Risk Analysis, Real Options, and Capital Budgeting
Multiple Choice Questions:
I. DEFINITIONS
SCENARIO ANALYSIS
b 1. An analysis of what happens to the estimate of the net present value when you examine
a number of different likely situations is called _____ analysis.
a. forecasting b. scenario c. sensitivity d. simulation e. break-even Difficulty level: Easy
SENSITIVITY ANALYSIS
c 2. An analysis of what happens to the estimate of net present value when only one
variable is changed is called _____ analysis.
a. forecasting b. scenario c. sensitivity d. simulation e. break-even Difficulty level: Easy
SIMULATION ANALYSIS
d 3. An analysis which combines scenario analysis with sensitivity analysis is called _____
analysis.
a. forecasting b. scenario c. sensitivity d. simulation e. break-even Difficulty level: Easy
BREAK-EVEN ANALYSIS
e 4. An analysis of the relationship between the sales volume and various measures of
profitability is called _____ analysis.
a. forecasting b. scenario c. sensitivity d. simulation e. break-even
Difficulty level: Easy
VARIABLE COSTS a 5. Variable costs: a. change in direct relationship to the quantity of output produced. b. are constant in the short-run regardless of the quantity of output produced. c. reflect the change in a variable when one more unit of output is produced. d. are subtracted from fixed costs to compute the contribution margin. e. form the basis that is used to determine the degree of operating leverage employed by a
firm.
Difficulty level: Easy
FIXED COSTS
b 6. Fixed costs: a. change as the quantity of output produced changes. b. are constant over the short-run regardless of the quantity of output produced. c. reflect the change in a variable when one more unit of output is produced. d. are subtracted from sales to compute the contribution margin. e. can be ignored in scenario analysis since they are constant over the life of a project. Difficulty level: Easy
ACCOUNTING BREAK-EVEN
c 7. The sales level that results in a project’s net income exactly equaling zero is called the
_____ break-even.
a. operational b. leveraged c. accounting d. cash e. present value Difficulty level: Easy
PRESENT VALUE BREAK-EVEN
e 8. The sales level that results in a project’s net present value exactly equaling zero is
called the _____ break-even.
a. operational b. leveraged c. accounting d. cash e. present value Difficulty level: Easy
II. CONCEPTS
SCENARIO ANALYSIS
b 9. Conducting scenario analysis helps managers see the: a. impact of an individual variable on the outcome of a project. b. potential range of outcomes from a proposed project. c. changes in long-term debt over the course of a proposed project. d. possible range of market prices for their stock over the life of a project. e. allocation distribution of funds for capital projects under conditions of hard rationing. Difficulty level: Easy
SENSITIVITY ANALYSIS
b 10. Sensitivity analysis helps you determine the: a. range of possible outcomes given possible ranges for every variable. b. degree to which the net present value reacts to changes in a single variable. c. net present value given the best and the worst possible situations. d. degree to which a project is reliant upon the fixed costs. e. level of variable costs in relation to the fixed costs of a project. Difficulty level: Easy
SENSITIVITY ANALYSIS
c 11. As the degree of sensitivity of a project to a single variable rises, the: a. lower the forecasting risk of the project. b. smaller the range of possible outcomes given a pre-defined range of values for the input. c. more attention management should place on accurately forecasting the future value of that variable. d. lower the maximum potential value of the project. e. lower the maximum potential loss of the project. Difficulty level: Medium
SENSITIVITY ANALYSIS
c 12. Sensitivity analysis is conducted by: a. holding all variables at their base level and changing the required rate of return assigned to a project. b. changing the value of two variables to determine their interdependency. c. changing the value of a single variable and computing the resulting change in the current value of a project. d. assigning either the best or the worst possible value to each variable and comparing the results to those achieved by the base case. e. managers after a project has been implemented to determine how each variable relates to the level of output realized. Difficulty level: Medium
SENSITIVITY ANALYSIS
d 13. To ascertain whether the accuracy of the variable cost estimate for a project will have much effect on the final outcome of the project, you should probably conduct _____ analysis. a. leverage b. scenario c. break-even d. sensitivity e. cash flow Difficulty level: Easy
SIMULATION
d 14. Simulation analysis is based on assigning a _____ and analyzing the results. a. narrow range of values to a single variable b. narrow range of values to multiple variables simultaneously c. wide range of values to a single variable d. wide range of values to multiple variables simultaneously e. single value to each of the variables Difficulty level: Medium
SIMULATION
e 15. The type of analysis that is most dependent upon the use of a computer is _____ analysis. a. scenario b. break-even c. sensitivity d. degree of operating leverage e. simulation Difficulty level: Easy
VARIABLE COSTS
d 16. Which one of the following is most likely a variable cost? a. office rent b. property taxes c. property insurance d. direct labor costs e. management salaries Difficulty level: Easy
VARIABLE COSTS
a 17. Which of the following statements concerning variable costs is (are) correct? I. Variable costs minus fixed costs equal marginal costs. II. Variable costs are equal to zero when production is equal to zero.
