Deck 13: Risk Analysis and Project Evaluations

Question 1

According to the capital asset pricing model, scenario risk is the only relevant risk for capital-budgeting purposes.

Answer 1

False

Question 2

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 2

D

Question 3

The required rate of return on an investment should not include the compensation for delaying consumption equal to the risk-free rate of return.

Answer 3

False

Question 4

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

Question 5

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

A)20
B)40
C)60
D)80

Question 6

Employees who propose capital projects often have a vested interest in getting them accepted.

Question 7

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 are risky.
D)Financial analysts are rarely excessively pessimistic.

Question 8

Which of the following events might negatively affect a project's net present value?

A)Rules change to allow for faster depreciation of plant and equipment.
B)Tax rates go down, which lowers the value of the tax shelter from depreciation.
C)Projected sales over the life of the project remain the same, but they are higher in the early years and lower in the later years.
D)Interest rates go up requiring an increase in the required rate of return.

Question 9

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.

Question 10

Michael believes that if he can make a good case for opening a new shop in the chain for which he works, he will be promoted to manager.Can we be confident that Michael's sales forecasts are accurate?

Question 11

Risk-adjusted discount rate is based on the notion that investors require higher rates of return on more risky projects.

Question 12

[blank] is the project's risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm's other projects and assets.

A)Project's stand-alone risk
B)Project's contribution-to-firm risk
C)Systemic risk
D)Scenario risk

Question 13

What are the consequences of excessive optimism or pessimism in forecasting expected project cash flows?

Question 14

[blank] is the amount of risk that the project contributes to the firm as a whole.

A)Project's stand-alone risk
B)Project's contribution-to-firm risk
C)Systemic risk
D)Scenario risk

Question 15

Why is it important to perform risk analysis before accepting or rejecting major projects?

Question 16

[blank] is the risk of the project from the viewpoint of a well-diversified shareholder.

A)Project's stand-alone risk
B)Project's contribution-to-firm risk
C)Systemic risk
D)Scenario risk

Question 17

The most popular method of risk adjustment is the risk-adjusted discount rate.

Question 18

A would-be entrepreneur is considering buying a franchise from a national chain of fitness centers.Identify some of the risks she might face.

Question 19

Approximately what percentage of new businesses survive their first year?

A)20
B)40
C)60
D)80

Question 20

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

Question 21

The form of risk analysis which examines the effect of various combinations of value drivers is known as [blank].

A)scenario analysis
B)sensitivity analysis
C)value driver analysis
D)expected value analysis

Question 22

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

Question 23

[blank] 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

Question 24

There is a 30% probability that an office building will be sold after five 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 five years?

A)$20 million
B)$21 million
C)$30 million
D)$10 million

Question 25

[blank] 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

Question 26

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.

Question 27

Australian Fireplaces expects to sell 1200 gas fireplaces in 2019 at an average price of $2400 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 2021if 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

Question 28

Economists at Rudy Investments 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

Question 29

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.

Question 30

Bay Lake Enterprises has a large manufacturing facility in Mexico is particularly concerned that a tariff of unknown size will be imposed on goods reimported from that region.The type of risk analysis that accounts for various levels of tariff is [blank].

A)sensitivity analysis
B)political risk analysis
C)scenario analysis
D)exchange rate analysis

Question 31

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

Question 32

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.

Question 33

Future Pharmaceuticals believes that changes in health insurance may increase demand by as much as 10%, but also lower prices by as much as 10%.It is also concerned that the cost of materials may increase as much as 10% and the company may or may not be able to pass these higher costs on to its customers.To estimate expected, best case and worst case results, Future should use [blank].

A)sensitivity analysis
B)scenario analysis
C)political risk analysis
D)probability analysis

Question 34

Eagle Play sets estimates a 60% probability that sales of play sets in the summer of 2019 will be 45,000 units, about the same as in 2018.They believe there is a 20% probability that they will be more popular due to its new exclusive line, and potential sales would be 90,000 units.There is also a 20% probability that restrictive zoning ordinances will limit sales to 30,000 units.The expected unit sales of the play sets are

A)55,000
B)51,000
C)67,500
D)60,000

Question 35

The pure play method attempts to identify publicly traded firms that are engaged solely in the same business as the project or division.

Question 36

Buttercrumbs Bakery expects to sell 1 million scones next year for $1.25 each.The variable cost of a scone 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 scone to $1.50 and all other variables remain the same, free cash flow will increase by [blank].

