Explain three types of risk that are relevant in capital budgeting decisions.

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Talbot Industries, Campbell Company, and MorChuck Corporation are among the many companies that understand the importance of cash flow estimation and risk analysis. For example, Talbot conducts risk analysis using sensitivity analysis, break-even analysis, scenario analysis, and Monte Carlo simulation analysis on a wide variety of capital budgeting projects. The company’s CFO, Erin Joyner MBA says that risk analysis especially the use of Monte Carlo simulation has been very useful in analyzing more complex projects with simulation software packages, and ultimately helping the company to make superior decisions. Last year the company spent $1.5 million to investigate a site for a potential new distribution center, which was not realized because the distribution center was not built. The company is now contemplating replacing an old equipment with a new model. The $1.5 million cost of the site will not be included in any capital budgeting decision. The CEO of Talbot Industries has asked you to assist Erin Joyner to prepare a report for the Investment Committee to help finalize decision on the new equipment. In the report the CEO wants you to address certain key concepts, cash flow projections, and risk analysis.

1.Explain the following terms in the report:

i. incremental cash flow

ii. sunk cost

iii. externalities

iv. cannibalization

v. growth option

2. Talbot Industries Inc. is considering purchasing a new equipment. The manufacturing equipment will cost $18 million, the equipment will require an initial investment of $5 million in net working capital. Installation cost is $2 million.

i. What is the initial investment outlay?

ii. Talbot Inc. wants to depreciate the manufacturing equipment using straight-line depreciation method. The equipment will last for 10 years, and the cost basis is $20 million. Estimate the depreciation expense for each year.

3. The finance team of Talbot has identified the following information for the first year of the project:

i. The company faces a 25% tax rate. What is the cash flow for the first year?

4. Talbot Industries Inc. has determined that the cash flows the company will have if it buys the equipment is $100 million. However, if the firm rejects the expansion project and keep to its existing machinery and equipment, it will still be able to maintain its $65 million cash flows. Calculate the firm’s incremental or relevant cash flows.

5. The director of capital budgeting has asked you to include risk analysis in your report. He wants you to explain risk in the context of capital budgeting, and how the risk can be analyzed.

1. Explain three types of risk that are relevant in capital budgeting decisions.
2. How is each of these risk types measured?

6. Explain three techniques used to assess stand-alone risk