III. An increase in variable costs increases the operating cash flow. a. II only b. III only c. I and III only d. II and III only e. I and II only Difficulty level: Medium
VARIABLE COSTS
a 18. All else constant, as the variable cost per unit increases, the: a. contribution margin decreases. b. sensitivity to fixed costs decreases. c. degree of operating leverage decreases. d. operating cash flow increases. e. net profit increases. Difficulty level: Medium
FIXED COSTS
c 19. Fixed costs: I. are variable over long periods of time. II. must be paid even if production is halted. III. are generally affected by the amount of fixed assets owned by a firm. IV. per unit remain constant over a given range of production output. a. I and III only b. II and IV only c. I, II, and III only d. I, II, and IV only e. I, II, III, and IV Difficulty level: Medium
CONTRIBUTION MARGIN
c 20. The contribution margin must increase as: a. both the sales price and variable cost per unit increase. b. the fixed cost per unit declines. c. the gap between the sales price and the variable cost per unit widens. d. sales price per unit declines. e. the sales price minus the fixed cost per unit increases. Difficulty level: Medium
ACCOUNTING BREAK-EVEN
a 21. Which of the following statements are correct concerning the accounting break-even point? I. The net income is equal to zero at the accounting break-even point.
II. The net present value is equal to zero at the accounting break-even point. III. The quantity sold at the accounting break-even point is equal to the total fixed costs plus depreciation divided by the contribution margin. IV. The quantity sold at the accounting break-even point is equal to the total fixed costs divided by the contribution margin. a. I and III only b. I and IV only c. II and III only d. II and IV only e. I, II, and IV only Difficulty level: Medium
ACCOUNTING BREAK-EVEN
b 22. All else constant, the accounting break-even level of sales will decrease when the: a. fixed costs increase. b. depreciation expense decreases. c. contribution margin decreases. d. variable costs per unit increase. e. selling price per unit decreases. Difficulty level: Medium
PRESENT VALUE BREAK-EVEN
d 23. The point where a project produces a rate of return equal to the required return is known as the: a. point of zero operating leverage. b. internal break-even point. c. accounting break-even point. d. present value break-even point. e. internal break-even point. Difficulty level: Easy
PRESENT VALUE BREAK-EVEN
b 24. Which of the following statements are correct concerning the present value break-even point of a project? I. The present value of the cash inflows equals the amount of the initial investment. II. The payback period of the project is equal to the life of the project. III. The operating cash flow is at a level that produces a net present value of zero. IV. The project never pays back on a discounted basis. a. I and II only b. I and III only c. II and IV only d. III and IV only e. I, III, and IV only Difficulty level: Medium
INVESTMENT TIMING DECISION
b 25. The investment timing decision relates to: a. how long the cash flows last once a project is implemented. b. the decision as to when a project should be started. c. how frequently the cash flows of a project occur. d. how frequently the interest on the debt incurred to finance a project is compounded. e. the decision to either finance a project over time or pay out the initial cost in cash. Difficulty level: Medium
OPTION TO WAIT
e 26. The timing option that gives the option to wait: I. may be of minimal value if the project relates to a rapidly changing technology. II. is partially dependent upon the discount rate applied to the project being evaluated. III. is defined as the situation where operations are shut down for a period of time. IV. has a value equal to the net present value of the project if it is started today versus the net present value if it is started at some later date. a. I and III only b. II and IV only c. I and II only d. II, III, and IV only e. I, II, and IV only Difficulty level: Challenge
OPTION TO EXPAND
b 27. Last month you introduced a new product to the market. Consumer demand has been overwhelming and appears that strong demand will exist over the long-term. Given this situation, management should consider the option to: a. suspend. b. expand. c. abandon. d. contract. e. withdraw. Difficulty level: Easy
OPTION TO EXPAND
c 28. Including the option to expand in your project analysis will tend to: a. extend the duration of a project but not affect the project’s net present value. b. increase the cash flows of a project but decrease the project’s net present value. c. increase the net present value of a project. d. decrease the net present value of a project. e. have no effect on either a project’s cash flows or its net present value. Difficulty level: Medium
SENSITIVITY AND SENARIO ANALYSIS
d 29. Theoretically, the NPV is the most appropriate method to determine the acceptability
of a project. A false sense of security can be overwhelm the decision-maker when the procedure is applied properly and the positive NPV results are accepted blindly. Sensitivity and scenario analysis aid in the process by
a. changing the underlying assumptions on which the decision is based. b. highlights the areas where more and better data are needed. c. providing a picture of how an event can affect the calculations. d. All of the above. e. None of the above.
