13.1 The Importance of Risk Analysis
1) Which of the following is a reason why risk analysis is
an important part of capital budgeting?
A) The people who propose projects have no vested interest
in whether or not they are accepted.
B) Marketing managers are rarely excessively optimistic.
C) Project cash flows can be highly uncertain.
D) Financial analysts are rarely excessively pessimistic.
2) Which of the following are reasons to analyze the risk
of capital projects?
A) The people who propose projects have a vested interest
in getting them accepted.
B) Cash flows can rarely be estimated with certainty.
C) Many of the variables in capital budgeting analysis are
highly sensitive to changes in economic conditions.
D) All of the above.
3) Which of the following abilities are crucial for risk
analysis?
A) A knowledge of marketing
B) A knowledge of cost accounting
C) A knowledge of economics
D) All of the above
4) Which of the following are usually known with a high
level of confidence at the beginning of a project?
A) The number of units that will be sold
B) The price per unit that will result in the desired
number of units sold
C) Tax rates and depreciation rates
D) None of the above
5) Approximately what percentage of new businesses fail in
their first year?
A) 20%
B) 40%
C) 60%
D) 80%
6) Approximately what percentage of new businesses survive
their first year?
A) 20%
B) 40%
C) 60%
D) 80%
7) What is the approximate five year survival rate for new
businesses?
A) 20%
B) 40%
C) 60%
D) 80%
8) What is the approximate failure rate for new businesses
after five years?
A) 20%
B) 40%
C) 60%
D) 80%
9) In reality, anticipated cash flows are only estimates
and are thus uncertain.
Answer: TRUE
10) Most of the variables used in forecasting cash flows
are known with certainty.
Answer: FALSE
11) The consequences of excessive pessimism can be as
harmful as the consequences of excessive optimism.
Answer: TRUE
12) Random, unforeseeable events can a significant impact
on future cash flows.
Answer: TRUE
13) A would be entrepreneur is considering buying a
franchise from a national chain of fitness centers. Identify some of the risks
she might face.
Answer: Competition:
other franchises or even another franchisee in the same chain might locate
nearby. The demographics of the area in which she locates might change. Her
business might be sensitive to employment and economic conditions. Traffic
patterns could change making her location more or less accessible. In short,
the cash flows from her business could be highly unpredictable.
14) Jeffrey believes that if he can make a good case for
opening a new store in the chain for which he works, he will be promoted to
manager. Can we be confident that Jeffrey's sales forecasts are accurate?
Answer: Jeffrey has
a vested interest in making aggressive forecasts. In large corporations, those
who propose capital projects almost always have something to gain if they are
accepted and something to lose if they are rejected. On the other hand, some
executives would rather avoid the risk of new adventures. they fear the
consequences of failure more than they crave the rewards of success, so their
forecasts might be unduly pessimistic. Risk analysis examines the consequences
of both optimistic and pessimistic outcomes, hopefully reducing the influence
of subjective factors.
15) What are the consequences of excessive optimism or
pessimism in forecasting expected project cash flows?
Answer: Optimistic
biases can lead to accepting projects that fall short of expectations and
reduce the value of the firm. Excessive pessimism will lead to the rejection of
projects, especially risky projects, that might have large NPV's and add
substantial value to the business.
16) Why is it important to perform risk analysis before
accepting or rejecting major projects?
Answer: Most of the
time the cash flows from a project are highly uncertain and more so as time
extends into the future. Both the volume of sales and the price at which a
product can be sold are highly uncertain because they can be influenced by such
factors as unemployment, interest rates, and competition that are also
notoriously hard to forecast.
Forecasts are made by humans who are not only subject to
error, but also may have a vested interest in whether or not a project is
accepted. Selfinterest can lead to excessive optimism or pessimism which can
bias the forecasts.
13.2 Tools for Analyzing the Risk of Project Cash
Flows
1) The simulation approach provides us with
A) a single value for the riskadjusted net present value.
B) an approximation of the systematic risk level.
C) a probability distribution of the project's net present
value or internal rate of return.
D) a graphic exposition of the yearbyyear sequence of
possible outcomes.
2) ________ is a method of quantifying uncertainty without
having to estimate probabilities.
A) Standard deviation
B) Sensitivity analysis
C) Coefficient of variation
D) Decision tree analysis
3) The form of risk analysis intended to identify the most
important forces for the success or failure of a project is known as
A) scenario analysis.
B) sensitivity analysis.
C) value driver analysis.
D) expected value analysis.
4) Sensitivity analysis is the form of risk analysis
A) that examines the relationship between total firm cash
flows and the NPV of a particular project.
B) that examines the volatility of NPV.
C) that examines the impact of key variables such as sales
or costs in various combinations.
D) that examines the impact of key variables such as sales
or costs one at a time.
5) The form of risk analysis which examines the effect of
various combinations of value drivers is known as
A) scenario analysis.
B) sensitivity analysis.
C) value driver analysis.
D) expected value analysis.
