Finance

Created 7/1/1996
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Business Administration 130:

Where Do Cash Flows Come From?

 


Basics:

 


Exam:

Not good at knowing when your calculator has betrayed you; little sense of what answer should be. Little sense of the relationship between variance of securities, variance of portfolios, and betas...


No Black Boxes:

A black box is something that we accept and use but do not understand. We have been treating capital porjects as black boxes--but a good financial manager should never accept black boxes.

Techniques for project analysis:


Sensitivity Analysis:

An electric car project:

Year 0

Years 1-10

 Investment

- $150

 Revenue

 $375

 Variable Cost

 -$300

 Fixed Cost

 -$30

 Depreciation

 -$15

 Pretax Profit

 $30

 Tax

- $15

 Net Profit

 $15

 Operating Cash Flow

 $30

 Net Cash Flow

 -$150

 $30

Assuming that the investment is depreciated straight-line over ten years, and that corporate income is taxed at a rate of 50%.

With a 10% opportunity cost of capital, NPV = -150 +sum(i=1 to 10, $30/((1.10)t)) = +$34.3. Should you invest? The right answer is that you should make your forecasting staff do more work:

 Variable

 Pessimistic

 Expected

 Optimistic

 Market size

 +$11

+$34

+$57

 Market share

 -$104

+$34

+$173

 Unit price

 -$42

$34

+$50

 Unit variable cost

 -$150

+$34

+$111

 Fixed cost

 +$4

+$34

+$65

The project is by no means a sure thing--if you can find information to improve your forecasts of unit variable costs and of market share, you should do so.

Limits to sensitivity analysis: what does "optimistic" mean?

What if variables are interrelated? Scenarios. Different consistent combinations.


Break-Even Analysis


Adam Smith
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