Risk Analysis in Capital Investment Done

Question 1: 2D5-AT03

The proper discount rate to use in calculating certainty equivalent net present value is the: risk-free rate. cost of equity capital. cost of debt. risk-adjusted discount rate.

Certainty equivalents adjust annual project cash flows to account for uncertainty (i.e., risk). Therefore, the risk-free rate is used as the discount rate. When adjusting for uncertainty in capital budgeting, one can adjust the cash flows and use the risk-free rate as the discount rate or one can risk- adjust the discount rate and leave the cash flows alone. Do not adjust both the cash flows and the discount rate. Question 2: 2D5-LS02

Which of the following approaches to assessing project risk converts projected cash flows into risk-free cash flows? Simulations. Sensitivity analysis. Capital asset pricing model. Certainty equivalent approach.

By definition, the certainty equivalent approach to selecting projects attempts to separate the timing of cash flows from their risk. The expected cash flow is converted into an amount that has a higher probability of actually materializing. These cash flows are then discounted at a risk-free rate such as the rate for a U.S Treasury bill. Question 3: 2D5-LS08

Which of the following most concisely describes the Monte Carlo Simulation technique? Allows for the testing of a capital investment project using hypothetical variables to approximate cash flow. A separation of the timing of cash flows from their risk to evaluate a project's success. It uses repeated random sampling and computational algorithms to calculate a range of most likely outcomes for a project. A what-if technique for evaluating how NPV, IRR, and other indicators of the profitability of a project change if some given variable varies from one case to another.

Simulations allow testing of a capital investment project before it is accepted. One simulation technique is referred to as the Monte Carlo Simulation, which uses repeated random sampling and computational algorithms to calculate a range of most likely outcomes for a project. Question 4: 2D5-CQ01

Long Inc. is analyzing a $1 million investment in new equipment to produce a product with a $5 per unit margin. The equipment will last 5 years, be depreciated on a straight-line basis for tax purposes, and have no value at the end of its life. A study of unit sales produced the following data.

If Long utilizes a 12% hurdle rate and is subject to a 40% effective income tax rate, the expected net present value (NPV) of the project would be: $261,750. $427,580. $297,800. $283,380.

To calculate the expected NPV of the project, the first step is to calculate the expected annual sales, as follows: Expected annual sales volume = ? (annual sales volume)(associated probability) Expected annual sales volume= (80,000)(0.1) + (85,000)(0.2) + (90,000)(0.3) + (95,000)(0.2) + (100,000)(0.1) + (110,000)(0.1) Expected annual sales volume = 8,000 + 17,000 + 27,000 + 19,000 + 10,000 + 11,000 Expected annual sales volume= 92,000 Total margin = (sales)(margin per unit) The expected margin per year, would then be calculated as: Expected annual margin = (92,000)($5) = $460,000 The cash flow for each of the five years of the project is calculated as follows: Cash flow, each year = (contribution margin − depreciation)(1 − tax rate) + depreciation

Depreciation = $1,000,000 / 5 years = $200,000 per year Cash flow, each year = ($460,000 − $200,000)(1 − 0.4) + $200,000 Cash flow, each year = $260,000(0.6) + $200,000 = $156,000 + $200,000 = $356,000 The expected net present value (NPV) of the project can now be calculated: Expected NPV of project = (initial investment) + (estimated annual cash flow)(PV factor of annuity, i=12, n=5) Expected NPV of project = −$1,000,000 + ($356,000)(3.605) = $283,380. Question 5: 2D5-LS05

If a firm needs to fund a new technology with relatively uncertain demand potential, which of the following is the best type of real option? Expand. Abandon. Postpone. Adapt.

An option to abandon (or contract) allows the flexibility to bail out of a situation. Akin to a put option on a stock, an abandon option is like an insurance policy. If an investment is disappointing, a firm could abandon the project and recover funds. Question 6: 2D5-LS03

What is a primary caution when using a company's cost of capital as the discount rate to evaluate a capital project? Opportunity costs can be distorted. The cost of capital may need to be risk-adjusted. Evaluation typically rejects high-risk projects. Low-risk projects are favored.