6) Scenario analysis is the form of risk analysis
A) that examines the relationship between total firm cash
flows and the NPV of a particular project.
B) that examines the volatility of NPV.
C) that examines the impact of key variables such as sales
or costs in various combinations.
D) that examines the impact of key variables such as sales
or costs one at a time.
7) Which of the following is considered the major risk when
analyzing projects in a multinational environment?
A) Currency fluctuations
B) Inflation
C) Political risk
D) Lack of available betas
8) Which of the following results in a probability
distribution for possible project outcomes rather than a dollar estimate?
A) Sensitivity analysis
B) Simulation
C) Value driver analysis
D) Scenario analysis
9) ________ is a risk analysis technique in which the best
and worstcase net present values are compared with the project's expected net
present value.
A) Project standing alone risk
B) Decision tree analysis
C) Scenario analysis
D) Pure play method
10) There is a 30% probability that an office building will
be sold after 5 years for $30 million, a 50% probability that it will be sold
for $20 million and a 20% probability that it will be sold for $10 million.
What is the expected value of the office building in 5 years?
A) $20 million
B) $21 million
C) $30 million
D) $10 million
11) Economists at PHE Llc estimate a 20% probability of a
recession next year, a 50% probability of an average economy, and a 30%
probability of a rapid expansion. If
there is a recession, the NPV of project O will be $20 million; if the economy
is average, it will be $45 million and in case of a rapid expansion, it will be
$75 million. What is the expected NPV of the project?
A) $57.5 million
B) $49 million
C) $46.67 million
D) $45 million
12) Pederson Home Heating Inc. anticipates that cash flows
from home heating fuel sales next year will be $800,000 if the winter is mild,
$1,000,000 if winter is average, and $1,500,000 if winter is exceptionally
cold. The probability of an average winter is 60%, while the probability of
either a mild or an exceptionally cold winter is 20%. What is Pederson's
expected cash flow from fuel sales next winter?
A) $1,060,000
B) $1,100,000
C) $1,000,000
D) $1,150,000
13) Lemminburg Plastics estimates a 60% probability that
sales of pink flamingo lawn ornaments in the summer of 2011 will be 45,000
units, about the same as in 2010. They believe there is a 20% probability that
they will go viral and potential sales would be 90,000. There is also a 20%
probability that restrictive zoning ordinances will limit sales to 30,000
units. Expected unit sales of the pink flamingos are
A) 55,000.
B) 51,000.
C) 67,500.
D) 60,000.
14) Enchanted Hearth expects to sell 1,200 wood pellet
stoves in 2011 at an average price of $2,400 each. It believes that unit sales
will grow between 5% and +5% per year and prices will rise or fall by as much
as 5% per year. Forecast sales revenue for 2013 if the number of units sold
increases by 5% per year and prices remain flat.
A) $2,880,000
B) $3,168,000
C) $3,333,960
D) $3,175,200
15) Enchanted Hearth expects to sell 1,200 wood pellet
stoves in 2011 at an average price of $2,400 each. It believes that unit sales
will grow between 5% and +5% per year and prices will rise or fall by as much
as 5% per year. Forecast sales revenue for 2013 if both price and the number of
units sold increase by 5% per year.
A) $3,492,720
B) $3,500,658
C) $3,333,960
D) $3,175,200
16) When Quineboag Textile's sales revenue increased from
$5.0 million to $5.25 million, net operation income increased from $500,000 to
$575,000. What is Quineboag's degree of operating leverage (DOL)?
A) .015
B) .33
C) 3.00
D) 10
17) When Charles River Publisher's sales revenue increased
from $25 million to $27.5 million, net operating income increased from
$3,750,000 to $3,937,500. What is Quineboag's degree of operating leverage
(DOL)?
A) .5
B) 2
C) 6.67
D) .05
18) Boulangerie Bouffard expects to sell 1 million
croissants next year for $1.25 each. Variable cost of a croissant is $0.75.
Fixed costs are $150,000, depreciation $200,000 and the tax rate is 25%. If the
bakery can increase the price of a croissant to $1.50 and all other variables
remain the same, free cash flow will increase by
A) $37,500.
B) $150,000.
C) $187,500.
D) $250,000.
19) Boulangerie Bouffard expects to sell 1.25 million
croissants next year for $1.50 each. Variable cost of a croissant is $0.80.
Fixed costs are $150,000, depreciation $200,000 and the tax rate is 34%. If the
bakery can increase the price of a croissant to $1.75 sales will fall by 50,000
croissants. All other things equal,
operating cash flow will increase or decrease
A) $300,000 increase.
B) $148,500 increase.
C) $148,500 decrease.
D) $174,900 increase.
Use the following information to answer the following
question(s).
Orange Electronics projects sales of its new OPhones for
next year at 10,000 units priced at $150 each. The variable costs of an OPhone
are expected to be $75. Fixed cash costs are expected to be $150,000 and
depreciation $100,000. The tax rate is 40%. Orange believes that any of its
forecasts including fixed costs, but not depreciation or the tax rate which are
known for certain, could be high or low by as much as 10%.
20) What is the expected net operating profit after tax
(NOPAT) for the worst case scenario?
A) $300,000
B) $223,500
C) $174,000
D) $124,500
21) What is the expected net operating profit after tax
(NOPAT) if the most likely estimates are used?
A) $493,500
B) $330,000
C) $300,000
D) $124,500
22) What is the expected net operating profit after tax
(NOPAT) for the best case scenario?
A) $493,500
B) $330,000
C) $394,500
D) $124,500
23) An appropriate tool to analyze the interaction of
