Corporate finance fundamentals and applications

Corporate Finance

3a) This depends on the project. b) Better than the company or industry average, whichever is higher. C) Higher than the cost of capital. d) e) over 0.

The objection is based on speculation. Since we do not know what the future reinvestment rate is going to be, we must work with the best information we have today.

Again, the objection is the same. A complaint that we have less than perfect information when we are forecasting the future is absurd. We also do not know precisely what the future cash flows will be. We still need to make a decision, and that decision must therefore be made on the basis of the best information that we have today. The criticism has no validity.

Ch 9-1. Forecasting risk reflects the risk associated with forecasting future cash flows. There is more forecasting risk for a new product than for a cost-cutting proposal. This is because the new product deals with an unknown -- we do not have any past performance data on which to base our future projections, so there is greater risk of them being inaccurate. The projections for a cost-cutting measure will be based on current data to which adjustments have been made. With more information to assist in the forecast, the forecast for the cost-cutting proposal is going to be less risky. Moreover, forecasting risk for a new product incorporates external demand conditions; much of the forecasted change in a cost-cutting proposal is internal in nature.

2. Sensitivity analysis sees the numbers changed to reflect how sensitive the numbers are to changes in things like discount rate, or some of the cash flows. It allows management to understand the degree to which the project is sensitive to particular individual variables. Scenario analysis is when radically different scenarios are presented. The numbers reflect changes to multiple variables simultaneously to reflect the scenario.

3. That view is oversimplified. When we are looking at spending money, we want to spend it wisely. A profitable company that starts to spend its money stupidly, under the notion that if we're still profitable all is fine, might find that after a few consecutive bad decisions it is no longer a profitable company. Aggregate performance, as he suggests, is a poor way to evaluate individual decisions. If each individual decision is strong, then the aggregate performance will take care of itself.