Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 9 Risk Analysis, Real Options, and Capital Budgeting
1) In a decision tree, the accept/reject decision is dependent upon
A) cash flows, probabilities, and future decisions.
B) only the cash flows from the successful path.
C) only the cash flows and probabilities of the successful path.
D) the path where the probabilities sum to one.
E) only the lower half of the tree.
2) To set up a decision tree, you should
A) assign the most optimistic values to a success and the most pessimistic values to a failure.
B) determine the cash flows that are most apt to occur given a set of circumstances.
C) assign a constant discount rate to all decisions within the tree.
D) ignore a project’s initial cost.
E) use equal probabilities for success and failure.
3) To make a project accept/reject decision using a decision tree
A) you start in the middle of the decision tree and work both forward and backward through the
decision process.
B) you start with the decisions that lie furthest into the future.
C) you make the decisions in the top half of the tree prior to those in the bottom half.
D) you begin with the decision at Time 0.
E) you can make the decisions in any order of time.
4) In scenario analysis, which one of the following items is least apt to be assigned a range of
values?
A) Sales price per unit
B) Variable cost per unit
C) Fixed cost
D) Initial cost
E) Sales quantity
5) In scenario analysis, the expected case is
A) determined by a firm’s current level of sales and costs.
B) a firm’s most optimistic outlook that is likely to occur.
C) the situation where a project obtains its financial breakeven point.
D) a firm’s best guess of a future outcome.
E) based on a firm’s historical average sales and costs.
6) Which one of these is a disadvantage of sensitivity analysis?
A) Sensitivity analysis may decrease the false sense of security among managers.
B) Sensitivity analysis fails to identify the key variable that affects a project’s net present value.
C) Each variable in sensitivity analysis is treated in isolation.
D) A sophisticated computer program is required to conduct sensitivity analysis.
E) Sensitivity analysis assumes most variables will achieve their most optimistic value.
7) The financial breakeven point determines which one of these values?
A) Total sales
B) Sales price
C) Variable cost per unit
D) Fixed costs
E) Sales quantity
8) If a project breaks even on an accounting profit basis, then
A) the project’s net present value will be zero.
B) its sales quantity will be higher than if the project were to break even on a financial basis.
C) the project’s net present value will be negative.
D) it will also break even on a financial basis.
E) its contribution margin must be zero.
9) Which term is used to represent the sales level that results in a project’s net income exactly
equalling zero?
A) Operational breakeven
B) Financial breakeven
C) Accounting profit breakeven
D) Cash breakeven
E) Present value breakeven
10) Which one of these occurs at the financial breakeven point?
A) Fixed costs equal variable costs
B) EBIT equals zero
C) Net income equals zero
D) Net present value equals zero
E) IRR equals zero
11) Conducting scenario analysis helps managers see the
A) impact an individual variable has on the outcome of a project.
B) possible range of market prices for a firm’s stock over the life of a project.
C) potential changes in long-term debt over the course of a proposed project.
D) potential range of outcomes from a proposed project.
E) distribution of funds to various independent capital projects.
12) Sensitivity analysis helps determine the
A) range of possible outcomes given possible ranges for each variable.
B) degree to which the net present value reacts to changes in a single variable.
C) net present value given the best and the worst possible situations.
D) degree to which a firm is reliant upon multiple economic factors changing simultaneously.
E) ideal level of variable costs in relation to the fixed costs of a project.
13) As a project’s degree of sensitivity to variable costs increases, the
A) forecasting risk of the project decreases.
B) dependence of the final outcome on variable costs decreases.
C) more attention management should pay to the actual variable costs throughout the project.
D) lower the maximum potential value of the project.
E) lower the maximum potential loss of the project.
14) Sensitivity analysis of a project is conducted by
A) changing the value of a single variable and computing the resulting change in the net present
value.
B) changing the value of two project variables to determine their interdependency.
C) holding all variables to their base level and changing the project’s required rate of return.
D) assigning either the best or the worst possible value to each variable and comparing the results
to those of the expected case.
E) comparing actual values to projected values to determine which variable had the greatest
variation.
15) Which one of the following statements concerning variable costs is correct?
A) Variable costs minus fixed costs equal marginal costs.
B) Variable costs are equal to zero when production is equal to zero.
C) An increase in variable costs increases the operating cash flow.
D) Variable costs minus fixed costs equals the contribution margin.
