructor ： Zou Ying

75. Why use MIRR versus IRR?  MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.  Managers like rate of return comparisons, and MIRR is better for this than IRR. Instructor ： Zou Ying

76.  Normal cash flow project ： Cost (negative CF) followed by a series of positive cash inflows.  One change of signs.  Nonnormal Cash Flow Project: Two or more changes of signs.  Most common: Cost (negative CF), then string of positive CFs, then cost to close project.  Nuclear power plant, strip mine. Normal/ Nonnormal Cash Flow Project: Instructor ： Zou Ying

77. Inflow (+) or Outflow (-) in Year 012345NNN -+++++ -++++- ---+++ +++--- -++-+- Instructor ： Zou Ying N N N NN

78. 5,000-5,000 012 r = 10% -800 o NPV = -386.78 o IRR =25%&400% o Why ? Instructor ： Zou Ying

79. Nonnormal CFs--two sign changes Result: 2 IRRs. At very low discount rates, the PV of CF 2 is large & negative, so NPV < 0. At very high discount rates, the PV of both CF 1 and CF 2 are low, so CF 0 dominates and again NPV < 0. In between, the discount rate hits CF 2 harder than CF 1, so NPV > 0.

80. When there are nonnormal CFs and more than one IRR, use MIRR: 012 -800,0005,000,000-5,000,000 PV outflows @ 10% = -4,932,231.40 TV inflows @ 10% = 5,500,000.00. MIRR = 5.6% Reject because MIRR = 5.6% < r = 10%. Also, if MIRR < r, NPV will be negative.

81. S and L are mutually exclusive and will be repeated. r = 10%. Which is better? (000s) 01234 Project S: (100) Project L: (100) 60 33.5 60 33.5 Instructor ： Zou Ying

82. S L CF 0 -100,000 -100,000 CF 1 60,000 33,500 N j 2 4 NPV 4,132 6,190  NPV L > NPV S. But is L better? Can’t say yet. Need to perform common life analysis.  Can use either replacement chain or equivalent annual annuity analysis to make decision. i=10% Note ： Project S could be repeated after 2 years to generate additional profits.

83. Project S with Replication: NPV = $7,547. Replacement Chain Approach 01234 Project S: (100) (100) 60 60 (100) (40) 60 Instructor ： Zou Ying

84. Compare to Franchise L NPV = $6,190. Or, use NPVs: 01234 4,132 3,415 7,547 4,132 10% Instructor ： Zou Ying Replacement Chain Approach

85.  Finance theory says to accept all positive NPV projects.  Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:  An increasing marginal cost of capital.  Capital rationing. Instructor ： Zou Ying Choosing the Optimal Capital Budget

86.  Externally raised capital can have large flotation costs, which increase the cost of capital.  If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.  Investors often perceive large capital budgets as being risky, which drives up the cost of capital. Instructor ： Zou Ying Increasing Marginal Cost of Capital

87.  Capital rationing occurs when a company chooses not to fund all positive NPV projects.  The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. Instructor ： Zou Ying Capital Rationing

88.  Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital.  Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital. (More...) Instructor ： Zou Ying

89.  Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects.  Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. Instructor ： Zou Ying (More...)

90.  Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.  Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project. Instructor ： Zou Ying

91. Summary  The most important (and most difficult) step in analyzing a capital budgeting project is estimating the incremental after-tax cash flows the project will produce.  Project cash flow is different from accounting income. Project cash flow reflects: (1) cash outlays for fixed assets, (2) the tax shield provided by depreciation, and (3) cash flows due to changes in net operating working capital. Project cash flow does not include interest payments. Instructor ： Zou Ying

92.  In determining incremental cash flows, opportunity costs must be included, but sunk costs (cash outlays that have been made and that cannot be recouped) are not included. Any externalities (effects of a project on other parts of the firm) should also be reflected in the analysis.  Capital projects often require an additional investment in net operating working capital (NOWC). An increase in NOWC must be included in the Year 0 initial cash outlay, and then shown as a cash inflow in the final year of the project. Instructor ： Zou Ying Summary

93.  The incremental cash flows from a typical project can be classified into three categories: (1) initial investment outlay, (2) operating cash flows over the project’s life, and (3) terminal year cash flows.  Corporate risk is important because it influences the firm’s ability to use low-cost debt, to maintain smooth operations over time, and to avoid crises that might consume management’s energy and disrupt its employees, customers, suppliers, and community. Instructor ： Zou Ying Summary

94.  Since stockholders are generally diversified, market risk is theoretically the most relevant measure of risk. Market, or beta, risk is important because beta affects the cost of capital, which, in turn, affects stock prices. Instructor ： Zou Ying Summary

95.  Sensitivity analysis is a technique that shows how much a project’s NPV will change in response to a given change in an input variable such as sales, other things held constant.  Scenario analysis is a risk analysis technique in which the best- and worst-case NPVs are compared with the project’s expected NPV.  Monte Carlo simulation is a risk analysis technique that uses a computer to simulate future events and thus to estimate the profitability and riskiness of a project. Instructor ： Zou Ying Summary

96.  The risk-adjusted discount rate, or project cost of capital, is the rate used to evaluate a particular project. It is based on the corporate WACC, which is increased for projects that are riskier than the firm’s average project but decreased for less risky projects.  Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during or at the end of the project’s life. Instructor ： Zou Ying Summary

97.  Many projects include a variety of embedded options that can dramatically affect the true NPV. Examples of embedded options include (1) the option to accelerate or delay a project, (2) “growth options” that might enable a firm to pursue other profitable future projects, (3) the option to abandon or shut down the project, and (4) “flexibility” options that allow a firm to modify its operations over time.  Projects whose capital outlays are made in stages over several years are often evaluated using decision trees. Decision trees are also useful for identifying real options, which, in turn, may materially affect a project’s true NPV. Instructor ： Zou Ying Summary

98.  An investment timing option involves not only the decision of whether to proceed with a project but also the decision of when to proceed with it. This opportunity to affect a project’s timing can dramatically change its estimated value.  If an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible, then the investment is said to contain a growth option.  The abandonment option is the ability to abandon a project if the operating cash flows and/or abandonment value turn out to be lower than expected. It reduces the riskiness of a project and increases its value. Instructor ： Zou Ying Summary

99.  A flexibility option is the option to modify operations depending on how conditions develop during a project’s life, especially the type of output produced or the inputs used.  For planning purposes, managers need to forecast the total dollar amount that will be required to fund the acceptable projects, or the total capital budget for the planning period. They need this information to determine how much capital will have to be raised.  Capital rationing occurs when management places a constraint on the size of the firm’s capital budget during a particular period. Instructor ： Zou Ying Summary