Capital Budgeting

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Capital Budgeting

Category : Articles

2. Capital Budgeting
Review Concept Question 1, 2 and 3 on page 284. In at least 200 words, fully answer Concept Question 9 on page 284, give at least three considerations. Support your answer. Respond to at least two of your fellow students postings.
1. Forecasting Risk What is forecasting risk In general, would the degree of forecasting risk be greater for a new product or a cost-cutting proposal Why
Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with new product because the cash flows are harder to predict.

2. Sensitivity Analysis and Scenario Analysis What is the essential difference between sensitivity analysis and scenario analysis
A sensitivity analysis, is one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.

3. Marginal Cash Flows A co-worker claims that looking at all this marginal this and incremental that is just a bunch of nonsense, and states: ???Listen, if our average revenue doesn??™t exceed our average cost, then we will have a negative cash flow, and we will go broke!??? How do you respond
It is true that if average revenue is less than average cost the firm is loosing money. This much of the statement is therefore correct. At the margin, however accepting a project with marginal revenue in excess of its marginal cost clearly act s to increase operating cash flow.

9. Option to Wait An option can often have more than one source of value. Consider a logging company. The company can log the timber today, or wait another year (or more) to log the timber. What advantages would waiting one year potentially have

There are two sources of value with this decision to wait. Potentially the price of the timber can increase, and the amount of timber will almost definitely increase, barring a natural catastrophe or forest fire. The option to wait for a logging company is quite valuable, and companies in the industry have models to estimate the future growth of a forest depending on its age.