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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.

Answer: C

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: D

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: D

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

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.

Answer: C

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

5) Approximately what percentage of new businesses fail in their first year?

A) 20%

B) 40%

C) 60%

D) 80%

Answer: B

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: survival rates

Principles: Principle 2: There Is a Risk-Return Tradeoff

6) Approximately what percentage of new businesses survive their first year?

A) 20%

B) 40%

C) 60%

D) 80%

Answer: C

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: survival rates

Principles: Principle 2: There Is a Risk-Return Tradeoff

7) What is the approximate five year survival rate for new businesses?

A) 20%

B) 40%

C) 60%

D) 80%

Answer: A

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: survival rates

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

8) What is the approximate failure rate for new businesses after five years?

A) 20%

B) 40%

C) 60%

D) 80%

Answer: D

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: survival rates

Principles: Principle 2: There Is a Risk-Return Tradeoff

9) In reality, anticipated cash flows are only estimates and are thus uncertain.

Answer: TRUE

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

10) Most of the variables used in forecasting cash flows are known with certainty.

Answer: FALSE

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

11) 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.

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

12) 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.

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: human factors

Principles: Principle 2: There Is a Risk-Return Tradeoff

13) 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.

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: human factors

Principles: Principle 2: There Is a Risk-Return Tradeoff

14) 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.

Diff: 1

Topic: 13.1 The Importance of Risk Analysis

Keywords: project cash flows

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

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.

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: sensitivity analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: sensitivity analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: D

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: sensitivity analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

5

Copyright 2011 Pearson Education, Inc.

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.

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: value drivers

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

6

Copyright 2011 Pearson Education, Inc.

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

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: expected value

Principles: Principle 2: There Is a Risk-Return Tradeoff

11) There is a 20% probability that the NPV of a project will be $20 million, a 50% probability

that it will be sold for $45 million and a 30% probability that it will be for $15 million. What is

the expected NPV of the project?

A) $17.5 million

B) $45 million

C) $31 million

D) $26.67 million

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: expected value

Principles: Principle 2: There Is a Risk-Return Tradeoff

7

Copyright 2011 Pearson Education, Inc.

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

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: expected value

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: expected value

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: D

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

8

Copyright 2011 Pearson Education, Inc.

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

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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. Quineboag's degree of operating

leverage (DOL) is ________.

A) .015

B) .33

C) 3.00

D) 10

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: degree of operating leverage (DOL)

Principles: Principle 2: There Is a Risk-Return Tradeoff

17) When Charles River Publisher's sales revenue increased from $25 million to $27.5 million,

net operation income increased from $3,750,000 to $3,937,500. Quineboag's degree of operating

leverage (DOL) is ________.

A) .5

B) 2

C) 6.67

D) .05

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: degree of operating leverage (DOL)

Principles: Principle 2: There Is a Risk-Return Tradeoff

9

Copyright 2011 Pearson Education, Inc.

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

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: sensitivity analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

19) 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 sales will fall by 50,000

croissants. Free cash flow will increase or decrease by:

A) $131,250 increase.

B) $37,500 increase.

C) $75,000 decrease.

D) $250,000 increase.

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: sensitivity analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: D

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

10

Copyright 2011 Pearson Education, Inc.

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

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: D

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

11

Copyright 2011 Pearson Education, Inc.

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

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: D

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

12

Copyright 2011 Pearson Education, Inc.

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

Answer: D

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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%

Answer: A

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: C

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

13

Copyright 2011 Pearson Education, Inc.

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.

Answer: B

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

32) Using simulation provides the financial manager with a probability distribution of an

investment's net present value or internal rate of return.

Answer: TRUE

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

33) In capital-budgeting decisions, simulation analysis gives a probability distribution only for

cash flows.

Answer: FALSE

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

34) Sensitivity analysis shows how the distribution of possible net present values is affected by a

change in one input variable.

Answer: TRUE

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: sensitivity analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

35) One advantage of simulation is that it can differentiate between unsystematic and systematic

risk.

