Investment Decisions Flashcards

Which technique adjusts for project risk by adding a risk premium to the discount rate used in NPV analysis?

Answer: Risk-adjusted discount rate method

The risk-adjusted discount rate method incorporates project risk by adding a risk premium to the baseline cost of capital before discounting cash flows.

Sensitivity analysis in capital budgeting examines:

Answer: The impact on NPV of changing one variable at a time while holding others constant

Sensitivity analysis changes one input variable at a time (e.g., unit price, volume) to show how sensitive NPV is to that single factor.

A project with high operating leverage means:

Answer: Small changes in sales volume cause large changes in operating income

High operating leverage means a large proportion of costs are fixed, so small revenue changes produce amplified swings in operating income.

Scenario analysis differs from sensitivity analysis primarily because it:

Answer: Changes multiple variables simultaneously to reflect realistic combined conditions

Scenario analysis evaluates NPV under bundled sets of assumptions (best case, base case, worst case) by varying several variables simultaneously.

The certainty equivalent approach to risk adjustment converts risky cash flows by:

Answer: Multiplying each risky cash flow by a certainty equivalent coefficient, then discounting at the risk-free rate

The certainty equivalent approach adjusts each risky cash flow downward to its risk-free equivalent and then discounts at the risk-free rate.

Real options in capital budgeting refer to:

Answer: Managerial flexibility to modify a project after the initial investment is made

Real options represent management's embedded flexibility to expand, abandon, defer, or switch a project as uncertainty resolves over time, adding value beyond standard NPV.