Difficulty level: Medium
DECSION TREE
a 30. In order to make a decision with a decision tree a. one starts farthest out in time to make the first decision. b. one must begin at time 0. c. any path can be taken to get to the end. d. any path can be taken to get back to the beginning. e. None of the above. Difficulty level: Medium
DECISION TREE
c 31. In a decision tree, the NPV to make the yes/no decision is dependent on a. only the cash flows from successful path. b. on the path where the probabilities add up to one. c. all cash flows and probabilities. d. only the cash flows and probabilities of the successful path. e. None of the above. Difficulty level: Medium
DECISION TREE
e 32. In a decision tree, caution should be used in analysis because a. early stage decisions are probably riskier and should not likely use the same discount
rate.
b. if a negative NPV is actually occurring, management should opt out of the project and
minimize their loss.
c. decision trees are only used for planning, not actually daily management. d. Both A and C. e. Both A and B. Difficulty level: Medium
SENSITIVITY ANALYSIS
d 33. Sensitivity analysis evaluates the NPV with respect to a. changes in the underlying assumptions. b. one variable changing while holding the others constant. c. different economic conditions. d. All of the above. e. None of the above. Difficulty level: Medium
SENSITIVITY ANALYSIS
d 34. Sensitivity analysis provides information on a. whether the NPV should be trusted, it may provide a false sense of security if all
NPVs are positive.
b. the need for additional information as it tests each variable in isolation. c. the degree of difficulty in changing multiple variables together. d. Both A and B. e. Both A and C. Difficulty level: Medium
FIXED COSTS
b 35. Fixed production costs are a. directly related to labor costs. b. measured as cost per unit of time. c. measured as cost per unit of output. d. dependent on the amount of goods or services produced. e. None of the above. Difficulty level: Medium
VARIABLE COSTS d 36. Variable costs a. change as the quantity of output changes. b. are zero when production is zero. c. are exemplified by direct labor and raw materials. d. All of the above. e. None of the above. Difficulty level: Easy
SENSITIVITY ANALYSIS
b 37. An investigation of the degree to which NPV depends on assumptions made about any
singular critical variable is called a(n)
a. operating analysis. b. sensitivity analysis. c. marginal benefit analysis.
d. decision tree analysis. e. None of the above. Difficulty level: Easy
SENSITIVITY AND SCENARIOS ANALYSIS
b 38. Scenario analysis is different than sensitivity analysis a. as no economic forecasts are changed. b. as several variables are changed together. c. because scenario analysis deals with actual data versus sensitivity analysis which deals
with a forecast.
d. because it is short and simple. e. because it is 'by the seat of the pants' technique. Difficulty level: Medium
EQUIVALENT ANNUAL COST
c 39. In the present-value break-even the EAC is used to a. determine the opportunity cost of investment. b. allocate depreciation over the life of the project. c. allocate the initial investment at its opportunity cost over the life of the project. d. determine the contribution margin to fixed costs. e. None of the above. Difficulty level: Medium
BREAK-EVEN
b 40. The present value break-even point is superior to the accounting break-even point
because
a. present value break-even is more complicated to calculate. b. present value break-even covers the economic opportunity costs of the investment. c. present value break-even is the same as sensitivity analysis. d. present value break-even covers the fixed costs of production, which the accounting
break-even does not.
e. present value break-even covers the variable costs of production, which the accounting
break-even does not.
Difficulty level: Easy
ABANDONMENT
d 41. The potential decision to abandon a project has option value because a. abandonment can occur at any future point in time. b. a project may be worth more dead than alive. c. management is not locked into a negative outcome. d. All of the above. e. None of the above.
Difficulty level: Easy
TYPES OF BREAK-EVEN ANALYSIS
d 42. Which of the following are types of break-even analysis? a. present value break-even b. accounting profit break-even c. market value break-even d. Both A and B. e. Both A and C. Difficulty level: Easy
MONTE CARLO SIMULATION
c 43. The approach that further attempts to model real word uncertainty by analyzing
projects the way one might analyze gambling strategies is called
a. gamblers approach. b. blackjack approach. c. Monte Carlo simulation. d. scenario analysis. e. sensitivity analysis. Difficulty level: Medium
MONTE CARLO SIMULATION c 44. Monte Carlo simulation is a. the most widely used by executives. b. a very simple formula. c. provides a more complete analysis that sensitivity or scenario. d. the oldest capital budgeting technique. e. None of the above. Difficulty level: Easy
OPTIONS IN CAPITAL BUDGETING
d 45. Which of the following are hidden options in capital budgeting? a. option to expand. b. timing option. c. option to abandon. d. All of the above. e. None of the above. Difficulty level: Easy
III. PROBLEMS
Use this information to answer questions 46 through 50.