Answer: FALSE

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

14

Copyright 2011 Pearson Education, Inc.

36) 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.

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: simulation analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

37) 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.)

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: value drivers

Principles: Principle 2: There Is a Risk-Return Tradeoff

38) 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

Diff: 2

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: expected value

Principles: Principle 2: There Is a Risk-Return Tradeoff

15

Copyright 2011 Pearson Education, Inc.

39) 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

Diff: 3

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

16

Copyright 2011 Pearson Education, Inc.

40) 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

Diff: 3

Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows

Keywords: scenario analysis

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: A

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

17

Copyright 2011 Pearson Education, Inc.

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

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

3) Klaus Nicholas plans to sell Christmas trees from a vacant lot in downtown Springfield. The

trees will cost him $12 each. It will cost Klaus $1,500 to rent the lot from November 1 through

December 30. If Klaus sells the trees for $20 each, how many trees must he sell to break even?

Assume that he makes an initial, non-refundable purchase of 200 trees but can buy more trees in

any quantity after that for $12 each.

A) $1,500/($20-$12) = 188 trees with a very small profit on the last tree

B) $3,900/$20 = 195 trees

C) All 200 trees

D) The Christmas tree project can never break even.

Answer: B

Diff: 3

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

4) Klaus Nicholas plans to sell Christmas trees from a vacant lot in downtown Springfield. The

trees will cost him $1200 per 100 tress. They can only be purchased in lots of 100. It will cost

Klaus $1,500 to rent the lot from November 1 through December 30. If Klaus sells the trees for

$20 each, how many trees must he sell to break even? Assume that he purchases makes an initial,

non-refundable purchase of 300 trees.

A) $1,500/($20-$12) = 188 trees with a very small profit on the last tree.

B) All 300 trees because he must purchase them in lots of 100.

C) At least 255 trees because all costs are fixed once the trees are purchased.

D) The Christmas tree project can never break even.

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

18

Copyright 2011 Pearson Education, Inc.

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

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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) Teds' Variety Store broke even with respect to net income.

B) Teds' Variety Store broke even with respect to cash.

C) Ted's Variety fell $20,000 short of cash break-even.

D) Teds' Variety Store broke even with a $20,000 surplus.

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: cash break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

19

Copyright 2011 Pearson Education, Inc.

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

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: A

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: cash break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

11) Excom Fiberoptics sell micro test tubes for biotechnology research in sets of 10,000 tubes.

Fixed costs associated with the project are $2,000,000, variable cost per set is $120. Excom

expects to sell 25,000 sets. What is the minimum price must it can charge and reach the

accounting break-even point?

A) $80

B) $120

C) $240

D) $200

Answer: D

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

20

Copyright 2011 Pearson Education, Inc.

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.

Answer: D

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: A

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

21

Copyright 2011 Pearson Education, Inc.

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.

Answer: D

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Answer: D

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

22

Copyright 2011 Pearson Education, Inc.

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

Answer: A

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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%

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

20) Miller River Light that manufactures the project 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?

A) $70,000.00

B) $97,093.41

C) $92,329.12

D) $86,690.54

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

23

Copyright 2011 Pearson Education, Inc.

21) Project Zeta is expected to produce after-tax cash flows $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

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: C

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: cash break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

24

Copyright 2011 Pearson Education, Inc.

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.

Answer: D

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: cash break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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%.

Answer: B

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: cash break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

26) Break-even NPV means that the expected rate of return on a project is equal to the required

rate of return.

Answer: TRUE

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

27) Dudster company's DOL is 2. If sales increase by 10%, NOI will increase by 5%.

Answer: FALSE

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: degree of operating leverage (DOL)

Principles: Principle 2: There Is a Risk-Return Tradeoff

28) Accounting break-even means that the company is able to pay its interest expense and also

the dividends shareholders were expecting.

Answer: FALSE

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

25

Copyright 2011 Pearson Education, Inc.

