Capital Budgeting Case Study

Part e. Estimate the required net working capital for each year and the cash flow due to investments in net working capital.
The firm needs to increase its net working capital by 12% of incremental sales revenues. This amount is needed in the year before the sales revenue is earned. The amount for year 0 is 12% x $250,000 = $30,000.00, and that for year 1, 2, and 3 are $30,900.00, $31,827.00, and $32,781.81 respectively. The cash flow due to the changes in the working capital is shown in Table 2.
Year 0 1 2 3 4
Cash flow due to the changes in the working capital $ (30,000) $(900) $ (927) $(955) $32,782

Table 2: The cash flow due to investments in the net working capital

Part f.
Part h. What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgemental estimates?
Answer. In capital budgeting, the term ‘risk’ refers to the chance that a chosen action or activity or the the choice of inaction will lead to an undesirable outcome (e.g. a loss). There are many different types of risks, and some of them can be quantified using formal statistical methods such as the scenario analysis with the mean and standard deviation of the NPV. However, some are quantified using subjective judgemental estimates involving human decision making. Both methods of risk assessment are important to capital budgeting (“The relationship between risk and capital budgeting,” n.d.).

Part i. What are the three types of risk that are relevant in capital budgeting? How is each of these risk types measured, and how do they relate to one
What is sensitivity analysis? According to Brigham and Ehrhardt (2014), a sensitivity analysis measures the percentage change in NPV that results from a given percentage changei n an input variable when other inputs are held at their expected values. Adams (n.d.) added that the sensitivity analysis process involves identifying the factors that influence the project's cash flows, establishing a mathematical relationship between these factors and analyzing how a change in each of these factors affect the project's cash flows. One should avoid a project whose cash flows are sensitive to changes in any of the above-listed factors as it is considered risky (Adams, n.d.). Sensitivity analysis involves posing 'what-if' questions, and with this technique it is possible to establish which variables are more critical than others in affecting a decision (“Sensitivity analysis,”