Chap010.pdf

Chapter 10 - Project Analysis

Chapter 10 Project Analysis Multiple Choice Questions

1. Discounted cash flow (DCF) analysis generally: I) assumes that firms hold assets passively when it invests in a project II) considers opportunities to expand a project if the project is successful III) considers opportunities to abandon a project if the project is a failure A. I only B. II only C. II and III only D. I, II, and III

2. A firm's capital investment proposals should reflect: I) Capital budgeting process II) Strategic planning process III) Middle managers' ideas and views A. I only B. I and II only C. I, II, and III D. III only

3. Generally, postaudits are conducted for large projects: A. shortly after the completion of the project B. after several years after the completion of the project C. shortly after the project has begun to operate D. well before the start of the project

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Chapter 10 - Project Analysis

4. Generally, postaudits for projects are conducted: I) to identify problems that need fixing II) to check the accuracy of forecasts III) to come up with questions that should have been asked before the project was undertaken A. I only B. II only C. I and II only D. I, II, and III

5. You are given the following data for year-1. Revenue = $43; Total costs = $30; Depreciation = $3; Tax rate = 30%. Calculate the operating cash flow for the project for year1. A. $7 B. $10 C. $13 D. None of the above

6. A project has an initial investment of 100. You have come up with the following estimates of the projects with cash flows.

If the cash flows are perpetuities and the cost of capital is 10%. What does a sensitivity analysis of NPV (no taxes) show? A. -50, 20, +100 B. -100, -50, +80 C. -50, +50, +70 D. None of the above

7. You are given the following data for year-1: Revenues = 100, Fixed costs = 30; Total variable costs = 50; Depreciation = $10; Tax rate = 30%. Calculate the after tax cash flow for the project for year-1. A. $17 B. $7 C. $10 D. None of the above

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8. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3 = 100,000. If the discount rate changes from 12% to 15%, what is the change in the NPV of the project (approximately)? A. 12,750 increase B. 12,750 decrease C. 122,650 increase D. 135,400 decrease

9. You have come up with the following estimates of project cash flows:

The cash flows are perpetuities and the cost of capital is 8%. What does a sensitivity analysis of NPV (without taxes) show? A. 25, +232.50, +440 B. -100, +500, +800 C. -90, -55, -20 D. None of the above

10. A project has an initial investment of $150. You have come up with the following estimates of revenues and costs. Calculate the NPV assuming that cash flow and perpetuities. (No taxes.) (Cost of capital = 10%)

A. 50, -100, +400 B. -50, +300, +500 C. -100, +150, +350 D. None of the above

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11. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. Cash flows from the project are: A. CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600 B. CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600 C. CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600 D. none of the above

12. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. Calculate the NPV of the project: A. 3840 B. 8443 C. -2735 D. None of the above

13. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 12%. Calculate the NPV of the project: A. 14,418 B. 8443 C. -2735 D. None of the above

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14. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. What would the NPV of the project be if the revenues were higher by 10% and the costs were 65% of the revenues? A. $8443 B. $964 C. $5566 D. None of the above

15. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. What would the NPV if the discount rate were higher by 10%? A. $5648 B. $3840 C. -$2735 D. None of the above

16. The following are drawbacks of sensitivity analysis except: A. it provides ambiguous results. B. underlying variables are likely to be interrelated. C. it provides additional information about the project that is useful. D. all of the above statements are drawbacks of sensitivity analysis.

17. Which of the following statements most appropriately describes "Scenario Analysis". A. it looks at the project by changing one variable at a time B. it provides the break-even level of sales for the project C. it looks at different but consistent combination of variables D. each of the above statements describes "Scenario Analysis" correctly

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18. Financial Calculator Company proposes to invest $12 million in a new calculator making plant. Fixed costs are $3 million a year. A financial calculator costs $10 per unit to manufacture and can be sold for $30 per unit. If the plant lasts for 4 years and the cost of capital is 20%, what is the break-even level (i.e. NPV = 0) of annual rates? (Approximately)(Assume no taxes.) A. 150,000 units B. 342,290 units C. 381,777 units D. None of the above

19. Calculator Company proposes to invest $5 million in a new calculator making plant. Fixed costs are $2 million a year. A calculator costs $5/unit to manufacture and can be sold for $20/unit. If the plant lasts for 3 years and the cost of capital is12%, what is the approximate break-even level (i.e. NPV = 0) of annual sales? (Assume no taxes.)(approximately) A. $133,333 units B. $272,117 units C. $227,533 units D. None of the above

20. Firms often calculate a project's break-even sales using book earnings. Generally, breakeven sales based on NPV is: A. Higher than the one calculated using book earnings B. Lower than the one calculated using book earnings C. Equal to the one calculated using book earnings D. None of the above

21. The accounting break-even point occurs when: A. the total revenue line cuts the fixed cost line B. the present value of inflows line cuts the present value of outflows line C. the total revenue line cuts the total cost line D. none of the above