29) If the worst case scenario for a project results in an NPV of zero, the project should be

accepted.

Answer: TRUE

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: human factors

Principles: Principle 2: There Is a Risk-Return Tradeoff

30) 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

Topic: 13.3 Break-Even Analysis

Keywords: accounting break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

26

Copyright 2011 Pearson Education, Inc.

31) Actual 2010 figures and forecasted 2011 figures are shown below for HEMOPath Labs

Sales

Total Variable

Costs

Total Fixed

Costs

NOI

DOL

$6,000,000

$6,480,000

3,600,000

3,888,000

2,000,000

?

2,000,000

?

Answer: 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

$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

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: degree of operating leverage (DOL)

Principles: Principle 2: There Is a Risk-Return Tradeoff

27

Copyright 2011 Pearson Education, Inc.

32)

Year 0

Year 0

Revenue

Variable Cost

Depreciation

Fixed Cost

Operating

Income

Taxes at 30%

NOPAT

Capital

Investment

($5,753)

Free Cash

Flow

NPV

$6,074.69

Year 1

$15,000

($5,000)

($200)

($350)

Year 2

$15,000

($5,000)

($200)

($350)

$9,450

($2,835)

$6,615

$9,450

($2,835)

$6,615

$6,815

$6,815

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.

Diff: 2

Topic: 13.3 Break-Even Analysis

Keywords: NPV break-even

Principles: Principle 2: There Is a Risk-Return Tradeoff

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 that will be used for the manufacturing facility.

Answer: C

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

28

Copyright 2011 Pearson Education, Inc.

A) increasing a project's NPV.

B) reducing a project's risk.

C) gaining information about future opportunities.

D) all of the above.

Answer: D

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

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.

Answer: A

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

4) What is the NPV of the project if it is expanded?

A) $100,000

B) $500,000

C) $300,000

D) $600,000

Answer: C

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

29

Copyright 2011 Pearson Education, Inc.

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

Answer: B

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

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) $155,00 (no change)

C) $213,000

D) $97,000

Answer: D

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

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

Answer: B

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

30

Copyright 2011 Pearson Education, Inc.

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

Answer: A

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

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

Answer: B

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

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

Answer: C

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

31

Copyright 2011 Pearson Education, Inc.

Tropical Soft Drinks is evaluating a proposal to install solar panels on the roof of it's 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

Answer: B

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

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

Answer: A

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

13) Tennessee Fried Chicken is evaluating a proposal to open a fast food restaurant in

Westphalia. The restaurant will cost $14.5 million to open. Expected cash flows are $4 million

per year for the first five years. At the end of 5 years, the government of Westphalia will either

revoke TFC's permit and the restaurant will close, or renew the permit indefinitely. In that case,

assume that the $4 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) $18.83 million

B) ($.08 million)

C) $13.16 million

D) $9.43 million

Answer: C

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

32

Copyright 2011 Pearson Education, Inc.

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

Answer: D

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

15) Real options can be either calls, options to buy the project, or calls, options to sell the

project.

Answer: FALSE

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

16) When evaluating projects with real options, businesses must consider the probability that the

option will be exercised.

Answer: TRUE

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

17) One type of real option is to delay the beginning of a project until conditions are more

favorable.

Answer: TRUE

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

18) The holder of the patent on a new energy efficient, long lived light bulb that gives off a warm

yellow light and does not contain mercury intends to manufacture and market it over the internet.

Which of the following possibilities represent real options?

A) Sell the patent to a major manufacturer after 2 or 3 years.

B) Expand production and sell the product through major retailers.

C) Delay the launch of the website until energy prices rise.

D) All of the above.

Answer: D

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

33

Copyright 2011 Pearson Education, Inc.

19) 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.)

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

20) 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.

Diff: 3

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

21) 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.)

Diff: 2

Topic: 13.4 Real Options in Capital Budgeting

Keywords: real options

Principles: Principle 3: Cash Flows Are the Source of Value

34

Copyright 2011 Pearson Education, Inc.

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