The Adept Co. is analyzing a proposed project. The company expects to sell 2,500
units, give or take 10 percent. The expected variable cost per unit is $8 and the expected
fixed costs are $12,500. Cost estimates are considered accurate within a plus or minus 5 percent range. The depreciation expense is $4,000. The sale price is estimated at $16 a unit, give or take 2 percent. The company bases their sensitivity analysis on the expected case scenario.
SCENARIO ANALYSIS
d 46. What is the sales revenue under the optimistic case scenario? a. $40,000 b. $43,120 c. $44,000 d. $44,880 e. $48,400 Difficulty level: Medium
SCENARIO ANALYSIS
d 47. What is the contribution margin under the expected case scenario? a. $2.67 b. $3.00 c. $7.92 d. $8.00 e. $8.72 Difficulty level: Medium
SCENARIO ANALYSIS
c 48. What is the amount of the fixed cost per unit under the pessimistic case scenario? a. $4.55 b. $5.00 c. $5.83 d. $6.02 e. $6.55 Difficulty level: Medium
SENSITIVITY ANALYSIS
b 49. The company is conducting a sensitivity analysis on the sales price using a sales price estimate of $17. Using this value, the earnings before interest and taxes will be: a. $4,000 b. $6,000 c. $8,500 d. $10,000 e. $18,500
Difficulty level: Medium
SENSITIVITY ANALYSIS
b 50. The company conducts a sensitivity analysis using a variable cost of $9. The total variable cost estimate will be: a. $21,375 b. $22,500 c. $23,625 d. $24,125 e. $24,750 Difficulty level: Medium
Use this information to answer questions 51 through 55.
The Can-Do Co. is analyzing a proposed project. The company expects to sell 12,000 units, give or take 4 percent. The expected variable cost per unit is $7 and the expected
fixed cost is $36,000. The fixed and variable cost estimates are considered accurate
within a plus or minus 6 percent range. The depreciation expense is $30,000. The tax rate is 34 percent. The sale price is estimated at $14 a unit, give or take 5 percent. The company bases their sensitivity analysis on the expected case scenario.
SCENARIO ANALYSIS
a 51. What is the earnings before interest and taxes under the expected case scenario? a. $18,000 b. $24,000 c. $36,000 d. $48,000 e. $,000 Difficulty level: Medium
SCENARIO ANALYSIS
c 52. What is the earnings before interest and taxes under anoptimistic case scenario? a. $22,694.40 b. $24,8.40 c. $37,497.60 d. $52,694.40 e. $67,947.60 Difficulty level: Challenge
SCENARIO ANALYSIS
b 53. What is the earnings before interest and taxes under the pessimistic case scenario?
a. -$566.02 b. -$422.40 c. -$278.78 d. $3,5.50 e. $5,385.60 Difficulty level: Challenge
SENSITIVITY ANALYSIS
d . What is the operating cash flow for a sensitivity analysis using total fixed costs of $32,000? a. $14,520 b. $16,520 c. $22,000 d. $44,520 e. $52,000 Difficulty level: Medium
SENSITIVITY ANALYSIS
d 55. What is the contribution margin for a sensitivity analysis using a variable cost per unit of $8? a. $3 b. $4 c. $5 d. $6 e. $7 Difficulty level: Medium
VARIABLE COST
c 56. A firm is reviewing a project with labor cost of $8.90 per unit, raw materials cost of $21.63 a unit, and fixed costs of $8,000 a month. Sales are projected at 10,000 units
over the three-month life of the project. What are the total variable costs of the project?
a. $216,300 b. $297,300 c. $305,300 d. $313,300 e. $329,300 Difficulty level: Medium
VARIABLE COST
d 57. A project has earnings before interest and taxes of $5,750, fixed costs of $50,000, a
selling price of $13 a unit, and a sales quantity of 11,500 units. Depreciation is $7,500. What is the variable cost per unit?
