BU393 Lecture Notes - Lecture 6: Sunk Costs, Sensitivity Analysis, Net Present Value
10.4: Capital Budgeting Refinements
Incremental Cash Flows:
There are some rules to use when estimating cash flows:
- Aggressively seek and include indirect costs
- Disregard sunk costs
- Include opportunity costs
- Consider externalities
- Adjust for taxes
- Ignore financing costs
Projects with different lives:
- A longer-term project may have the highest NPV because it consumes company
resources for a long time – could have a situation where a series of shorter-term
projects would have a total larger NPV than one long term
Replacement Chain Approach:
- String together as many short-term projects as necessary to equal the life of the long-
term project, and you can then compute the NPV and compare them in the usual way
- Short-term can be repeated any number of times to equal the length of the long term
Equivalent Annual Annuity Method:
- Assumed both short-term and long-term projects can be repeated forever
- Cash flows from each are turned into annuities, and then are compared
Sensitivity Analysis:
- Can be difficult to make estimates about costs and revenues for a product or activity
that has never been attempted
- Produce a series of analyses that reflect the effects of different assumptions
- Sensitivity analysis tells the analyst how sensitive the results are to changes in estimates
- If a very small change in projection makes a large difference in NPV, the estimates may
require additional review
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
There are some rules to use when estimating cash flows: A longer-term project may have the highest npv because it consumes company resources for a long time could have a situation where a series of shorter-term projects would have a total larger npv than one long term. String together as many short-term projects as necessary to equal the life of the long- term project, and you can then compute the npv and compare them in the usual way. Short-term can be repeated any number of times to equal the length of the long term. Assumed both short-term and long-term projects can be repeated forever. Cash flows from each are turned into annuities, and then are compared. Can be difficult to make estimates about costs and revenues for a product or activity that has never been attempted. Produce a series of analyses that reflect the effects of different assumptions.