various value drivers for Orange Electronics would be
A) simulation.
B) sensitivity analysis.
C) scenario analysis.
D) either A or C
Use the following information to answer the following
question(s).
Destroya Extermination Services projects next year's sales
of its new XRay termite inspection service at 5,000 inspections priced at $175
each. The variable costs per inspection are expected to be $87.50 Fixed cash
costs are expected to be $90,000 and depreciation $110,000. The company's
marginal tax rate is 34%. Destroya believes that any of its forecasts including
fixed costs, but not depreciation or the tax rate which are known for certain,
could be high or low by as much as 10%.
24) What is the expected free cash flow if the most likely
estimates are used?
A) $156,750
B) $266,750
C) $237,500
D) $383,240
25) What is the expected free cash flow for the best case
scenario?
A) $414,400
B) $330,000
C) $394,500
D) $383,240
26) What is the expected free cash flow for the worst case
scenario?
A) $153,973
B) $43,972
C) $84,910
D) $383,240
27) An appropriate tool to analyze the interaction of
various value drivers for Destroya Extermination Services would be
A) simulation.
B) scenario analysis.
C) sensitivity analysis.
D) either A or B
28) The end result of a simulation analysis is
A) a probability distribution of project cash flows.
B) a clear decision on whether or not a project should be
accepted.
C) a probability distribution of possible NPV's.
D) a list of value drivers and their probabilities.
29) When using simulation to analyze a large capital
project, the decision rule is
A) there is no clear cut decision rule, but the
probabilities will produce a more informed decision.
B) accept the project if the probability of a positive NPV
is greater than 50%.
C) reject the project if the probability of a negative NPV
is greater than 5%.
D) reject the project if the probability of a negative NPV
is greater than 16%
30) Cranston Plastic Packaging Solutions has run a
simulation on a large project to produce ecofriendly packaging for personal
hygiene products. The mean NPV is an impressive $8,000,000, but there is a 16%
probability of a negative NPV and a 5% probability of an NPV worse than
($6,000,000).
A) Cranston should reject the project. It is too risky.
B) Cranston should accept the project. The odds are in
their favor.
C) Cranston should explore options to reduce the likelihood
of very unfavorable outcomes.
D) Cranston should change the probabilities used in the
simulation to reduce the likelihood of a negative NPV.
31) Natick Nurseries has used scenario analysis to evaluate
the purchase of a former dairy to use for nursery stock. The best case scenario
produced a very favorable NPV of $4,000,000; the NPV of the most likely case
was $2,000,000, but the worst case scenario resulted in an NPV of $(3,000,000)
which would bring the company close to bankruptcy. Natick could improve its
decision by
A) using sensitivity analysis.
B) using simulation analysis.
C) simply accepting the best case scenario and rejecting
the other outcomes.
D) weighting the favorable scenarios more heavily to
increase the expected NPV.
32) Using simulation provides the financial manager with a
point estimate of an investment's net present value or internal rate of return.
Answer: FALSE
33) In capitalbudgeting decisions, simulation analysis
gives a probability distribution only for cash flows.
Answer: FALSE
34) Sensitivity analysis shows how the distribution of
possible net present values is affected by a change in one input variable.
Answer: TRUE
35) One advantage of simulation is that it can
differentiate between unsystematic and systematic risk.
Answer: FALSE
36) A company that was most concerned about the impact of
price changes in raw materials would use sensitivity analysis.
Answer: TRUE
37) The expected NPV of a project is simply the NPV
calculated using the most likely estimates for costs and revenues.
Answer: FALSE
38) Briefly distinguish between sensitivity analysis,
scenario analysis, and simulation.
Answer: Sensitivity
analysis changes one value driver at a time to see how much impact the change
will have on free cash flow and NPV. Scenario analysis looks at various combinations
of value drivers, for example reducing prices to increase the number of units
sold. Simulation assigns a range of possibilities for the value drivers and
selects them randomly in many possible combinations. The output of simulation
is a probability distribution resulting from many trials, with a mean and
standard deviation of possible outcomes.
39) List at least four typical value drivers that could
seriously impact the outcome of a project.
Answer: Typical
value drivers that can affect the outcome of many projects are sales volume
(number of units sold), price at which products can be sold, variable costs,
fixed costs. (Answers will vary but should not include such "givens"
as depreciation.)
40) Webster Footwear believes that a new line of foul
weather footwear they are planning to introduce this year will result in an NPV
of $500,000 if the winter weather is exceptionally cold and wet, $400,000 if
weather is normal, and $200,000 if winter is relatively warm and dry. The
probability of a hard winter is 30%, an average winter is 50%, and a mild
winter 20%. Compute the project's expected NPV.
Answer: Expected NPV
= .30($500,000) + .50($400,000) + .20($200,000) = $390,000
41) Boulangerie Bouffard expects to sell 1 million
croissants next year for $1.25 each. Variable cost of a croissant is $0.75.
Fixed costs are $150,000, depreciation $200,000 and the tax rate is 25%. If the
number of croissants sold increases by 10%, and all other variables remain the
same, how much will free cash flow increase?
Answer:
Croissants sold

