Financial Management (Chapter 13: Risk Analysis and Project Evaluation)

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. Self-interest 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 risk-adjusted 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 year-by-year 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 worst-case 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 O-Phones for next year at 10,000 units priced at $150 each. The variable costs of an O-Phone 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 X-Ray 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 eco-friendly 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 capital-budgeting 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   Break-Even Analysis

1) Which of the following costs is NOT covered in an accounting break-even 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 break-even 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 break-even 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 break-even.

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 break-even 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 break-even 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 break-even 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 break-even 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 break-even 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 break-even 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 break-even 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 break-even 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 break-even 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 break-even NPV?  Assume cash flows come in the form of an end-of-the-year annuity.

A) $70,000.00

B) $97,093.41

C) $92,329.12

D) $86,690.54

21) Project Zeta is expected to produce after-tax 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 break-even 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) Break-even 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 break-even 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 break-even point in every year of its life, it must also have a positive NPV.

Answer:  FALSE

32) The NPV break-even 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 break-even.

b. cash break-even

Answer:  

a. Accounting break-even = $2,400,000/($800-$500) = 8,000 snowblowers.

b. Cash break-even = ($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 take-out 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 after-tax 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.)