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22. The NPV break-even point occurs when: A. the present value of inflows line cuts the present value of outflows line B. the total revenue line cuts the fixed cost line C. the total revenue line cuts the total cost line D. none of the above

23. Financial Calculator Company proposes to invest $12 million in a new calculator making plant. Fixed costs are $3 million a year. A financial calculator costs $10 per unit to manufacture and can be sold for $30 per unit. If the plant lasts for 4 years and the cost of capital is 20%, what is the accounting break-even level? (Approximately)(Assume no taxes.) A. 300,000 units B. 150,000 units C. 381,777 units D. None of the above

24. Calculator Company proposes to invest $5 million in a new calculator making plant. Fixed costs are $2 million a year. A calculator costs $5/unit to manufacture and can be sold for $20/unit. If the plant lasts for 3 years and the cost of capital is 12%, what is the approximate break-even level (accounting) of annual sales? (Assume no taxes.)(approximately) A. $133,334 units B. $272,117 units C. $244,444 units D. None of the above

25. Taj Mahal Tour Company proposes to invest $3 million in a new tour package project. Fixed costs are $1 million per year. The tour package costs $500 and can be sold at $1500 per package to tourists. This tour package is expected to be attractive for the next five years. If the cost of capital is 20%, what is the NPV break-even number of tourists per year? (Ignore taxes, give an approximate answer) A. 1000 B. 2000 C. 15000 D. None of the above

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26. Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $0.5 million per year. The equipment is expected to last for five years. The manufacturing cost per hammer is $1and the selling price per hammer is $6. Calculate the break-even (i.e. NPV = 0) volume per year. (Ignore taxes.) A. 500,000 units B. 600,000 units C. 100,000 units D. None of the above

27. Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $1.0 million per year. The equipment is expected to last for five years. The manufacturing cost per hammer is $1 and the selling price per hammer is $6. Calculate the break-even (i.e. NPV = 0) volume per year. (Ignore taxes.) A. 500,000 units B. 600,000 units C. 100,000 units D. None of the above

28. Everything else remaining the same, an increase in fixed costs: I) increases the break-even point based on NPV II) increases the accounting break-even point III) decreases the break-even point based on NPV IV) decreases the accounting break-even point A. I and III only B. III and IV only C. II and III only D. I and II only

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29. Project analysis, in addition to NPV analysis, includes the following procedures: I) Sensitivity analysis II) Break-even analysis III) Monte Carlo simulation IV) Scenario Analysis A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

30. Simulation models are useful: I) To understand the project better II) To forecast expected cash flows III) To assess the project risk A. I only B. II only C. III only D. I, II and III

31. Monte Carlo simulation involves the following steps: I) Step 1: Modeling the project II) Step 2: Specifying probabilities III) Step 3: Simulate the cash flows IV) Step 4: Calculate present value A. I and II only B. I, II, and III only C. II, III, and IV only D. I, II, III, and IV

32. After the completion of project analysis, the final decision on the project would be from: A. Sensitivity analysis B. Break-even analysis C. Decision trees D. NPV

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33. Which of the following simulation outputs is likely to be most useful and easy to interpret? The output shows the distribution(s) of the project: A. Earnings B. Internal rate of return C. Cash flows D. Profits

34. Generally, the simulation models for projects are developed using a: A. Pair of dice B. Roulette wheel C. Computer D. Pack of cards

35. Monte Carlo simulation is likely to be most useful: A. For very complex problems B. For problems of moderate complexity C. For very simple problems D. Regardless of the problem's complexity

36. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year, which is also the cost of capital (Ignore taxes). Calculate the NPV to invest today. A. +10,000,000 B. +6,000,000 C. +4,000,000 D. none of the above

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37. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year, which is also the cost of capital (Ignore taxes). Suppose the oil price is uncertain and can be $70/bbl or $40/bbl next year and then expected NPV of the project if postponed by one year is: A. +10,000,000 B. +25,000,000 C. +5,000,000 D. none of the above

38. The following are real options except: A. Stock options B. Timing options C. Option to expand D. Option to abandon

39. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year which is also the cost of capital (Ignore taxes). Suppose the oil price is uncertain and can be $70/bbl or $40/bbl next year. If the project if postponed by one year, calculate the value of the option to wait for one year: (approximately) A. +15,000,000 B. +40,000,000 C. +10,000,000 D. none of the above

40. Option to expand a project is a: A. Call option B. Put option C. Stock option D. Swap

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41. Option to abandon a project is a: A. Call option B. Put option C. Stock option D. Swap

42. You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for 3 years (starting next year). If it fails, you will only have net cash flows of $10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in. You have to spend $80 million immediately for equipment and the rights to produce the figure. If the discount rate is 10%, calculate the NPV without the abandonment option. A. -9.15 B. +13.99 C. +9.15 D. -14.4