1,000,000

1,100,000

Revenue

$1,250,000

$1,375,000

Variable cost

750,000

825,000

Depreciation

200,000

200,000

Fixed cost

150,000

150,000

Operating Income

$150,000

$200,000

Taxes

37,500

50,000

NOPAT

$112,500

$150,000

FCF

$262,500

$300,000

Free cash flow will increase by $37,500



42) Angie's Sub Shop expects to sell 200,000 subs next year
at an average price of $5.00. Variable cost of a sub is $3.00. Cash fixed costs
are $85,000, depreciation $95,000 and the tax rate is 25%. If the price
increases to $5.50 and all other variables remain the same, how much will free
cash flow increase?
Answer:
Subs sold

200,000

200,000

Revenue

$1,000,000

$1,100,000

Variable cost

600,000

600,000

Depreciation

95,000

95,000

Fixed cost

85,000

85,000

Operating Income

$220,000

$320,000

Taxes

55,000

80,000

NOPAT

$165,000

$240,000

FCF

$260,000

$335,000

Free cash flow will increase by $75,000



13.3 BreakEven Analysis
1) Which of the following costs is NOT covered in an
accounting breakeven analysis?
A) Shareholders expected rate of return
B) Variable production costs
C) Interest expense
D) Depreciation expense
2) The Oviedo Thespians are planning to present
performances of their Florida Revue on 2 consecutive nights in January. It will
cost them $5,000 per night for theater rental, event insurance and professional
musicians. The theater will also take 10% of gross ticket sales. How many
tickets must they sell at $10.00 per ticket to break even?
A) 1000 tickets
B) 1,112 tickets
C) 1,223 tickets
D) There is not enough information.
3) Betty Gilmore plans to sell berry pies at a local
farmer's market. The permit and space
rental will cost her $2,000 for the June through August season. The pies will sell for $7.00. Ingredients and overhead average $4.00 per
pie. She also has to pay five percent of
her gross sales to the market's organizers.
How many pies will she need to sell to cover her fixed costs?
A) 755 pies with a very small profit on the last pie.
B) 667 pies with a very small profit on the last pie.
C) 301 pies
D) She can never break even.
4) Betty Gilmore plans to sell berry pies at a local
farmer's market. The permit and space
rental will cost her $2,000 for the June through August season. The pies will sell for $7.00. Ingredients and overhead average $4.00 per
pie. She also has to pay five percent of
her gross sales to the markets's organizers.
How many pies will she need to sell to cover her fixed costs and realize
a $3,000 profit?
A) 752
B) 1,667 pies
C) 1,887 pies
D) 1,250 pies
5) The Oviedo Thespians are planning to present
performances of their Florida Revue on 2 consecutive nights in January. It will
cost them $5,000 per night for theater rental, event insurance and professional
musicians. The theater will also take 10% of gross ticket sales. How many
tickets must they sell at $10.00 per ticket to raise $1,000 for their
organization?
A) 1000 tickets
B) 1,112 tickets
C) 1,223 tickets
D) There is not enough information.
6) Accounting breakeven analysis solves for the level of
sales that will result in
A) IRR = Cost of Capital.
B) net income = $0.00.
C) Free cash flow = $0.00.
D) NPV = $0.00.
7) Accounting breakeven analysis uses
A) free cash flows over the entire life of a project.
B) sales, variable costs and fixed costs over the entire
life of a project.
C) sales, variable costs and fixed costs for a single
period.
D) free cash flows for a single period.
8) February sales for Ted's Variety Store equal $100,000,
variable costs equal $60,000, fixed costs, including depreciation of $20,000,
total $60,000.
A) Ted's Variety Store broke even with respect to net
income.
B) Ted's Variety Store broke even with respect to cash.
C) Ted's Variety fell $20,000 short of cash breakeven.
D) Ted's Variety Store broke even with a $20,000 surplus.
