Deck 9: Risk Analysis, Real Options, and Capital Budgeting

Question 1

All else equal, the contribution margin must increase as:

A) both the sales price and variable cost per unit increase.
B) the fixed cost per unit declines.
C) the variable cost per unit declines.
D) sales price per unit declines.
E) the sales price minus the fixed cost per unit increases.

Answer 1

the variable cost per unit declines.

Question 2

In the present-value break-even the EAC is used to:

A) determine the opportunity cost of investment.
B) allocate depreciation over the life of the project.
C) allocate the initial investment at its opportunity cost over the life of the project.
D) determine the contribution margin to fixed costs.

Answer 2

allocate the initial investment at its opportunity cost over the life of the project.

Question 3

Given the following information, calculate the present value break-even point. Fixed costs: $2000/year. (Initial investment $2000).
Variable costs: $6/unit.
Depreciation: $250/year.
Price: $20/unit.
Discount rate: 10%.
Project life: 4 years.
Tax rate: 34%.

A) 100 units/year.
B) 143 units/year.
C) 202 units/year.
D) 286 units/year.

Answer 3

202 units/year.

Question 4

Sensitivity analysis helps you determine the:

A) range of possible outcomes given possible ranges for every variable.
B) degree to which the net present value reacts to changes in a single variable.
C) net present value given the best and the worst possible situations.
D) degree to which a project is reliant upon the fixed costs.

Question 5

The present value break-even point is superior to the accounting break-even point because:

A) present value break-even is more complicated to calculate.
B) present value break-even covers the economic opportunity costs of the investment.
C) present value break-even is the same as sensitivity analysis.
D) present value break-even covers the fixed costs of production, which the accounting break-even does not.
E) present value break-even covers the variable costs of production, which the accounting break-even does not.

Question 6

Scenario analysis is different than sensitivity analysis:

A) as no economic forecasts are changed.
B) as several variables are changed together.
C) because scenario analysis deals with actual data versus sensitivity analysis which deals with a forecast.
D) because it is short and simple.

Question 7

The Mini-Max Company has the following cost information on their new prospective project. Fixed costs are $200/year. (Initial investment is $700)
Variable costs: $3/unit.
Depreciation: $140/year.
Price: $8/unit.
Discount rate: 12%.
Project life: 3 years.
Tax rate: 34%.
Calculate the present value break-even point.

A) 68.00 units/year.
B) 113.27 units/year.
C) 84.42 units/year.
D) 75 units/year.

Question 8

The Mini-Max Company has the following cost information on their new prospective project. Fixed costs are $200/year. (Initial investment is $700)
Variable costs: $3/unit.
Depreciation: $140/year.
Price: $8/unit.
Discount rate: 12%.
Project life: 5 years.
Tax rate: 34%.
Calculate the accounting break-even point.

A) 68.00 units/year.
B) 103.03 units/year.
C) 113.33 units/year.
D) 25.00 units/year.

Question 9

The accounting profit break-even point occurs when:

A) the total revenue curve cuts the total cost curve.
B) the total revenue curve cuts the fixed cost curve.
C) the variable cost curve cuts the total cost curve.
D) the total revenue curve cuts the variable cost curve.

Question 10

From the information below, calculate the impact of discount rate changes on the present-value break-even point. Fixed costs are $2500/year. (Initial investment is $2000.)
Variable costs: $8/unit.
Depreciation: $500/year.
Price: $25/unit.
Initial Discount rate: 10%.
Project life: 4 years.
Tax rate: 34%.
If the discount rate were 15% and 5% what would be the present-value break-even points. How sensitive is the break-even to the discount rate change (show your results).

Question 11

At stage 2 of the decision tree it shows that if a project is successful the payoff will be $53,000 with a 2/3 chance of occurrence. There is also the 1/3 chance of a -$24,000 payoff. The cost of getting to stage 2 (1 year out) is $44,000. The cost of capital is 15%. What is the NPV of the project at stage 1?

