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Financial Management: Principles and Applications, 11e (Titman)
Chapter 13 Risk Analysis and Project Evaluation
1) Which of the following is a reason why risk analysis is an important part of capital budgeting?
A) The people who propose projects have no vested interest in whether or not they are accepted.
B) Marketing managers are rarely excessively optimistic.
C) Project cash flows can be highly uncertain.
D) Financial analysts are rarely excessively pessimistic.
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) Which of the following are reasons to analyze the risk of capital projects?
A) The people who propose projects have a vested interest in getting them accepted.
B) Cash flows can rarely be estimated with certainty.
C) Many of the variables in capital budgeting analysis are highly sensitive to changes in
economic conditions.
D) All of the above.
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) Which of the following abilities are crucial for risk analysis?
A) A knowledge of marketing
B) A knowledge of cost accounting
C) A knowledge of economics
D) All of the above
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
1
Copyright © 2011 Pearson Education, Inc.
4) Which of the following are usually known with a high level of confidence at the beginning of
a project?
A) The number of units that will be sold.
B) The price per unit that will result in the desired number of units sold.
C) Tax rates and depreciation rates.
D) None of the above.
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Approximately what percentage of new businesses fail in their first year?
A) 20%
B) 40%
C) 60%
D) 80%
Topic: 13.1 The Importance of Risk Analysis
Keywords: survival rates
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) Approximately what percentage of new businesses survive their first year?
A) 20%
B) 40%
C) 60%
D) 80%
Topic: 13.1 The Importance of Risk Analysis
Keywords: survival rates
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) What is the approximate five year survival rate for new businesses?
A) 20%
B) 40%
C) 60%
D) 80%
Topic: 13.1 The Importance of Risk Analysis
Keywords: survival rates
Principles: Principle 2: There Is a Risk-Return Tradeoff
2
Copyright © 2011 Pearson Education, Inc.
8) What is the approximate failure rate for new businesses after five years?
A) 20%
B) 40%
C) 60%
D) 80%
Topic: 13.1 The Importance of Risk Analysis
Keywords: survival rates
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) In reality, anticipated cash flows are only estimates and are thus uncertain.
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) Most of the variables used in forecasting cash flows are known with certainty.
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) A would be entrepreneur is considering buying a franchise from a national chain of fitness
centers. Identify some of the risks she might face.
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
3
Copyright © 2011 Pearson Education, Inc.
12) Jeffrey believes that if he can make a good case for opening a new store in the chain for
which he works, he will be promoted to manager. Can we be confident that Jeffrey's sales
forecasts are accurate?
Topic: 13.1 The Importance of Risk Analysis
Keywords: human factors
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) What are the consequences of excessive optimism or pessimism in forecasting expected
project cash flows?
Topic: 13.1 The Importance of Risk Analysis
Keywords: human factors
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) Why is it important to perform risk analysis before accepting or rejecting major projects?
Topic: 13.1 The Importance of Risk Analysis
Keywords: project cash flows
Principles: Principle 2: There Is a Risk-Return Tradeoff
4
Copyright © 2011 Pearson Education, Inc.
1) The simulation approach provides us with:
A) a single value for the risk-adjusted net present value.
B) an approximation of the systematic risk level.
C) a probability distribution of the project's net present value or internal rate of return.
D) a graphic exposition of the year-by-year sequence of possible outcomes.
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: simulation analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) ________ is a method of quantifying uncertainty without having to estimate probabilities.
A) Standard deviation
B) Sensitivity analysis
C) Coefficient of variation
D) Decision tree analysis
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: sensitivity analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) The form of risk analysis intended to identify the most important forces for the success or
failure of a project is known as:
A) scenario analysis.
B) sensitivity analysis.
C) value driver analysis.
D) expected value analysis.
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: sensitivity analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
4) Sensitivity analysis is the form of risk analysis:
A) that examines the relationship between total firm cash flows and the NPV of a particular
project.
B) that examines the volatility of NPV.
C) that examines the impact of key variables such as sales or costs in various combinations.
D) that examines the impact of key variables such as sales or costs one at a time.
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: sensitivity analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
5
Copyright © 2011 Pearson Education, Inc.
5) The form of risk analysis which examines the effect of various combinations of value drivers
is known as:
A) scenario analysis.
B) sensitivity analysis.
C) value driver analysis.
D) expected value analysis.
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: scenario analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) Scenario analysis is the form of risk analysis:
A) that examines the relationship between total firm cash flows and the NPV of a particular
project.
B) that examines the volatility of NPV.
C) that examines the impact of key variables such as sales or costs in various combinations.
D) that examines the impact of key variables such as sales or costs one at a time.
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: scenario analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) Which of the following is considered the major risk when analyzing projects in a multinational
environment?
A) Currency fluctuations
B) Inflation
C) Political risk
D) Lack of available betas
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: value drivers
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) Which of the following results in a probability distribution for possible project outcomes
rather than a dollar estimate?