9) Variable cost for Light.com's fluorescent tubes is
$12.50, the tubes are sold over the internet to businesses and organizations
for $20.00 each. Fixed costs are $7,500,000. What is the breakeven quantity
for the fluorescent tubes?
A) 600,000
B) 1,000,000
C) 375,000
D) 7,500,000
10) Variable cost for Light.com's fluorescent tubes is
$12.50, the tubes are sold over the internet to businesses and organizations
for $20.00 each. Fixed costs are $7,500,000. $500,000 in depreciation expense
is included in fixed costs. What is the cash breakeven quantity for the
fluorescent tubes?
A) 933,333
B) 1,000,000
C) 375,000
D) 1,066,667
11) Excom Fiberoptics is bidding on contracts to sell micro
test tubes for biotechnology research in sets of 1,000 tubes. Fixed costs
including depreciation associated with the project are $2,000,000, variable
cost per set is $16. Excom expects to sell 250,000 sets. What is the minimum
price it can charge and reach the accounting breakeven point?
A) $8
B) $12
C) $24
D) $20
12) In the 4th year of project M, expected revenues will be
$4,750,000, variable costs will be $4,000,000, depreciation expense $180,000,
and fixed cash costs $570,000. Which of the following is true?
A) Accounting income equals $0.00
B) Free cash flow equals $180,000
C) Free cash flow equals 0
D) Both A and B are true.
13) Jake's Tree farm is evaluating a proposal to plant
5,000 ornamental trees at an initial cost of $10,000. The trees will be sold in
5 years. What is the minimum after tax cash flow from selling the trees that
will allow the tree planting project to reach break even NPV? Use a discount
rate of 12%.
A) $12,000.00
B) $5,674.26
C) $17,623.42
D) $17,958.56
14) Miniature Molding is planning to introduce a valve for
use in medical implants. Variable costs per unit are $250. The maximum price MM
could charge is $325. Fixed costs associated with this product are $20,000,000.
The worst case forecast calls for sales of 240,000 valves, the best case for
290,400. Will MM reach accounting breakeven in the worst case scenario?
A) Sales will fall short of break even by $8,666,667.
B) The product will exactly break even.
C) Sales will fall short of break even by $5,000,025.
D) Sales will exceed break even $58,000,000.
15) Miniature Molding is planning to introduce a valve for
use in medical implants. Variable costs per unit are $250. The maximum price MM
could charge is $325. Fixed costs associated with this product are $20,000,000.
Depreciation expense of $2,500,000 are included in fixed costs. The worst case
forecast calls for sales of 240,000 valves, the best case for $290,400. Will MM
reach cash breakeven in the worst case scenario?
A) Sales will fall short of cash break even by $8,666,667.
B) The product will exactly break even.
C) Sales will fall short of cash break even by $2,000,025.
D) Sales will exceed cash break even by $2,166,667.
16) Net present value breakeven is reached
A) after the time period when NPV finally turns from
negative to positive.
B) at the discount rate that produces an NPV of $0.00.
C) at the level of sales over the life of the project that
results in free cash flow of $0.000 for a given period.
D) at the level of sales over the life of the project that
results in an NPV of $0.00.
17) Garcia Developers will erect a small office building at
a cost of $4,500,000. They have a client who will lease the space for 5 years
at a price that will produce free cash flows of $150,000 per year. For
approximately how much would they need to sell the building for at the end of
the 5th year to reach breakeven NPV? Garcia uses a discount rate of 10% for
projects of this type.
A) $3,750,000
B) $5,755,936
C) $6,331,530
D) $6,964,683
18) DNATECH has developed a hair growth treatment at a cost
of $10 million. They can license the technology to another company for a period