Many firms use their company's cost of capital as the yardstick to discount the cash flows on new investments. But in situations where new projects are more or less risky than is normal for the firm, use of the company rate can lead to erroneously accepting or rejecting a project. Question 7: 2D5-LS09

Which of the following broadly defines simulation methodologies in evaluating projects? Allows for the testing of a capital investment project using hypothetical variables to approximate cash flow. A separation of the timing of cash flows from their risk to evaluate a projects success.

A what-if technique for evaluating how NPV, IRR, and other indicators of the profitability of a project change if some given variable varies from one case to another. It uses repeated random sampling and computational algorithms to calculate a range of most likely outcomes for a project.

A simulation approach for evaluating the success of a project allows for the testing of a capital investment projects using hypothetical variables to approximate cash flow. Question 8: 2D5-LS11

The modeling technique that should be used in a complex situation involving uncertainty is a(n): *Source: Retired ICMA CMA Exam Questions.

Monte Carlo simulation. program evaluation review technique. Markov process. expected value analysis.

One of the best-known computer simulation models in capital budgeting is the Monte Carlo simulation tool, which uses repeated random sampling and computational algorithms to calculate a range of most likely outcomes for projects involving uncertainty. Question 9: 2D5-CQ02

Parker Industries is analyzing a $200,000 equipment investment to produce a new product for the next 5 years. A study of expected annual after-tax cash flows from the project produced the following data.

If Parker utilizes a 14% hurdle rate, the probability of achieving a positive net present value is: 20%. 30%. 60%. 40%.

The expected annual after-tax cash flow from the project is calculated as follows: Expected annual after-tax cash flow = Σ(annual cash flows)(probability %) Expected annual after-tax cash flow = ($45,000)(0.1) + ($50,000)(0.2) + ($55,000)(0.3) + ($60,000)(0.2) + ($65,000)(0.1) + ($70,000)(0.1) Expected annual after-tax cash flow = $4,500 + $10,000 + $16,500 + $12,000 + $6,500 + $7,000 Expected annual after-tax cash flow = $56,500 The annual after-tax cash flow required to generate a positive net present value (NPV) would be found by setting the NPV at 14% to 0. The equation would be set up as follows: (cash flow)(3.433 PV annuity i=14, n=5) − $200,000 = 0 3.433(cash flow) = $200,000 cash flow = $58,258, which is almost $60,000 The probability of having annual cash flows of $60,000 = 40% = (20% @ $60,000 + 10% @ $65,000 + 10% @ $70,000) Question 10: 2D5-CQ04

Susan Hines has developed an estimate of the earnings per share (EPS) for her firm for the next year using the following parameters. Sales $20 million Cost of goods sold 70% of sales General & administrative expenses $300,000 Selling expense $100,000 plus 10% of sales Debt outstanding $5 million @ 8% interest rate Effective tax rate 35% Common shares outstanding 2 million She is now interested in the sensitivity of earnings per share to sales forecast changes. A 10% sales increase would increase earnings per share by: *Source: Retired ICMA CMA Exam Questions

13 cents per share. 10.4 cents per share. 20 cents per share. 7 cents per share.

The current EPS is 1.04 (2.08 million in after-tax income divided by 2 million shares). The new EPS would be 1.17 (2,34 million in after-tax income divided by 2 million shares. Also note the following:

Question 11: 2D5-AT04

Sensitivity analysis in an investment project proposal: develops the discount rate to be used in project evaluation. calculates the change in the result due to a change in the project's cash flows. develops probabilities for a variety of results. determines the firm's cost of capital.

Sensitivity analysis is used to determine how sensitive a decision is to changes in the parameters and variables used in the decision model. The parameters used in capital budgeting are the initial investment, the annual cash flows, and the discount rate. Question 12: 2D5-AT01

When evaluating a capital budgeting project, a company's treasurer wants to know how changes in operating income and the number of years in the project's useful life will affect its breakeven internal rate of return. The treasurer is most likely to use:

learning curve analysis. Monte Carlo simulation. sensitivity analysis. scenario analysis.