A) Sensitivity analysis
B) Simulation
C) Value driver analysis
D) Scenario analysis
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: simulation analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
6
Copyright © 2011 Pearson Education, Inc.
9) ________ is a risk analysis technique in which the best- and worst-case net present values are
compared with the project's expected net present value.
A) Project standing alone risk
B) Decision tree analysis
C) Scenario analysis
D) Pure play method
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: scenario analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
50% probability that it will be sold for $20 million and a 20% probability that it will be sold for
$10 million. What is the expected value of the office building in 5 years?
A) $20 million
B) $21 million
C) $30 million
D) $10 million
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: expected value
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) There is a 20% probability that the NPV of a project will be $20 million, a 50% probability
that it will be sold for $45 million and a 30% probability that it will be for $15 million. What is
the expected NPV of the project?
A) $17.5 million
B) $45 million
C) $31 million
D) $26.67 million
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: expected value
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright © 2011 Pearson Education, Inc.
12) Pederson Home Heating Inc. anticipates that cash flows from home heating fuel sales next
year will be $800,000 if the winter is mild, $1,000,000 if winter is average, and $1,500,000 if
winter is exceptionally cold. The probability of an average winter is 60%, while the probability
of either a mild or an exceptionally cold winter is 20%. What is Pederson's expected cash flow
from fuel sales next winter?
A) $1,060,000
B) $1,100,000
C) $1,000,000
D) $1,150,000
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: expected value
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) Lemminburg Plastics estimates a 60% probability that sales of pink flamingo lawn ornaments
20% probability that they will go viral and potential sales would be 90,000. There is also a 20%
probability that restrictive zoning ordinances will limit sales to 30,000 units. Expected unit sales
of the pink flamingos are ________.
A) 55,000
B) 51,000
C) 67,500
D) 60,000
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: expected value
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) Enchanted Hearth expects to sell 1,200 wood pellet stoves in 2011 at an average price of
$2,400 each. It believes that unit sales will grow between -5% and +5% per year and prices will
rise or fall by as much as 5% per year. Forecast sales revenue for 2013 if the number of units
sold increases by 5% per year and prices remain flat.
A) $2,880,000
B) $3,168,000
C) $3,333,960
D) $3,175,200
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: scenario analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright © 2011 Pearson Education, Inc.
15) Enchanted Hearth expects to sell 1,200 wood pellet stoves in 2011 at an average price of
$2,400 each. It believes that unit sales will grow between -5% and +5% per year and prices will
rise or fall by as much as 5% per year. Forecast sales revenue for 2013 if both price and the
number of units sold increase by 5% per year.
A) $3,492,720
B) $3,500,658
C) $3,333,960
D) $3,175,200
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: scenario analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
16) When Quineboag Textile's sales revenue increased from $5.0 million to $5.25 million, net
operation income increased from $500,000 to $575,000. Quineboag's degree of operating
leverage (DOL) is ________.
A) .015
B) .33
C) 3.00
D) 10
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: degree of operating leverage (DOL)
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) When Charles River Publisher's sales revenue increased from $25 million to $27.5 million,
net operation income increased from $3,750,000 to $3,937,500. Quineboag's degree of operating
leverage (DOL) is ________.
A) .5
B) 2
C) 6.67
D) .05
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: degree of operating leverage (DOL)
Principles: Principle 2: There Is a Risk-Return Tradeoff
9
Copyright © 2011 Pearson Education, Inc.
18) Boulangerie Bouffard expects to sell 1 million croissants next year for $1.25 each. Variable
25%. If the bakery can increase the price of a croissant to $1.50 and all other variables remain
the same, free cash flow will increase by ________.
A) $37,500
B) $150,000
C) $187,500
D) $250,000
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: sensitivity analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) Boulangerie Bouffard expects to sell 1 million croissants next year for $1.25 each. Variable
25%. If the bakery can increase the price of a croissant to $1.50 sales will fall by 50,000
croissants. Free cash flow will increase or decrease by:
A) $131,250 increase.
B) $37,500 increase.
C) $75,000 decrease.
D) $250,000 increase.
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: sensitivity analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
Use the following information to answer the following question(s).
Orange Electronics projects sales of its new O-Phones for next year at 10,000 units priced at
$150 each. The variable costs of an O-Phone are expected to be $75. Fixed cash costs are
expected to be $150,000 and depreciation $100,000. The tax rate is 40%. Orange believes that
any of its forecasts including fixed costs, but not depreciation or the tax rate which are known for
certain, could be high or low by as much as 10%.
20) What is the expected net operating profit after tax (NOPAT) for the worst case scenario?
A) $300,000
B) $223,500
C) $174,000
D) $124,500
Topic: 13.2 Tools for Analyzing the Risk of Project Cash Flows
Keywords: scenario analysis
Principles: Principle 2: There Is a Risk-Return Tradeoff
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