43. You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for 3 years (starting next year). If it fails, you will only have net cash flows of $10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in. You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million once the first year's cash flows are received, calculate the NPV with the abandonment option. (The discount rate is 10%) A. -9.1 B. +9.1 C. +13.99 D. -14.4

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44. You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for 3 years (starting next year). If it fails, you will only have net cash flows of $10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in. You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million once the first year's cash flows are received, calculate the value of the abandonment option. (The discount rate is 10%) A. -9.15 B. +13.99 C. +23.14 D. None of the above

45. The following options associated with a project increases managerial flexibility: I) Option to expand II) Option to abandon III) Production options IV) Timing options A. I only B. II only C. I, II, III, and IV D. IV only

46. Given the following net future values for harvesting trees (one time harvest):

If the cost of capital is 15%, calculate the optimal year to harvest: A. Year 1 B. Year 2 C. Year 3 D. Year 4

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Chapter 10 - Project Analysis

47. The Consumer- Mart Company is going to introduce a new consumer product. If brought to market without research about consumer tastes the firm believes that there is a 60% chance that the product will be successful. If successful, the project has a NPV = $500,000. If the product is a failure (40%) and withdrawn from the market, then NPV = -$100,000. A consumer survey will cost $60,000 and delay the introduction by one year. If the survey is successful, then there is an 80% chance of consumer acceptance, in which case the NPV = $500,000. If, on the other hand the survey is a failure, then NPV = -$100,000. The discount rate is 10%. By how much does the marketing survey change the expected net present value of the project? (approximately) A. Increase the NPV by $25,455 B. decrease the NPV by $5950 C. decrease the NPV by $8955 D. decrease the NPV by $25,455

48. KMW Inc. sells a finance textbook for $150 each. The variable cost per book is $30 and the fixed cost per year is $30,000. The process of creating a textbook costs $150,000 and the average book has a life span of 3 years. Using straight line depreciation and a tax rate of 25%, what is the economic or present value break even number of books that must be sold given a discount rate of 12%? A. 582 B. 667 C. 805 D. 953

49. KMW Inc. sells a finance textbook for $150 each. The variable cost per book is $30 and the fixed cost per year is $30,000. The process of creating a textbook costs $150,000 and the average book has a life span of 3 years. Using straight line depreciation and a tax rate of 25%, What is the accounting break even number of books that must be sold? A. 582 B. 667 C. 805 D. 953

True / False Questions

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Chapter 10 - Project Analysis

50. Postaudits are conducted before the start of the projects. True False

51. Most firms keep track of the progress of projects by conducting postaudits shortly after the projects have begun to operate. True False

52. Projects with high fixed costs have lower break-even points. True False

53. The break-even point in terms of NPV is usually lower than the break-even point on an accounting basis. True False

54. Firms that use break-even on an accounting basis are really losing the opportunity cost of capital on their investments. True False

55. Monte Carlo simulation is a tool for considering all possible combinations of variables. True False

56. In constructing a simulation model of an investment project, one can ignore possible interdependencies between variables. True False

57. Monte Carlo simulation should be used to get the distribution of NPV values for a project. True False

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Chapter 10 - Project Analysis

58. Tangible assets usually have higher abandonment value than intangible ones. True False

59. Abandonment option is a call option, while the option to expand is a put option. True False

60. In drawing a decision tree, a square represents a decision point, and a triangle represents a decision point for fate. True False

61. In drawing a decision tree, it is important to include all possible eventualities. True False

62. In almost al cases the present value break even quantity is higher than the accounting break even quantity. True False

63. Monte Carlo simulation is merely an advanced version of scenario analysis. True False

Short Answer Questions

64. Indicate some of the problems associated with capital investment process.

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65. Discuss the importance of conducting post audits.

66. Briefly describe sensitivity analysis used for project analysis.

67. How do managers supplement the NPV analysis of a project to gain better understanding of a project?

68. Briefly discuss break-even analysis.

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69. Briefly discuss the usefulness of Monte Carlo simulation in project analysis.

70. Briefly explain the term "real options."

71. Briefly discuss various real options associated with capital budgeting projects.

72. Define the term "abandonment value."

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73. Briefly explain timing options.

