Cash Flow Estimation and Risk Analysis

Chapter 12

Cash Flow Estimation and Risk Analysis

LEARNING OBJECTIVES

After reading this chapter, students should be able to:

• Discuss difficulties and relevant considerations in estimating net cash flows, and explain the four major ways that project cash flow differs from accounting income.

• Define the following terms: relevant cash flow, incremental cash flow, sunk cost, opportunity cost, externalities, and cannibalization.

• Identify the three categories to which incremental cash flows can be classified.

• Analyze an expansion project and make a decision whether the project should be accepted on the basis of standard capital budgeting techniques.

• Explain three reasons why corporate risk is important even if a firm’s stockholders are well diversified.

• Identify two reasons why stand-alone risk is important.

• Demonstrate sensitivity and scenario analyses and explain Monte Carlo simulation.

• Discuss the two methods used to incorporate risk into capital budgeting decisions.

• List four different types of embedded real options, explain what a decision tree is, and provide an example of one.

• List the steps a firm goes through when establishing its optimal capital budget in practice.

LECTURE SUGGESTIONS

This chapter develops procedures for estimating and identifying relevant cash flows, discusses techniques used to measure and take account of project risk, introduces the concept of real options, and discusses general principles for determining the optimal capital budget.

Assuming you are going to cover the entire chapter, the details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 12. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

ANSWERS TO END-OF-CHAPTER QUESTIONS

12-1 Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapter

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