A)$37,500
B)$150,000
C)$187,500
D)$250,000

Question 37

An important value driver for an automobile dealership would be

A)depreciation.
B)inventory turnover.
C)tax rates.
D)debt to equity ratios.

Question 38

Anderson Heating and Cooling 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 Anderson'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

Question 39

Buttercrumbs Bakery expects to sell 1.25 million scones next year for $1.50 each.The variable cost of a scone 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 scone to $1.75, sales will fall by 50,000 scone.All other things equal, operating cash flow will increase or decrease by

A)$300,000 increase.
B)$148,500 increase.
C)$148,500 decrease.
D)$174,900 increase.

Question 40

Australian Fireplaces expects to sell 1200 gas fireplaces in 2019 at an average price of $2400 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 2021 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

Question 41

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.

Question 42

Using simulation provides the financial manager with a point estimate of an investment's net present value or internal rate of return.

Question 43

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

Question 44

Richardson Supplies 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.

Question 45

Briefly describe the five steps in performing a simulation analysis.

Question 46

Briefly distinguish between sensitivity analysis, scenario analysis, and simulation.

Question 47

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%

Question 48

Buttercrumbs Bakery expects to sell 1 million scones next year for $1.25 each.Variable cost of a scone is $0.75.Fixed costs are $150,000, depreciation $200,000 and the tax rate is 25%.If the number of scones sold increases by 10%, and all other variables remain the same, how much will free cash flow increase?

Question 49

Sensitivity analysis shows how the distribution of possible net present values is affected by a change in one input variable.

Question 50

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

Question 51

A company that was most concerned about the impact of price changes in raw materials would use sensitivity analysis.

Question 52

What is the expected free cash flow for the best case scenario?

A)$414,400
B)$330,000
C)$394,500
D)$383,240

Question 53

What is the expected free cash flow for the worst case scenario?

A)$153,973
B)$43,972
C)$84,910
D)$383,240

Question 54

One advantage of simulation is that it can differentiate between unsystematic and systematic risk.

Question 55

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 NPVs.
D)a list of value drivers and their probabilities.

Question 56

Simulation analysis is basically a form of scenario analysis in which a great many scenarios are examined to produce a probability distribution of possible outcomes.

Question 57

Mikey's Sandwich Shop expects to sell 200,000 sandwiches 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?

Question 58

List at least four typical value drivers that could seriously impact the outcome of a project.

Question 59

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

Question 60

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

Question 61

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

Question 62

Why is it important to consider real options in the capital budgeting process? Give two specific examples.

Question 63

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.

Question 64

Briefly explain what is meant by a real option in capital budgeting.Give two concrete examples.

Question 65

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.

Question 66

What is the expected NPV of the project if the option to abandon is not considered?

A)$4545
B)$31,694
C)$37,267
D)$63,388

Question 67

When evaluating projects with real options, businesses must consider the probability that the option will be exercised.

Question 68

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 two 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?

Question 69

What is the NPV of the project if first year savings are only $75,000 and the project is not sold?

A)$4545
B)$15,691
C)$15,619
D)$75,000

Question 70

EnVo is evaluating a proposal to move some manufacturing operations from an obsolescent plant in Mexico to a new facility in China.The new facility will cost $58 million to open and is expected to result in savings of $16 million per year for the first five years.At the end of five years, Porter will decide either to close the plant in China or to keep it indefinitely.If EnVo closes the plant, the building and equipment can be sold for $20,000,000.If the plant is kept, assume that the $16 million turns into a perpetuity.There is a 30% chance the plant will be closed and a 70% chance it will be kept.Calculate the expected NPV of the project.Use a discount rate of 12%.

A)$75.32 million
B)$30.32 million
C)$56.04 million
D)$114.04 million

Question 71

What is the expected NPV of the project if the option to abandon is considered?

A)$4545
B)$31,694
C)$37,267
D)$63,388

Question 72

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

A)$100,000
B)$500,000
C)$300,000
D)$600,000

Question 73

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

Question 74

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

Question 75

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

Question 76

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

Question 77

What is the NPV of the project if first year savings are only $75,000 and the project is sold?

A)$4545
B)$15,700
C)$15,691
D)$75,000

Question 78

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

Question 79

The option to abandon a project before the end of its forecasted life may increase its NPV.