74. Explain the usefulness of decision trees in project analysis.

75. Why is sensitivity analysis less realistic than Monte Carlo Simulation?

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Chapter 10 - Project Analysis

Chapter 10 Project Analysis Answer Key

Multiple Choice Questions

1. Discounted cash flow (DCF) analysis generally: I) assumes that firms hold assets passively when it invests in a project II) considers opportunities to expand a project if the project is successful III) considers opportunities to abandon a project if the project is a failure A. I only B. II only C. II and III only D. I, II, and III

Type: Medium

2. A firm's capital investment proposals should reflect: I) Capital budgeting process II) Strategic planning process III) Middle managers' ideas and views A. I only B. I and II only C. I, II, and III D. III only

Type: Difficult

3. Generally, postaudits are conducted for large projects: A. shortly after the completion of the project B. after several years after the completion of the project C. shortly after the project has begun to operate D. well before the start of the project

Type: Medium

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4. Generally, postaudits for projects are conducted: I) to identify problems that need fixing II) to check the accuracy of forecasts III) to come up with questions that should have been asked before the project was undertaken A. I only B. II only C. I and II only D. I, II, and III

Type: Difficult

5. You are given the following data for year-1. Revenue = $43; Total costs = $30; Depreciation = $3; Tax rate = 30%. Calculate the operating cash flow for the project for year1. A. $7 B. $10 C. $13 D. None of the above (43 - 30 - 3) = 10; Tax = 10(0.3) = 3; Net Profit = 10 - 3 = 7; Operating cash flow 7 + 3 = 10

Type: Difficult

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6. A project has an initial investment of 100. You have come up with the following estimates of the projects with cash flows.

If the cash flows are perpetuities and the cost of capital is 10%. What does a sensitivity analysis of NPV (no taxes) show? A. -50, 20, +100 B. -100, -50, +80 C. -50, +50, +70 D. None of the above Pessimistic NPV = [(15 - 10)/0.1] - 100 = -50 Most Likely NPV = [(20 - 8)/0.1] 100 = +20 Optimistic NPV = [(25 - 5)/0.1] 100 = +100

Type: Medium

7. You are given the following data for year-1: Revenues = 100, Fixed costs = 30; Total variable costs = 50; Depreciation = $10; Tax rate = 30%. Calculate the after tax cash flow for the project for year-1. A. $17 B. $7 C. $10 D. None of the above EBT = (100 - 30 - 50 - 10) = 10; T = 10(0.3) = 3; CF1 = 10 - 3 + 10 = 17

Type: Difficult

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8. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3 = 100,000. If the discount rate changes from 12% to 15%, what is the change in the NPV of the project (approximately)? A. 12,750 increase B. 12,750 decrease C. 122,650 increase D. 135,400 decrease NPV at 12% = 135,400, NPV at 15% = 122,650. Change = 135, 410 - 122,650 = 12,750

Type: Difficult

9. You have come up with the following estimates of project cash flows:

The cash flows are perpetuities and the cost of capital is 8%. What does a sensitivity analysis of NPV (without taxes) show? A. 25, +232.50, +440 B. -100, +500, +800 C. -90, -55, -20 D. None of the above Pessimistic NPV = [(30 - 20)/0.08] - 100 = +25 Most likely NPV = [(40 - 15)/0.08] - 80 = +232.50 Optimistic NPV = [(50 - 10)/0.08] - 60 = +440

Type: Medium

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10. A project has an initial investment of $150. You have come up with the following estimates of revenues and costs. Calculate the NPV assuming that cash flow and perpetuities. (No taxes.) (Cost of capital = 10%)

A. 50, -100, +400 B. -50, +300, +500 C. -100, +150, +350 D. None of the above Pessimistic NPV = [(30 - 25)/0.1] - 150 = -100 Expected NPV = [(50 - 20)/0.1] - 150 = +150 Optimistic NPV = [(65 - 15)/0.1] - 150 = +350

Type: Difficult

11. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. Cash flows from the project are: A. CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600 B. CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600 C. CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600 D. none of the above Initial Investment = 90,000 + 10,000 = 100,000; CF0 = -100,000 CF1&CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600 CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 59,600

Type: Difficult

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12. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. Calculate the NPV of the project: A. 3840 B. 8443 C. -2735 D. None of the above NPV = -100,000 + 42,600/(1.15) + 42,600/(1.15^2) + 59,600/(1.15^3) = 8,443

Type: Difficult

13. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 12%. Calculate the NPV of the project: A. 14,418 B. 8443 C. -2735 D. None of the above Initial Investment = 90,000 + 10,000 = 100,000; CF0 = -100,000 CF1&CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600 CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 59,600 NPV = -100,000 + 42,600/(1.12) + 42,600/(1.12^2) + 59,600/(1.12^3) = 14,418

Type: Difficult

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14. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. What would the NPV of the project be if the revenues were higher by 10% and the costs were 65% of the revenues? A. $8443 B. $964 C. $5566 D. None of the above Initial Investment = 90,000 + 10,000 = 100,000; CF0 = -100,000 CF1&CF2: (132,000 - 85,800 - 30,000)(1 - 0.3) + 30,000 = 41,340 CF3: (132,000 - 85,800 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 58,340 NPV = -100,000 + 41,340/(1.15) + 41,340/(1.15^2) + 58,340/(1.15^3) = 5,566

Type: Difficult

15. A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. What would the NPV if the discount rate were higher by 10%? A. $5648 B. $3840 C. -$2735 D. None of the above Initial Investment = 90,000 + 10,000 = 100,000; CF0 = -100,000 CF1&CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600 CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 59,600 NPV at 16.5% = -100000 + (42,600/1.165) + (42600/(1.165^2)) + (59600/(1.165^3)) = $5648

Type: Difficult

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Chapter 10 - Project Analysis

16. The following are drawbacks of sensitivity analysis except: A. it provides ambiguous results. B. underlying variables are likely to be interrelated. C. it provides additional information about the project that is useful. D. all of the above statements are drawbacks of sensitivity analysis.

