Investment Analysis Flashcards

Which risk analysis technique changes one input variable at a time while holding all others constant to see its effect on NPV?

Answer: Sensitivity analysis

Sensitivity analysis isolates the effect of each individual variable on project outcomes.

What is the primary output of a Monte Carlo simulation in capital budgeting?

Answer: A probability distribution of possible NPVs

Monte Carlo runs thousands of random trials to produce a distribution of outcomes and their likelihoods.

A firm plans to build a new plant on land it already owns, which could be sold for $2 million. How should the land be treated in the NPV analysis?

Answer: Include its $2 million market value as an opportunity cost

The forgone sale proceeds are an opportunity cost and a relevant incremental outflow.

A project requires a $300,000 increase in net working capital at launch. How is this typically handled in the cash flow analysis?

Answer: Treated as an initial outflow and recovered at the end of the project

Working capital is an upfront investment that is usually recaptured when the project ends.

A project generates $100,000 of annual depreciation and the firm's tax rate is 25%. What is the annual depreciation tax shield?

Answer: $25,000

Tax shield = depreciation × tax rate = $100,000 × 25% = $25,000.

A diversified firm evaluates a project in a much riskier industry than its core business. Which discount rate is most appropriate?

Answer: A risk-adjusted rate based on a pure-play comparable's beta

Project-specific risk should be reflected using a beta from comparable firms in that industry.

Under single-period capital rationing, which metric is best for ranking projects to maximize total NPV within the budget?

Answer: Profitability index

The profitability index ranks projects by NPV generated per dollar invested, which maximizes value under a budget constraint.