of 10 years. What is the minimum annual free cash flow they could accept in
order to reach breakeven NPV on this product? Use a discount rate of 8%.
A) $1,490,295
B) $1,639,324
C) $1,108,000
D) $1,000,000
19) Brookfield Heavy Equipment is considering a project
that will produce after tax cash of $40,000 per year for 5 years. The project
will require an initial investment of $144,191. At what discount rate will the
project reach breakeven NPV?
A) 8%
B) 10%
C) 12%
D) 11.11%
20) Miller River Light is evaluating a project that will
require an initial investment of $350,000. Miller River uses a 12% discount
rate for capital projects of this type. What level of operating cash flows over
a period of 5 years will cause the project to reach breakeven NPV? Assume cash flows come in the form of an
endoftheyear annuity.
A) $70,000.00
B) $97,093.41
C) $92,329.12
D) $86,690.54
21) Project Zeta is expected to produce aftertax cash
flows of $30 million in year 1, $40 million in year 2, and $50 million in year
3. If the company uses a 12% required rate of return, what is the most it can
invest in this project and break even with respect to NPV?
A) $69.03 million
B) $94.26 million
C) $1,11 million
D) $120 million
22) If Untel Inc. decides to manufacture a new generation
of computer chips with a brief 2 year product life cycle, it expects to sell 1
million units each year. Variable cost per unit will be $75, fixed costs $5
million, and depreciation $3 million. The initial investment will be $22.91
million. Untel uses a discount rate of 10%; its marginal tax rate is 40%. To
reach breakeven NPV, UNTEL must sell the chips for at least ________ each.
A) $87
B) $105
C) $100
D) $1,000
23) Charlestown Marina's forecasts indicate that if slip
rentals equal $500,000, net operating income will be $25,000 and if rentals
equal $525,000, net operating income will be $37,500. What is Charletown's
degree of operating leverage?
A) 2
B) 10
C) .05
D) .10
24) Chevre Imported Cheese Inc. forecasts that if sales
revenue for next year is $1,250,000, net operating income will be $100,000 and
if sales revenue is $1,000,000, net operating income will be $80,000. Chevre's
degree of operating leverage is
A) 2.
B) 10.
C) .5.
D) 1.
25) Gardner
Furniture Co. has calculated its degree of operating leverage as 3.5. If
Gardner can increase sales revenue by 5%, net operating income should increase
by
A) 15%.
B) 17.5%.
C) 1.43%.
D) 3.5%.
26) Breakeven NPV means that the expected rate of return
on a project is equal to the required rate of return.
Answer: TRUE
27) Dudster company's DOL is 2. If sales increase by 10%,
NOI will increase by 5%.
Answer: FALSE
28) Accounting breakeven means that the company is able to
pay its interest expense and also the dividends shareholders were expecting.
Answer: FALSE
29) If the worst case scenario for a project results in an
NPV of zero, the project should be accepted.
Answer: TRUE
30) A project's internal rate of return and the company's
required rate of return were both exactly 12%, therefore the project's NPV was
greater than $0.00.
Answer: FALSE
31) If a project reaches the accounting breakeven point in
every year of its life, it must also have a positive NPV.
Answer: FALSE
32) The NPV breakeven point means that a company has
covered its cost of capital.
Answer: TRUE
33) For a line of snowblowers sold by Arctic Equipment,
fixed costs, including depreciation of $1,000,000, total $2,400,000. The snowblowers
sell for $800 each. Variable costs of a snowblower are $500. Compute
a. accounting breakeven.
b. cash breakeven
Answer:
a. Accounting breakeven = $2,400,000/($800$500) = 8,000 snowblowers.
b. Cash breakeven = ($2,400,000$1,000,000)/($800$500) =
4,667 snowblowers.
Diff: 2
34) Actual 2014 figures and forecasted 2015 figures are
shown below for HEMOPath Labs.