Type: Medium

17. Which of the following statements most appropriately describes "Scenario Analysis". A. it looks at the project by changing one variable at a time B. it provides the break-even level of sales for the project C. it looks at different but consistent combination of variables D. each of the above statements describes "Scenario Analysis" correctly

Type: Easy

18. Financial Calculator Company proposes to invest $12 million in a new calculator making plant. Fixed costs are $3 million a year. A financial calculator costs $10 per unit to manufacture and can be sold for $30 per unit. If the plant lasts for 4 years and the cost of capital is 20%, what is the break-even level (i.e. NPV = 0) of annual rates? (Approximately)(Assume no taxes.) A. 150,000 units B. 342,290 units C. 381,777 units D. None of the above EAC = 12/2.5887 = $4,635,531 million; X (30 - 10) -3,000,000 = 4,635,531; X = 7,635,531/20 = 381,777 units

Type: Difficult

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Chapter 10 - Project Analysis

19. Calculator Company proposes to invest $5 million in a new calculator making plant. Fixed costs are $2 million a year. A calculator costs $5/unit to manufacture and can be sold for $20/unit. If the plant lasts for 3 years and the cost of capital is12%, what is the approximate break-even level (i.e. NPV = 0) of annual sales? (Assume no taxes.)(approximately) A. $133,333 units B. $272,117 units C. $227,533 units D. None of the above EAC = 5,000,000/2.40183 = 2,081,745 million; (X) (20 - 5) - 2,000,000 = 2,081745; X = (4,081,745/15) = 272,117 units

Type: Difficult

20. Firms often calculate a project's break-even sales using book earnings. Generally, breakeven sales based on NPV is: A. Higher than the one calculated using book earnings B. Lower than the one calculated using book earnings C. Equal to the one calculated using book earnings D. None of the above

Type: Difficult

21. The accounting break-even point occurs when: A. the total revenue line cuts the fixed cost line B. the present value of inflows line cuts the present value of outflows line C. the total revenue line cuts the total cost line D. none of the above

Type: Medium

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Chapter 10 - Project Analysis

22. The NPV break-even point occurs when: A. the present value of inflows line cuts the present value of outflows line B. the total revenue line cuts the fixed cost line C. the total revenue line cuts the total cost line D. none of the above

Type: Medium

23. Financial Calculator Company proposes to invest $12 million in a new calculator making plant. Fixed costs are $3 million a year. A financial calculator costs $10 per unit to manufacture and can be sold for $30 per unit. If the plant lasts for 4 years and the cost of capital is 20%, what is the accounting break-even level? (Approximately)(Assume no taxes.) A. 300,000 units B. 150,000 units C. 381,777 units D. None of the above X = (FC + D)/(p-v) = (3,000,000 + 3,000,000)/(30 - 10) = 300,000

Type: Difficult

24. Calculator Company proposes to invest $5 million in a new calculator making plant. Fixed costs are $2 million a year. A calculator costs $5/unit to manufacture and can be sold for $20/unit. If the plant lasts for 3 years and the cost of capital is 12%, what is the approximate break-even level (accounting) of annual sales? (Assume no taxes.)(approximately) A. $133,334 units B. $272,117 units C. $244,444 units D. None of the above X = (2,000,000 + 1,666,667)/(20 - 5) = 244,444 units

Type: Difficult

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Chapter 10 - Project Analysis

25. Taj Mahal Tour Company proposes to invest $3 million in a new tour package project. Fixed costs are $1 million per year. The tour package costs $500 and can be sold at $1500 per package to tourists. This tour package is expected to be attractive for the next five years. If the cost of capital is 20%, what is the NPV break-even number of tourists per year? (Ignore taxes, give an approximate answer) A. 1000 B. 2000 C. 15000 D. None of the above EAC = $3 million/2.9906 = $1.00 million; (X) * (1500 - 500) - 1,000,000 = 1,000,000 X (1000) = 2,000,000 X = 2,000,000/1000 = 2000

Type: Difficult

26. Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $0.5 million per year. The equipment is expected to last for five years. The manufacturing cost per hammer is $1and the selling price per hammer is $6. Calculate the break-even (i.e. NPV = 0) volume per year. (Ignore taxes.) A. 500,000 units B. 600,000 units C. 100,000 units D. None of the above EAC = 6/2.9906 = 2 million X (6 - 1) - 500,000 = 2,000,000 X = 2,500,000/5 = 500,000 units