a. $6.75
b. $7.00 c. $7.25 d. $7.50 e. $7.75 Difficulty level: Medium
FIXED COST
b 58. At a production level of 5,600 units a project has total costs of $,000. The variable
cost per unit is $11.20. What is the amount of the total fixed costs? a. $24,126 b. $26,280 c. $27,090 d. $27,820 e. $28,626 Difficulty level: Medium
FIXED COST
e 59. At a production level of 6,000 units a project has total costs of $120,000. The variable
cost per unit is $14.50. What is the amount of the total fixed costs? a. $25,165 b. $28,200 c. $30,570 d. $32,000 e. $33,000 Difficulty level: Medium
CONTRIBUTION MARGIN
c 60. Wilson’s Meats has computed their fixed costs to be $.60 for every pound of meat
they sell given an average daily sales level of 500 pounds. They charge $3. per pound of top-grade ground beef. The variable cost per pound is $2.99. What is the contribution margin per pound of ground beef sold?
a. $.30 b. $.60 c. $.90 d. $2.99 e. $3. Difficulty level: Medium
CONTRIBUTION MARGIN
e 61. Ralph and Emma’s is considering a project with total sales of $17,500, total variable costs of $9,800, total fixed costs of $3,500, and estimated production of 400 units. The depreciation expense is $2,400 a year. What is the contribution margin per unit? a. $4.50 b. $10.50
c. $14.14 d. $19.09 e. $19.25 Difficulty level: Medium
ACCOUNTING BREAK-EVEN
a 62. You are considering a new project. The project has projected depreciation of $720, fixed costs of $6,000, and total sales of $11,760. The variable cost per unit is $4.20. What is the accounting break-even level of production? a. 1,200 units b. 1,334 units c. 1,372 units d. 1,8 units e. 1,910 units Difficulty level: Medium
ACCOUNTING BREAK-EVEN
b 63. The accounting break-even production quantity for a project is 5,425 units. The fixed costs are $31,600 and the contribution margin is $6. What is the projected depreciation expense? a. $700 b. $950 c. $1,025 d. $1,053 e. $1,100 Difficulty level: Medium
ACCOUNTING BREAK-EVEN
d . A project has an accounting break-even point of 2,000 units. The fixed costs are $4,200 and the depreciation expense is $400. The projected variable cost per unit is $23.10. What is the projected sales price? a. $20.80 b. $21.00 c. $21.20 d. $25.40 e. $25.60 Difficulty level: Medium
ACCOUNTING BREAK-EVEN
a 65. A proposed project has fixed costs of $3,600, depreciation expense of $1,500, and a sales quantity of 1,300 units. What is the contribution margin if the projected level of sales is the accounting break-even point? a. $3.92
b. $4.14 c. $4.50 d. $4.80 e. $5.00 Difficulty level: Medium
PRESENT VALUE BREAK-EVEN
c 66. A project has a contribution margin of $5, projected fixed costs of $12,000, projected variable cost per unit of $12, and a projected present value break-even point of 5,000 units. What is the operating cash flow at this level of output? a. $1,000 b. $12,000 c. $13,000 d. $68,000 e. $73,000 Difficulty level: Medium
PRESENT VALUE BREAK-EVEN
a 67. Thompson & Son have been busy analyzing a new product. They have determined that an operating cash flow of $16,700 will result in a zero net present value, which is a company requirement for project acceptance. The fixed costs are $12,378 and the contribution margin is $6.20. The company feels that they can realistically capture 10 percent of the 50,000 unit market for this product. Should the company develop the new product? Why or why not? a. yes; because 5,000 units of sales exceeds the quantity required for a zero net present value b. yes; because the internal break-even point is less than 5,000 units c. no; because the firm can not generate sufficient sales to obtain at least a zero net present value d. no; because the project has an expected internal rate of return of negative 100 percent e. no; because the project will not pay back on a discounted basis Difficulty level: Challenge
PRESENT VALUE BREAK-EVEN
e 68. Kurt Neal and Son is considering a project with a discounted payback just equal to the project’s life. The projections include a sales price of $11, variable cost per unit of $8.50, and fixed costs of $4,500. The operating cash flow is $6,200. What is the break- even quantity? a. 1,800 units b. 2,480 units c. 3,057 units d. 3,750 units e. 4,280 units
Difficulty level: Medium
DECISION TREE NET PRESENT VALUE
b 69. At stage 2 of the decision tree it shows that if a project is successful, the payoff will be
$53,000 with a 2/3 chance of occurrence. There is also the 1/3 chance of a $-24,000 payoff. The cost of getting to stage 2 (1 year out) is $44,000. The cost of capital is 15%. What is the NPV of the project at stage 1?
a. $-13,275 b. $-20,232 c. $ 2,087 d. $ 7,536 e. Can not be calculated without the exact timing of future cash flows. Difficulty level: Medium
Use the following to answer questions 70-71:
The Quick-Start Company has the following pattern of potential cash flows with their planned
investment in a new cold weather starting system for fuel injected cars.
