NaimExplain

Why is managerial flexibility important in capital budgeting? Answer: Some projects may take in added value because they give the firm the option to bail out if things go wrong or to capitalize on success by expanding. These options are known as REAL OPTIONS, which include options to expand, abandon, delay investment, or make use of flexible production facilities. We showed how DECISION TREES may be used to set out the possible choices.

Why is an overestimate of sales more serious for projects with high operating leverage? Answer: OPERATING LEVERAGE, the degree to which costs are fixed. A project's breakeven point will be affected by the extent to which costs can be reduced as sales decline. If the project has mostly FIXED COSTS, it is said to have HIGH OPERATING LEVERAGE. High operating leverage implies that profits are more sensitive to changes in sales.

How are sensitivity, scenario, and break-even analyses used to see the effects of forecasting errors on project profitability? Answer: Good managers realize that the forecasts behind NPV calculations are imperfect. Therefore, they explore the consequences of a poor forecast and check whether it is worth doing some more homework. They use the following principal tools to answer these "what if" questions: - SENSITIVITY ANALYSIS, in which one variable at a time is changed. - SCENARIO ANALYSIS, in which the manager looks at the project under alternative scenarios. - SIMULATION ANALYSIS, an extension of scenario analysis in which a computer generates hundreds or thousands of possible combinations of variables. - BREAK-EVEN ANALYSIS, in which the focus is on how far sales could fall before a project begins to lose money. Often the phrase "lose money" is defined in terms of accounting losses, but it makes more sense to define it as "failing to cover the op...

How do large corporations go about selecting positive NPV projects? Answer: For most large corporations there are two stages in the investment process: the preparation of the CAPITAL BUDGET, which is a list of planning investments, and the authorization process for individual projects. This process is usually a cooperative effort. Investment projects should never be selected through a purely mechanical process. Managers need to ask why a project should have a positive NPV. A positive NPV is plausible only if the company has some competitive advantage that prevents its rivals from stealing most of the gains.