A) -$13,275
B) -$20,232
C) $2,087
D) $7,536

Question 12

From the information below, calculate the accounting break-even point. Fixed costs are $2000/year. (Initial investment is $2000.)
Variable costs: $6/unit.
Depreciation: $250/year.
Price: $20/unit.
Discount rate: 10%.
Project life: 4 years.
Tax rate: 34%.

A) 88 units/year.
B) 161 units/year.
C) 143 units/year.
D) 100 units/year.

Question 13

As the degree of sensitivity of a project to a single variable rises, the:

A) lower the forecasting risk of the project.
B) smaller the range of possible outcomes given a pre-defined range of values for the input.
C) more attention management should place on accurately forecasting the future value of that variable.
D) lower the maximum potential value of the project.

Question 14

In order to make a decision with a decision tree:

A) one starts furthest out in time to make the first decision.
B) One must begin at time 0.
C) Any path can be taken to get to the end.
D) Any path can be taken to get back to the beginning.

Question 15

The Marx Brewing Company recently installed a new bottling machine. The machine's initial cost is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years. The machine's per year fixed cost is $1,800, and its variable cost is $0.50 per unit. The selling price per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. If Marx sells 2500 units what is the accounting profit and contribution margin for Marx Brewing?

Question 16

Including the option to expand in your project analysis will tend to:

A) extend the duration of a project but not affect the project's net present value.
B) increase the net present value of a project.
C) decrease the net present value of a project.
D) have no effect on either a project's cash flows or its net present value.

Question 17

Fixed production costs are:

A) directly related to labor costs.
B) measured as cost per unit of time.
C) measured as cost per unit of output.
D) dependent on the amount of goods or services produced.

Question 18

An investigation of the degree to which NPV depends on assumptions made about critical variables is called a(n)

A) operating analysis
B) sensitivity analysis
C) marginal benefit analysis
D) decision tree analysis.

Question 19

In a decision tree, the NPV to make the yes/no decision is dependent on:

A) only the cashflows from successful path.
B) on the path where the probabilities add up to one.
C) all cashflows and probabilities.
D) only the cashflows and probabilities of the successful path.

Question 20

The Marx Brewing Company recently installed a new bottling machine. The machine's initial cost is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years. The machine's per year fixed cost is $1,800, and its variable cost is $0.50 per unit. The selling price per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. Calculate the accounting break-even point on the new machine, as well as the present value break-even point on the new machine.

Question 21

Your company has a new project to be considered. You are given the following information on the best guess of related outcomes for the project. The cost of developing and market testing the product over the next year is $225 million. If the test is successful, which is expected to be 65%, the company will spend another $800 million to put the productive capabilities in place. The expected cashflows after tax for a successful project are $225 million each year for the next six years with a probability of .8; there is a 20% chance of a zero NPV. If the tests fail the cashflows associated with continuing through the sixth year is $125 million per year after tax. The company uses a 12% discount rate for these types of projects. Determine the net present value if the tests are a success. Determine the net present value and the decision to undertake testing or not.

Question 22

The market value of an investment project should be viewed as the sum of the standard NPV and the value of managerial options. Explain two different options that management may have, what they are, and how they would influence market value.

Question 23

Sensitivity analysis is a method which allows for evaluation of the NPV given a series of changes to the underlying assumptions. Discuss why and how scenario analysis is used in addition to sensitivity analysis.

Question 24

Your company has a new project to be considered. You are given the following information on the best guess of related outcomes for the project. The cost of developing and market testing the product over the next year is $225 million. If the test is successful, which has a 65% chance, the company will spend another $800 million to put the productive capabilities in place. The expected cashflows after tax for a successful project are $225 million each year for the next six years with a probability of .8; there is a 20% chance of a zero NPV. If the test fails the cashflows associated with continuing through the sixth year is $125 million per year after tax. The company uses a 12% discount rate for these types of projects. Draw and label the decision tree. Explain what decisions management would make at each node upon their realization.