Type: Difficult

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Chapter 10 - Project Analysis

27. Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $1.0 million per year. The equipment is expected to last for five years. The manufacturing cost per hammer is $1 and the selling price per hammer is $6. Calculate the break-even (i.e. NPV = 0) volume per year. (Ignore taxes.) A. 500,000 units B. 600,000 units C. 100,000 units D. None of the above EAC = 6/2.9906 = 2 million X (6 - 1) - 1,000,000 = 2,000,000 X = 3,000,000/5 = 600,000 units

Type: Difficult

28. Everything else remaining the same, an increase in fixed costs: I) increases the break-even point based on NPV II) increases the accounting break-even point III) decreases the break-even point based on NPV IV) decreases the accounting break-even point A. I and III only B. III and IV only C. II and III only D. I and II only

Type: Medium

29. Project analysis, in addition to NPV analysis, includes the following procedures: I) Sensitivity analysis II) Break-even analysis III) Monte Carlo simulation IV) Scenario Analysis A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

Type: Easy

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Chapter 10 - Project Analysis

30. Simulation models are useful: I) To understand the project better II) To forecast expected cash flows III) To assess the project risk A. I only B. II only C. III only D. I, II and III

Type: Easy

31. Monte Carlo simulation involves the following steps: I) Step 1: Modeling the project II) Step 2: Specifying probabilities III) Step 3: Simulate the cash flows IV) Step 4: Calculate present value A. I and II only B. I, II, and III only C. II, III, and IV only D. I, II, III, and IV

Type: Medium

32. After the completion of project analysis, the final decision on the project would be from: A. Sensitivity analysis B. Break-even analysis C. Decision trees D. NPV

Type: Difficult

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33. Which of the following simulation outputs is likely to be most useful and easy to interpret? The output shows the distribution(s) of the project: A. Earnings B. Internal rate of return C. Cash flows D. Profits

Type: Medium

34. Generally, the simulation models for projects are developed using a: A. Pair of dice B. Roulette wheel C. Computer D. Pack of cards

Type: Easy

35. Monte Carlo simulation is likely to be most useful: A. For very complex problems B. For problems of moderate complexity C. For very simple problems D. Regardless of the problem's complexity

Type: Easy

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Chapter 10 - Project Analysis

36. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year, which is also the cost of capital (Ignore taxes). Calculate the NPV to invest today. A. +10,000,000 B. +6,000,000 C. +4,000,000 D. none of the above NPV today = -50,000,000 + (200,000)(50 - 20)/0.1 = +10,000,000

Type: Difficult

37. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year, which is also the cost of capital (Ignore taxes). Suppose the oil price is uncertain and can be $70/bbl or $40/bbl next year and then expected NPV of the project if postponed by one year is: A. +10,000,000 B. +25,000,000 C. +5,000,000 D. none of the above NPV(oil price = $70/bbl) = +50,000,000 NPV(oil price = $40 \/bbl) = -10,000,000/1.1 = -9,090,909 (reject) NPV(oil price = $10/bbl) = 0 Expected NPV = (0.5)(0) + (0.5)(50,000,000) = 25,000,000

Type: Difficult

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Chapter 10 - Project Analysis

38. The following are real options except: A. Stock options B. Timing options C. Option to expand D. Option to abandon

Type: Medium

39. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (I0) and is expected to remain constant. The price of oil is $50/bbl and the extraction costs are $20/bbl. The quantity of oil Q = 200,000 bbl per year forever. The risk-free rate is 10% per year which is also the cost of capital (Ignore taxes). Suppose the oil price is uncertain and can be $70/bbl or $40/bbl next year. If the project if postponed by one year, calculate the value of the option to wait for one year: (approximately) A. +15,000,000 B. +40,000,000 C. +10,000,000 D. none of the above NPV today = -50,000,000 + (200,000)(50 - 20)/0.1 = +10,000,000 NPV(oil price = $70/bbl) = +50,000,000 NPV(oil price = $40/bbl) = -10,000,000/1.1 = -9,090,909 (reject) NPV(oil price = $10/bbl) = 0 Expected NPV = (0.5)(0) + (0.5)(50,000,000) = 25,000,000 Value of the Option to Wait = 25,000,000 - 10,000,000 = 15,000,000

Type: Difficult

40. Option to expand a project is a: A. Call option B. Put option C. Stock option D. Swap

Type: Medium

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Chapter 10 - Project Analysis

41. Option to abandon a project is a: A. Call option B. Put option C. Stock option D. Swap

Type: Medium

42. You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for 3 years (starting next year). If it fails, you will only have net cash flows of $10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in. You have to spend $80 million immediately for equipment and the rights to produce the figure. If the discount rate is 10%, calculate the NPV without the abandonment option. A. -9.15 B. +13.99 C. +9.15 D. -14.4 PV(Success) = 50 (2.48685) = 124.3426 PV(Failure) = 10 (1.73554) = 17.3554 NPV = -80 + (124.3426)(0.5) + (17.3554)(0.5) = -9.15