Sensitivity analysis is used to determine the effect of changes in inputs on the outputs. Question 13: 2D5-LS07

Which type of real option would a firm most likely choose if there is a high probability of capturing additional future cash flows beyond the current estimates contained in the cash flow projections? Postpone. Abandon. Expand. Adapt.

An expand option is especially valuable when uncertainty is high but a firm's product or service market is growing rapidly. A common adage is that today's investments can generate tomorrow's opportunities. Question 14: 2D5-LS06

Which type of real option would a firm most likely choose if uncertainty about the initial investment is high and the potential loss of immediate cash flows are small? Adapt. Abandon. Expand. Postpone.

The postpone (wait-and-see) option is the equivalent of owning a call option on an investment project. The call option is exercised when a firm commits to the investment project. Deferral is desirable when uncertainty about the investment is high and the immediate cash inflows lost or postponed are small. Question 15: 2D5-LS10

Which of the following is not a potential issue when using a firm's cost of capital as the discount rate for all new investments? Good low-risk projects may be rejected. The firm's cost of capital does not effectively measure the risk of the project.

The firm's cost of capital effectively measures the risk of the project. Poor high-risk projects may be accepted.

Using the firm's cost of capital may inhibit the effectiveness of the analysis of a capital budgeting process. Since the firm's cost of capital does not necessarily reflect the risk level of specific projects, it can sometimes lead to an incorrect decision, such as rejecting a good lowrisk project, or accepting a poor high-risk project. Question 16: 2D5-LS04

Which type of real option would a firm be most likely to choose if there is a high probability that competitors can enter a market and capture profitable future cash flows? Abandon. Expand. Adapt. Postpone.

The ability of a firm to vary output or production methods in response to demand allows the firm to swap or exchange its output mix as demand changes. Given the myriad tumultuous and competitive market situations, companies often build flexibility into their manufacturing operations so they can respond quickly to any changes and produce the most valuable set of outputs. Question 17: 2D5-CQ03

Consider the following scenario regarding the certainty equivalent approach to selecting projects:  Annual net cash inflows over the life of a five-year investment are $18,000, $14,400, $12,600, $10,800, and $9,000  Certainty equivalent factors are estimated to be 95%, 90%, 80%, 75% and 50%  The total initial investment for the project is $43,000  The risk-free rate of return is 4% Is the project acceptable? Yes, as there is a positive net present value of $5,024. No, as there is a negative net present value of $48,024. No, as there is a negative net present value of $5,024.

Yes, as there is a positive net present value of $48,024.

The certainty equivalent approach to selecting projects attempts to separate the timing of cash flows from their risk. The expected cash flow is converted into an amount that has a higher probability of actually materializing. Therefore, the expected cash flows must be restated into the cash flows most likely occur, then utilize the discount factor, or risk-free rate, to calculate whether the project will have a positive net present value. In this case:

Therefore, the project is acceptable as there is a positive net present value of $5,024. Question 18: 2D5-LS12

All of the following are advantages of a simulation model except that it: *Source: Retired ICMA CMA Exam Questions.

generates optimal solutions to problems. allows what-if type of questions. does not interfere with the real world systems. allows the study of the interactive effect of variables.

Simulations allow testing of a capital investment project before it is accepted. Because the actual future values for cash flows and discount rates for investment projects are not known,

hypothetical cash flows and discount rates are assumed and can be studied using a simulation model. Optimal solutions require linear or non-linear program solutions. Question 19: 2D5-LS01

The amount of cash that an investor would have to receive to be indifferent between the payoff and a given gamble is called the: investment beta. covariance. variance. certainty equivalent.

By definition, a certainty equivalent is the amount of cash an investor requires at a given point in time to make that investor indifferent between that certain amount and the amount expected (assuming risk) at the same point in time. Question 20: 2D5-AT02

Sensitivity analysis is used in capital budgeting to: determine the amount that a variable can change without generating unacceptable results. determine the optimal contribution margin given a set of constraints. identify the required market share to make a new product viable and produce acceptable results. simulate probabilistic customer reactions to a new product.

Sensitivity analysis is used to determine how sensitive a decision is to changes in the parameters and variables used in the decision model. The parameters used in capital budgeting are the initial investment, the annual cash flows, and the discount rate.