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1. Concepts used in cash flow estimation and risk analysis You can come across different situations...

1. Concepts used in cash flow estimation and risk analysis

You can come across different situations in your life where the concepts from capital budgeting will help you in evaluating the situation and making calculated decisions. Consider the following situation:

The following table contains five definitions or concepts. Identify the term that best corresponds to the concept or definition given.

Concept or Definition

Term
An example of externality that can have a negative effect on a firm Cannibalization/corporate risk/ Exchange rate risk/ Beta risk
The cash flow at the end of the life of the project Initial cash flow/ Incremental cash flow/ Terminal cash flow/ Relevant cash flow
Creates value for a company because it gives the company the right but not the obligation to take future action to increase its cash flows Expropriation/ opportunity cost/ Externalities/ Real option
The risk of a project without factoring in the impact of diversification Beta risk/ Market risk/ Corporate risk/ stand alone risk
A risk analysis technique that measures changes in the internal rate of return (IRR) and net present value (NPV) as individual variables are changed pure-play analysis/ sensitivity analysis/ casino analysis/ possibility analysis

A successful sushi chain in Hong Kong spent $500,000 to conduct a study on whether to open a location in the United States. The study showed that the best place for the company to open its first location would be in Chicago. When conducting its capital budgeting analysis, how should the company account for the cost of the study when estimating the amount of the initial investment that the new store will require?

The company should include the cost of the study in the amount of the initial investment.

The company should ignore the cost of the study.

The company should include half of the cost of the study in the initial investment.

A large soft-drink company currently produces regular cola and diet cola. It is considering introducing a new soft drink that tastes like regular cola but has zero calories like the diet cola. The new zero-calorie drink that tastes like regular cola is most likely to produce ___(a negative within firm/an environmental/ a positive within firm)___ externality.

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Answer #1

Part 1 match the following with terms

An example of externality Cannibalization
The cash flow at the end of the life of the project Terminal cash flow
Creates value for a company Real option
The risk of a project without factoring in the impact of div. stand alone risk
A risk analysis technique that measures changes (IRR) & (NPV) sensitivity analysis

Part 2

The company should ignore the cost of the study. (The reason being that it is a sunk cost)

Part 3

A negative within-firm externality.

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