Cash Flow After Tax t = 0 t = 1 Invest $100,000,000 Success Years 2 – 5 $66,000,000/year .6 Do Not Invest Test Cost NPV = $ 0 Failure $20,000,000 .4 NPV = $-20,000,000 Do not test
DECISION TREE
a 70. If the company has a discount rate of 17%, what is the value closest to time 1 net
present value?
a. $ 48.6 million b. $ 80.9 million c. $108.2 million d. $181.4 million e. None of the above. Difficulty level: Challenge
DECISION TREE
b 71. If the company has a discount rate of 17%, should they decide to invest? a. yes, NPV = $ 2.2 million b. yes, NPV = $ 21.6 million c. no, NPV = $-1.9 million d. yes, NPV = $ 8.6 million e. No, since more than one branch is NPV = 0 or negative you must reject. Difficulty level: Challenge
ACCOUNTING BREAK-EVEN
e 72. The Mini-Max Company has the following cost information on their new prospective
project. Calculate the accounting break-even point.
Initial investment: $700
Fixed costs: $200 per year Variable costs: $3 per unit Depreciation: $140 per year. Price: $8 per unit Discount rate: 12% Project life: 5 years Tax rate: 34% a. 25 units per year b. 68 units per year c. 103 units per year d. 113 units per year e. None of the above. Difficulty level: Medium
PRESENT VALUE BREAK-EVEN
d 73. The Mini-Max Company has the following cost information on their new prospective
project. Calculate the present value break-even point.
Initial investment: $700 Fixed costs are $ 200 per year Variable costs: $ 3 per unit Depreciation: $ 140 per year Price: $8 per unit Discount rate: 12% Project life: 3 years Tax rate: 34% a. 68 units per year b. 75 units per year c. 84 units per year d. 114 units per year e. None of the above. Difficulty level: Challenge
ACCOUNTING BREAK-EVEN
d 74. From the information below, calculate the accounting break-even point. Initial investment: $2,000 Fixed costs are $2,000 per year Variable costs: $6 per unit Depreciation: $250 per year Price: $20 per unit Discount rate: 10% Project life: 4 years Tax rate: 34% a. 88 units per year b. 100 units per year c. 143 units per year d. 161 units per year
e. None of the above. Difficulty level: Challenge
PRESENT VALUE BREAK-EVEN
c 75. Given the following information, calculate the present value break-even point. Initial investment: $2,000 Fixed costs: $2,000 per year Variable costs: $6 per unit Depreciation: $ 250 per year Price: $20 per unit Discount rate: 10% Project life: 4 years Tax rate: 34% a. 100 units per year b. 143 units per year c. 202 units per year d. 286 units per year e. None of the above. Difficulty level: Challenge
TIMING OPTIONS
a 76. You are considering a project which has been assigned a discount rate of 8 percent. If you start the project today, you will incur an initial cost of $480 and will receive cash inflows of $350 a year for three years. If you wait one year to start the project, the initial cost will rise to $520 and the cash flows will increase to $385 a year for three years. What is the value of the option to wait? a. $15.23 b. $17.08 c. $18.67 d. $20.20 e. $50.20 Difficulty level: Challenge
TIMING OPTIONS
a 77. Wilson’s Antiques is considering a project that has an initial cost today of $10,000. The project has a two-year life with cash inflows of $6,500 a year. Should Wilson’s decide to wait one year to commence this project, the initial cost will increase by 5 percent and the cash inflows will increase to $7,500 a year. What is the value of the option to wait if the applicable discount rate is 10 percent? a. $1,006.76 b. $1,235. c. $1,509.28 d. $1,606.76 e. $1,735.
Difficulty level: Challenge
OPTION TO ABANDON
c 78. Your firm is considering a project with a five-year life and an initial cost of $120,000. The discount rate for the project is 12 percent. The firm expects to sell 2,100 units a year. The cash flow per unit is $20. The firm will have the option to abandon this project after three years at which time they expect they could sell the project for $50,000. At what level of sales should the firm be willing to abandon this project? a. 420 units b. 1,041 units c. 1,479 units d. 1,618 units e. 2,500 units Difficulty level: Challenge
OPTION TO ABANDON
e 79. Your firm is considering a project with a five-year life and an initial cost of $120,000. The discount rate for the project is 12 percent. The firm expects to sell 2,100 units a year. The cash flow per unit is $20. The firm will have the option to abandon this project after three years at which time they expect they could sell the project for $50,000. You are interested in knowing how the project will perform if the sales forecast for years four and five of the project are revised such that there is a 50/50 chance that the sales will be either 1,400 or 2,500 units a year. What is the net present value of this project given your sales forecasts? a. $23,617 b. $23,719 c. $25,002 d. $26,877 e. $28,746 Difficulty level: Challenge
OPTION TO ABANDON
b 80. Margerit is reviewing a project with projected sales of 1,500 units a year, a cash flow
of $40 a unit and a three-year project life. The initial cost of the project is $95,000. The relevant discount rate is 15 percent. Margerit has the option to abandon the project
after one year at which time she feels she could sell the project for $60,000. At what level of sales should she be willing to abandon the project? a. 9 units b. 923 units c. 967 units d. 1,199 units e. 1,206 units Difficulty level: Challenge
IV. ESSAYS
SCENARIO ANALYSIS 81. What is the benefit of scenario analysis if it does not produce an accept or reject
decision for a proposed project?