Actual 2011

Forecast 2011

Sales

$6,000,000

$6,480,000

Total Variable Costs

3,600,000

3,888,000

Total Fixed Costs

2,000,000

2,000,000

NOI

?

?

DOL






Compute Compute HEMOPath's degree of operating leverage
(DOL).
Answer:

Actual 2014

Forecast 2015

Sales

$6,000,000

$6,480,000

Total Variable Costs

3,600,000

3,888,000

Total Fixed Costs

2,000,000

2,000,000

NOI

$400,000

$592,000

DOL

6




If sales increase by 8% (480,000/6,000,000) NOI increases
by 48% (192,000/400,000).
DOL = 48%/8% = 6
35)
Year 0

Year 0

Year 1

Year 2

Revenue


$15,000

$15,000

Variable Cost


($5,000)

($5,000)

Depreciation


($200)

($200)

Fixed Cost


($350)

($350)

Operating Income


$9,450

$9,450

Taxes at 30%


($2,835)

($2,835)

NOPAT


$6,615

$6,615

Capital Investment

($5,753)



Free Cash Flow


$6,815

$6,815

NPV

$6,074.69



Forecasts for project ST are shown above. Using a discount
rate of 10%, the project has a positive NPV of $6,074.69. Estimate within $100
the level of sales revenue that will result in an NPV of $0.00. No other
variables will change.
Answer: By trial and
error, sales revenue of $10,000 will result in free cash flow $3,315 for each
year and a net present value close to $0.00. Using a financial calculator,
students could also solve for the 2 year annuity that results in NPV = CAPEX
and then work their way back up through the pro forma cash flow
forecasts.
13.4 Real Options in Capital Budgeting
1) Which of the following is a real option with respect to
a capital budgeting decision?
A) A call option on the company's stock.
B) A put option on securities sold to finance the project.
C) An option to expand the scale of the project.
D) An option to purchase land that will be used for a
manufacturing facility.
2) Real options can have the effect of
A) increasing a project's NPV.
B) reducing a project's risk.
C) gaining information about future opportunities.
D) all of the above.
Use the following information to answer the following
question(s).
Enrico, the owner of a pizza parlor near a large university
campus, is considering opening a shop specializing in quick, inexpensive
takeout meals that are low in fat and calories. He will use a vacant space
adjacent to the pizza parlor. Assume that the project requires an initial cash
outlay of $100,000. Finance students from the university have taken on the
project as a course assignment.
They believe that there is a 50% chance that
the project will have modest success and return $11,000 per year for the
foreseeable future (a perpetuity). On the other hand, there is a 50% chance
that the project will be highly successful and produce returns of $20,000 per
year in perpetuity. If the restaurant is modestly successful, Enrico will keep
it open, but not expand.
If it is well received, he will immediately open 2
more shops at sites close to the sprawling campus. The additional shops would
have approximately the same cash flow as the first. Cash flows will be
discounted at 10%.
3) What is the project's NPV if success is modest and it is
not expanded?
A) $10,000
B) ($10,000)
C) $110,000
D) The present value of a perpetual cash flow cannot be
determined.
4) What is the NPV of the project if it is expanded?
A) $100,000
B) $500,000
C) $300,000
D) $600,000
5) What is the expected NPV of the project with the option
to expand?
A) $310,000
B) $155,000
C) $110,000
D) $300,000
6) What is the expected NPV of the project with the option
to expand if the probability of modest success is revised to 70% and great
success to 30%?
A) $310,000
B) $155,000 (no change)
C) $213,000
D) $97,000
Use the following information to answer the following
question(s).
An alternative energy project will cost $300,000. Depending
on the price of electricity, the project will create aftertax savings of
either $100,000 per year for 5 years or $75,000 per year for 5 years. If first
year savings are only $75,000, the project can be sold at the end of the first
year for $250,000. Use a discount rate of 10%.
7) What is the NPV of the project if first year savings are
only $75,000 and the project is not sold?
A) ($4,545)
B) ($15,691)
C) $15,691
D) $75,000
8) What is the NPV of the project if first year savings are
only $75,000 and the project is sold?
A) ($4,545)
B) ($15,691)
C) $15,691
D) $75,000
9) What is the expected NPV of the project if the option to
abandon is not considered?
A) ($4,545)
B) $31,694
C) $37,267
D) $63,388
10) What is the expected NPV of the project if the option
to abandon is considered?
A) ($4,545)
B) $31,694
C) $37,267
D) $63,388
Use the following information to answer the following
question(s).
Tropical Soft Drinks is evaluating a proposal to install