Type: Difficult

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Chapter 10 - Project Analysis

43. You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for 3 years (starting next year). If it fails, you will only have net cash flows of $10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in. You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million once the first year's cash flows are received, calculate the NPV with the abandonment option. (The discount rate is 10%) A. -9.1 B. +9.1 C. +13.99 D. -14.4 NPV with abandonment option: PV(success) = 50(2.48685) = 124.3426 PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 (assuming that the equipment will be sold if the action figure is a failure) NPV = -80 + (124.3426)(0.5) + (63.6364)(0.5) = +13.99

Type: Difficult

44. You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for 3 years (starting next year). If it fails, you will only have net cash flows of $10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in. You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million once the first year's cash flows are received, calculate the value of the abandonment option. (The discount rate is 10%) A. -9.15 B. +13.99 C. +23.14 D. None of the above Value of the abandonment option = NPV (with the option) - NPV (without the option) = 13.99 - (-9.15) = 23.14

Type: Difficult

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Chapter 10 - Project Analysis

45. The following options associated with a project increases managerial flexibility: I) Option to expand II) Option to abandon III) Production options IV) Timing options A. I only B. II only C. I, II, III, and IV D. IV only

Type: Medium

46. (p. 300) Given the following net future values for harvesting trees (one time harvest):

If the cost of capital is 15%, calculate the optimal year to harvest: A. Year 1 B. Year 2 C. Year 3 D. Year 4

Type: Difficult

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Chapter 10 - Project Analysis

47. The Consumer- Mart Company is going to introduce a new consumer product. If brought to market without research about consumer tastes the firm believes that there is a 60% chance that the product will be successful. If successful, the project has a NPV = $500,000. If the product is a failure (40%) and withdrawn from the market, then NPV = -$100,000. A consumer survey will cost $60,000 and delay the introduction by one year. If the survey is successful, then there is an 80% chance of consumer acceptance, in which case the NPV = $500,000. If, on the other hand the survey is a failure, then NPV = -$100,000. The discount rate is 10%. By how much does the marketing survey change the expected net present value of the project? (approximately) A. Increase the NPV by $25,455 B. decrease the NPV by $5950 C. decrease the NPV by $8955 D. decrease the NPV by $25,455 No survey: Expected NPV = 500,000 (0.6) - 100,000 (0.4) = +260,000 With the survey: Expected NPV = -60,000 + [(500,000)(0.8) - (100,000)(0.2)]/(1.1) = +285455 Increase in NPV by the survey = 285455 - 260,000 = 25,455

Type: Difficult

48. KMW Inc. sells a finance textbook for $150 each. The variable cost per book is $30 and the fixed cost per year is $30,000. The process of creating a textbook costs $150,000 and the average book has a life span of 3 years. Using straight line depreciation and a tax rate of 25%, what is the economic or present value break even number of books that must be sold given a discount rate of 12%? A. 582 B. 667 C. 805 D. 953 PVAF of 12% over 3 years = 2.4018 Solve for P if NPV = 0; NPV = -150,000 + 2.4018(90P - 10,000)

Type: Difficult

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Chapter 10 - Project Analysis

49. KMW Inc. sells a finance textbook for $150 each. The variable cost per book is $30 and the fixed cost per year is $30,000. The process of creating a textbook costs $150,000 and the average book has a life span of 3 years. Using straight line depreciation and a tax rate of 25%, What is the accounting break even number of books that must be sold? A. 582 B. 667 C. 805 D. 953 Solve for P if Net Income = 0; Net Income = 90P - 60,000

Type: Difficult

True / False Questions

50. Postaudits are conducted before the start of the projects. FALSE

Type: Easy

51. Most firms keep track of the progress of projects by conducting postaudits shortly after the projects have begun to operate. TRUE

Type: Easy

52. Projects with high fixed costs have lower break-even points. FALSE

Type: Medium

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Chapter 10 - Project Analysis

53. The break-even point in terms of NPV is usually lower than the break-even point on an accounting basis. FALSE

Type: Medium

54. Firms that use break-even on an accounting basis are really losing the opportunity cost of capital on their investments. TRUE

Type: Medium

55. Monte Carlo simulation is a tool for considering all possible combinations of variables. TRUE

Type: Medium

56. In constructing a simulation model of an investment project, one can ignore possible interdependencies between variables. FALSE

Type: Medium

57. Monte Carlo simulation should be used to get the distribution of NPV values for a project. FALSE

Type: Medium

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Chapter 10 - Project Analysis