Scenario analysis provides management with a look at potential outcomes given
various assumptions and helps measure the potential for project failure. This
information provides a basis upon which management can apply their wisdom and knowledge to make the accept or reject decision. However, the final decision does require human judgment.
EVALUATION 82. Consider the following statement by a project analyst: “I analyzed my project using
scenarios for the base case, best case, and worst case. I computed break-evens and degrees of operating leverage. I did sensitivity analysis and simulation analysis. I computed NPV, IRR, payback, AAR, and PI. In the end, I have over a hundred
different estimates and am more confused than ever. I would have been better off just sticking with my first estimate and going by my gut reaction.” Critique this statement.
The goal of evaluating an NPV estimate or other decision criteria is to determine the reasonableness of it. If done properly, the added analysis will heighten either the degree of comfort or the degree of discomfort about a project. Ultimately, this type of analysis reveals both the weaknesses and the strengths of a project. Furthermore, it helps isolate potential trouble areas and sharpens the focus on which variables are most crucial for forecasting. The very nature of the process still leaves a great deal of uncertainty even after all of the analysis is complete. However, in the end, the analyst should be better informed and more comfortable in making a decision, not less so.
PRESENT VALUE BREAK-EVEN 83. The Marx Brewing Company recently installed a new bottling machine. The machine's
initial cost is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years. The machine's per year fixed cost is $1,800, and its variable cost is $0.50 per unit. The selling price per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. Calculate the accounting break-even point on the new machine, as well as the present value break-even point on the new machine.
Accounting break-even is:
$1,800 + ($400)(1 – 0.34) / ($1.50 - $0.5)(1-.34) = 2,200 units Present value break-even is: EAC = $2,000/(PVIFA.16,5) = $2,000/3.2743 = $610.81 PV BEP = [EAC + FC(1-Tc)-Dep(Tc)]/(CM(1-Tc))
= [$610.81 + $1,800(1-.34) - $400(.34)] / ($1.50 - $0.50)(1-.34) = 2,519 units
DECISION TREE 84. Discuss two shortcomings in the standard decision tree analysis that a financial
manager should be cognizant of?
First, there is differential risk at various stages of the tree should imply the use of
different discount rates. Second, the firm has different options than following a
negative NPV path and may alter the total outcome under poor future stages.
SENSITIVITY AND SENARIOS ANALYSIS 85. Sensitivity analysis is a method which allows for evaluation of the NPV given a series
of changes to the underlying assumptions. Discuss why and how scenario analysis is used in addition to sensitivity analysis.
Sensitivity analysis:
measures input of changing one input at a time. variables may change simultaneously in reality. estimates may be overly optimistic or pessimistic. Scenario analysis: a variant of sensitivity analysis. allows for multiple factor influences. examines a number of different scenarios. minimizes the false sense of security that may come from sensitivity analysis.
OPTIONS IN CAPITAL BUDGETING 86. The market value of an investment project should be viewed as the sum of the standard
NPV and the value of managerial options. Explain three different real or managerial options that management may have, what they are, and how they would influence market value.
To expand project -- favorable market reaction
Contract business -- under conditions of poor demand, etc.
Abandonment, equipment replacement, opening and closing facilities.