solar panels on the roof of its factory near San Juan. The panels will cost
$150,000 per set. Depending on the price of electricity and the efficiency of
the panels, the project will increase operating cash flows by either $50,000
per year or $75,000 per year. The useful life of the panels is 5 years.
If
early results indicate savings of $75,000 per year, four additional sets of
panels will be installed immediately at the same cost with the same projected
savings. The probability of either outcome is 50%. Use a discount rate of 10%.
11) What is the expected NPV of the project if the option
to expand is not considered?
A) $39,539
B) $86,924
C) $236,924
D) $134,309
12) What is the expected NPV of the project if the option
to expand is considered?
A) $355,542
B) $671,545
C) $236,924
D) $711,084
13) Buffalo Drumsticks is evaluating a proposal to open a
restaurant in Bermuda. The restaurant will cost $29 million to open. Expected
cash flows are $8 million per year for the first five years. At the end of 5
years, the government of Bermuda will either revoke BD's permit and the
restaurant will close, or renew the permit indefinitely.
If the permit is
revoked, the building and equipment can be sold for $10,000,000. If the permit is renewed, assume that the $8
million turns into a perpetuity. There is a 30% chance the permit will be
revoked and a 70% chance it will be renewed. Compute the expected NPV of the
project. Use a discount rate of 12%.
A) $37.66 million
B) ($15.16 million)
C) $28.02 million
D) $18.86 million
14) Which of the following is NOT a typical real option in
capital budgeting?
A) The option to expand the project
B) The option to abandon the project
C) The option to reduce the scale of a project
D) The option to discount the project at a lower rate of
return
15) Real options can be either calls, options to buy the
project, or calls, options to sell the project.
Answer: FALSE
16) When evaluating projects with real options, businesses
must consider the probability that the option will be exercised.
Answer: TRUE
17) One type of real option is to delay the beginning of a
project until conditions are more favorable.
Answer: TRUE
18) Real options are traded on both the American Exchange
and Chicago Board Options Exchange (CBOE).
Answer: FALSE
19) Real options are derivative securities that derive
their value from the value of the underlying projects.
Answer: FALSE
20) Projects may appear to have less risk when real options
are considered.
Answer: TRUE
21) Briefly explain what is meant by a real option in
capital budgeting. Give 2 concrete examples.
Answer: Real options
are opportunities to use information gained after a project is in progress to
alter cash flow streams.
If a project does not live up to expectations, perhaps
it or the associated assets can be sold to another business for a profit, or at
least as a way of cutting losses. If a project is successful, it might be
possible to expand (e.g. increase production) or replicate it (open additional
stores, restaurants, etc.)
22) The NPV of a project based on forecasted cash flows is
$1,000,000. There is a 40% probability that cash flows from the project will be
seriously reduced because competitors will enter the market. In this case, if
the company did nothing, the NPV would be ($500,000). The project can also be
abandoned after 2 years and NPV will be ($100,000). What is the expected NPV of
the project when the option to abandon is considered. Should the projected be
accepted?
Answer: There is a
40% probability of abandonment, therefore a 60% probability of success. The
expected NPV is .6 × $1,000,000 + .4 × ($100,000) = $560,000. In spite of the
40% probability of a negative NPV, the expected NPV is positive because
potential gains are large compared to potential losses. The project should be
accepted.
23) Why is it important to consider real options in the
capital budgeting process? Give two specific examples.
Answer: The outcomes
of a project are rarely known with certainty before the project is undertaken
and are often not immutable. The ability to alter the course of a project may
turn a negative NPV to positive or make a project less risky once abandonment
cash flows are considered. For example, a movie or a new video game might have
a negative NPV, but if there is a serious possibility of a sequel or large cash
flows from the rental market, the expected NPV might turn positive.
Likewise, the option to sell a building or machinery if a project fails may
greatly reduce the negative impact on the business. (Examples will vary
greatly.)
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