58. Tangible assets usually have higher abandonment value than intangible ones. TRUE

Type: Medium

59. Abandonment option is a call option, while the option to expand is a put option. FALSE

Type: Medium

60. In drawing a decision tree, a square represents a decision point, and a triangle represents a decision point for fate. FALSE

Type: Medium

61. In drawing a decision tree, it is important to include all possible eventualities. FALSE

Type: Medium

62. In almost al cases the present value break even quantity is higher than the accounting break even quantity. TRUE

Type: Medium

63. Monte Carlo simulation is merely an advanced version of scenario analysis. TRUE

Type: Medium

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Chapter 10 - Project Analysis

Short Answer Questions

64. Indicate some of the problems associated with capital investment process. There are several problems associated with capital budgeting. They are establishing consistent forecasts, forecast bias, getting senior management timely and relevant information, and conflict of interest.

Type: Medium

65. Discuss the importance of conducting post audits. Post audits are important for several reasons: They identify problems in the capital budgeting process that needs fixing; they provide a check on the accuracy of the cash flow forecasts; they raise questions that are relevant for future projects.

Type: Medium

66. Briefly describe sensitivity analysis used for project analysis. Using sensitivity analysis one can analyze the factors, which might have a large impact on the project cash flows. For some projects, say, labor costs might have a large impact on the cash flows. That means that small changes in labor costs will cause a large change in the cash flows of the project. This helps the financial manager and the project manager to focus on a few key variables and take corrective actions wherever possible. One drawback of sensitivity analysis is that it always gives ambiguous results.

Type: Medium

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Chapter 10 - Project Analysis

67. How do managers supplement the NPV analysis of a project to gain better understanding of a project? Generally managers supplement the NPV analysis of a project through project analysis to get a better insight into the project. Project analysis includes sensitivity analysis, break-even analysis, Monte Carlo simulation and decision trees. The final decision should always be made from NPV analysis.

Type: Medium

68. Briefly discuss break-even analysis. Break-even analysis provides the minimum level of sales or output above which a project has positive net present value. Managers frequently calculate break-even points in terms of accounting profits rather than NPV. But, this does not consider the opportunity cost of capital and hence provides a misleading lower number.

Type: Medium

69. Briefly discuss the usefulness of Monte Carlo simulation in project analysis. Monte Carlo simulation provides an exhaustive analysis of project outcomes. The main problem is that developing the model is time consuming, expensive and difficult to verify. Monte Carlo simulation generally involves three steps: modeling the project, specifying probabilities, and simulating cash flows. This is generally done with the use of the computer.

Type: Medium

70. Briefly explain the term "real options." Real options are options to modify projects in the future. These have value as they provide flexibility to project decisions and therefore are valuable. There are several types of real options. They are: option to expand, option to abandon, timing options and production option.

Type: Medium

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Chapter 10 - Project Analysis

71. Briefly discuss various real options associated with capital budgeting projects. There are four types of real options. They are: • option to expand • option to abandon • production options • timing options Option to expand provides a firm with flexibility to expand but not commit them to expand. Therefore they add value to the project. These are call options. In many cases, ability to terminate a project or abandon a project adds flexibility to the project. This is useful when the project fails to be profitable and needs to be terminated. Abandonment options are put options. Production options provide a firm with additional flexibility to alter inputs or processes. These have value when an input becomes scarce and needs to be replaced with an alternative. These production options add value to the project. In many cases a positive NPV project need not be undertaken right away. It might be even more valuable if undertaken in the future. The ability to postpone a project also provides a firm with additional flexibility. These options add value to the project. A project may have many options associated with them. Many projects might become positive NPV projects if options associated with them are recognized and evaluated.

Type: Difficult

72. Define the term "abandonment value." The value of the option to bail out of a project is called abandonment value. This is a simple concept, which has broad practical implications. Generally, an abandonment option increases the value of a project. Generally, tangible assets have higher abandonment value than intangible assets and general-purpose machines have higher abandonment value than special purpose machines.

Type: Medium

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Chapter 10 - Project Analysis

73. Briefly explain timing options. Companies with positive-NPV projects need not undertake them right away. If there are uncertainties associated with the project, costly mistakes might be avoided by waiting to resolve them. These types of options to postpone investment are called timing options.

Type: Medium

74. Explain the usefulness of decision trees in project analysis. Financial mangers in order to analyze projects involving sequential decisions use Decision trees. Firms generally build prototypes or pilot plants before embarking on a large project with huge investments. These involve expansion and abandonment decisions. These types of sequential decisions are analyzed using decision trees.

Type: Medium

75. Why is sensitivity analysis less realistic than Monte Carlo Simulation? Sensitivity analysis only changes one variable to one outcome. Reality almost never involves only one variable changing and then have it change to one predetermined outcome. Reality involves many variables changing from the current state to an infinite number of possible outcomes. Monte Carlo more closely approximates reality given its many outcomes with many variables.

Type: Difficult

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