Question

Define each of the following terms:
a. Project cash flow; accounting income
b. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalization;
expansion project; replacement project
c. Net operating working capital changes; salvage value
d. Stand-alone risk; corporate (within-firm) risk; market (beta) risk
e. Sensitivity analysis; scenario analysis; Monte Carlo simulation analysis
f. Risk-adjusted discount rate; project cost of capital
g. Decision tree; staged decision tree; decision node; branch
h. Real options; managerial options; strategic options; embedded options
i. Investment timing option; growth option; abandonment option; flexibility option

Answer 1

a. Project Cash Flows: It is a part of financial planning for projects, understanding the inflows and outflows of cash that will be created by the project. A cash flow table is a tool that is used to study such cash flows by breaking inflows and outflows down, usually on a monthly basis. It also serves as an important tracking tool creating a baseline against which project spending can be compared. A cash flow enables to create a short term forecast that enables to determine how you are going to get money for the project and how you are going to pay for your expenses. Cash inflows usually arise from financing, operations, and investing, while cash outflows mainly results from expenses.

These cash flows can be segmented as follows:

1. Initial investment outlay: Cost needed to start the project.

2. Operating cash flow over a project life: Additional cash flow a new project generates.

3. Terminal year cash flow: This is the final cash flow, both the inflows and outflows at the end of the project life.

Accounting Income:

Accounting Income = Total Revenue - Total Expenses

It is the change in net income during a reporting period, excluding any receipts from or disbursements to owners. It shows the results of all operational and financial activities.

It has nothing to do with cash flows, but both concepts interelate. Net income translates into money, but this doesnot happen if customers face financial tedium and cant remit funds.

B. Incremental Cash Flows : These are the net additional cash flows generated by a company by undertaking a project. Incremental cash flows are estimated by comparing the company's net cash flows if the project is accepted and its cash flows if the project is not accepted. A positive incremental cash flow means that a company cash flow will increase with the acceptance of the project. It is a good indication that an organisation should spend some time and money investing in the project.

It is the net cash flow from all cash inflows and outflows over a specific time period and between two or more business choices.

Incremental cash flows = Revenues - Expenses - Initial Cost

Sunk Cost :  It is a cost that has already been incurred and cannot be recovered. Sunk cost cannot be changed or avoided in the future, they are not relevant for deceion making process. It is also known as stranded cost.

Example - A company pays a new recruit $10,000 to join the organisation. If the person proves to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether the individual employment should be terminated.

Opportunity Cost : It isis the difference between money already spent and potential returns not earned on an investment because capital was invested elsewhere. Opportunity cost is the cost of a foregone alternative. If yoy choose one alternative over another, then the cost of choosing that alternative is an opportunity cost.

Externality- They are defined as the third party effects arising from the production and consumption of goods and services for which no appropriate compensation is paid. It is defined as the positive or negative consequences of economic activities on unrelated third parties.

Cannibalization - It is observed if the sales of a firms new product is high because of decreasing sales of its existing and established product. It is the negative impact a company new product has on the sales performance of its existing and related products.

Expansion Project and Replacement Project-

Expansion projects are projects where the firm seeks to profitably increase sales of current products or introduce new products into the market.

Replacement Projects - Thesr are the projects where the firm must either replace worn out equipment or invest in new equipment that is expected to lower current production costs and increase current sales.

C. Net Operating Working Capital - The ratio measures a company ability to pay all of its working liabilities with its operational assets. This is an important metric because its shows the leverage of the company and the amount of current, working assets. It also shows how a company operates using its resources and how it efficiently the company can adapt to unexpected events and new opportunities

The net working capital is calculated by subtracting working liablities from working assets

= Cash+ Accounts Receivable + Inventory - Accounts Payable + Accrued Expenses.

Salvage Value - It is the estimated amount that an asset is worth at the end of its useful life. It is also known as scap value or residual value and is used to determine the annual depreciation expense of an asset.

D. Stand alone Risk - It refers to the involvement of the single unit or asset of the company. The risks associated with these individual entities separately, dealing one section at a time is formally known under the perspective of standalone risk.

Corporate Risk - This risk assumes the project of a company incorporated with a company other assets. It is measured by the potential impact a project may have on the company earnings.

Market Risk - It is the risk that the value of an investment nay decrease due to changes in market factors such as currency exchange rates, intrest rates, commodity prices. It affects the overall performance of the financial markets.