SOLUTIONS TO TEST BANK PROBLEMS
Chapter 9 46. Sales revenue for the best case = 2,500 1.1 $16 1.02 = $44,880 47. Contribution margin for the base case = $16 - $8 = $8 48. Fixed cost per unit for the worst case = ($12,500 1.05) (2,500 .9) = $5.83 49. EBIT = [($17 - $8) 2,500] - $12,500 - $4,000 = $6,000 50. Total variable cost = $9 2,500 = $22,500 51. EBIT for base case = [12,000 ($14 - $7)] - $36,000 - $30,000 = $18,000 52. EBIT for best case = (12,000 1.04) [($14 1.05) - ($7 .94)] – ($36,000 .94) -
$30,000 = $37,497.60
53. Net income for worst case = {[12,000 .96] [($14 .95) – ($7 1.06)] – ($36,000
1.06) - $30,000} (1 - .34} = -$278.78
. EBIT = [(12,000 ($14 - $7)] - $32,000 - $30,000 = $22,000
Tax = $22,000 .34 = $7,480
OCF = $22,000 + $30,000 - $7,480 = $44,520
55. Contribution margin = $14 - $8 = $6 56. Total variable costs = ($8.90 + $21.63) 10,000 = $305,300 57. [11,500 ($13.00 – v)] - $50,000 - $7,500 = $5,750; v = $7.50 58. Total fixed cost = $,000 – (5,600 $11.20) = $26,280 59. Total fixed cost = $120,000 – (6,000 $14.50) = $33,000 60. Contribution margin = $3. - $2.99 = $.90 61. Contribution margin = ($17,500 - $9,800) 400 = $19.25 62. Accounting break-even Q = ($6,000 + $720) [($11,760 Q) - $4.20]; Q =1,200 63. Depreciation at the accounting break-even = (5,425 $6) - $31,600 = $950 . Accounting break-even Q = 2,000 = ($4,200 + $400) (P - $23.10); P = $25.40 65. Contribution margin = ($3,600 + $1,500) 1,300 = $3.92 66. Operating cash flow at the financial break-even point = (5,000 $5) - $12,000 = $13,000 67. Financial break-even point = ($12,378 + $16,700) $6.20 = 4,690; The product should be accepted because the expected level of sales exceeds the financial break-even point. 68. Financial break-even point = ($4,500 + $6,200) ($11 - $8.50) = 4,280 69. $-44,000 + [((2/3($53,000)) + (1/3($-24,000))) / 1.15] = $-20,232
70. NPV1 = Pr[COST + CFAT*A.17,4] = NPV1 = .6[$-100,000,000+$66,000,000(2.7432)]
= $48,632,106
71. NPV0 = NPV1/(1+r) C0 = ($48,632,106/1.17) $20,000,000) = $21,565,903 72. Contribution Margin = ($8 - $3) (1 0.34) = $3.30 After-tax (Fixed Cost + Depreciation) = ($200 + $140) (1 0.34) = $224 Accounting BEP = $224/$3.30 = 67.88 = 68 units 73. EAC = $700/A.12,3 = $700/2.4018 = $291.45 PV BEP = [EAC + FC(1-Tc)-Dep(Tc)]/(CM(1-Tc)) = [$291.45 + $200(.66)-$140(.34)]/5(.66) = 113. units = 114 units 74. Contribution Margin = ($20 - $6) (1 0.34) = $9.24 After tax (Fixed Cost + Depreciation) = ($2,000 + $250) (1 0.34) = $1,485 Accounting BEP = $1,485/$9.24 = 160.71 units = 161 units 75. EAC = $2,000/(PVIFA.10,4) = $2,000/3.1699 = $630.93 PV BEP = [EAC + FC(1-Tc)-Dep(Tc)]/(CM(1-Tc)) = [$630.93+$2,000(1-0.34)-$250(.34)]/[($20 - $6)(1-0.34)] = 201.94 = 202 units
76.
$350$350$350$480$324.0741$300.0686$277.8413$421.981.0811.0821.083$385$385$385NPVt1$520$520$356.4815$330.07$305.62$472.1823;1.0811.0821.083NPVt0$472.18231.08$437.21NPVt0$480Value of option to wait = $437.21 $421.98 = $15.23
77.
$6,500$6,500$10,000$5,909.0909$5,371.9008$1,280.99121.101.10$7,500$7,500NPVt1($10,0001.05)$10,500$6,818.1818$6,198.3471$2,516.521.1011.102NPVt0$2,516.521.10$2,287.75Value of option to wait = $2,287.75 - $1,280.99 = $1,006.76
1[1/(1.12)2]$50,000(Q$20);$50,00033.801Q;Q1,479 units
.12Level to abandon =
1[1/(1.12)2]$50,000(Q$20);$50,00033.801Q;Q1,479 units;
.12At 1,400 units you will abandon the project and receive $50,000. At 2,500 you will continue the project and the NPV will be:
1[1/(1.12)2]NPV(2,500$20)$50,0001.6901$84,505.12$50,000$84,5052,100$202,100$202,100202 NPV$120,000;12331.121.121.121.12NPV$120,000$37,500$33,482.1429$29,4.7704$47,869.0011$28,746NPVt0$10,0001[1/(1.15)2]$60,000(Q$40);$60,00065.0284Q;Q923 units
.1578. 79.
80.
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