E) Future variable costs are generally known with certainty.
16) All else constant, as the variable cost per unit increases, the
A) net profit increases.
B) contribution margin decreases.
C) sensitivity to fixed costs decreases.
D) operating cash flow increases.
E) financial breakeven point decreases.
17) Assuming the selling price is greater than the total cost per unit, the contribution margin must
increase as
A) both the sales price and variable cost per unit increase.
B) the sales price per unit declines.
C) the difference between the sales price and the fixed cost per unit increases.
D) the gap between the sales price and the variable cost per unit widens.
E) the fixed cost per unit declines.
18) Ignoring taxes, which one of these is a correct formula for calculating the accounting profit
breakeven point?
A) (Fixed costs – Depreciation) / (Sales price – Variable costs)
B) Contribution margin / (Fixed costs + Total variable costs)
C) (Fixed costs + Depreciation) / Contribution margin
D) (Sales price – Variable costs) / (Fixed costs + Depreciation)
E) (Sales price – Variable costs – Fixed costs) / Depreciation
19) All else constant, the accounting profit breakeven level of sales will decrease when the
A) fixed costs increase.
B) contribution margin decreases.
C) depreciation expense decreases.
D) variable costs per unit increase.
E) selling price per unit decreases.
20) The point where a project produces a rate of return equal to the required rate of return is known
as the
A) external breakeven point.
B) accounting profit breakeven point.
C) internal breakeven point.
D) financial breakeven point.
E) contribution margin breakeven point.
21) Fixed production costs are
A) directly related to labor costs per unit.
B) defined as costs per unit of time.
C) dependent upon the output quantity.
D) ignored in project analysis.
E) treated as sunk costs in project analysis.
22) Les is concerned that his variable cost per unit projection for a project may not be reliable.
Which type of analysis will best help him determine the effect that an incorrect variable cost
estimate could have on the final outcome of the project?
A) Net income breakeven analysis
B) Financial breakeven analysis
C) Sensitivity analysis
D) Contribution margin analysis
E) Scenario analysis
23) In financial breakeven, the EAC is used to
A) allocate depreciation over the life of a project.
B) determine the tax benefit of depreciation.
C) allocate the initial investment over the life of a project.
D) determine the ideal contribution margin.
E) ascertain the appropriate discount rate.
24) Financial breakeven analysis is superior to accounting profit breakeven analysis because it
A) is easier to compute.
B) considers fixed costs while the accounting profit breakeven does not.
C) uses straight-line depreciation rather than the MACRS method.
D) considers the economic opportunity costs of the initial investment.
E) considers the contribution margin while the accounting profit breakeven does not.
25) Which one of the following statements is correct regarding the financial breakeven point of a
project?
A) The present value of the cash inflows exceeds the amount of the initial investment.
B) The payback period of the project is equal to the life of the project.
C) The operating cash flow is at a level that produces a net present value of zero.
D) The project never pays back on a discounted basis.
E) The IRR of the project exceeds the required rate of return.
26) To determine the lowest net present value that is likely to occur given a range of values for all
of the relevant variables, a firm should conduct which type of analysis?
A) Sensitivity
B) Scenario
C) Present value breakeven
D) Financial breakeven
E) Cash flow breakeven
27) Monte Carlo simulation is based on assigning a ________ and analyzing the results.
A) single value to each of a project’s variables
B) wide range of values to multiple variables simultaneously
C) wide range of values to a single variable
D) narrow range of values to two variables simultaneously
E) narrow range of values to a single variable
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28) Which type of analysis is most dependent upon the use of a computer?
A) Financial breakeven analysis
B) Monte Carlo simulation
C) Sensitivity analysis
D) Accounting profit breakeven analysis
E) Scenario analysis
29) The investment timing decision relates to
A) how long the cash flows last once a project is implemented.
B) how frequently the cash flows of a project occur.
C) how frequently the interest on the debt incurred to finance a project is compounded.
D) the decision as to when a project should be started.
E) the decision to either finance a project over time or pay out the initial cost in cash.
30) The option to wait:
I. may have minimal value if a project relates to a rapidly changing technology.
II. is partially dependent upon the discount rate applied to the project being evaluated.
III. could have a negative value.
IV. is valued based on a project’s EAC.
A) I and III only
B) II and IV only
C) I and II only
D) II, III, and IV only
E) I, II, and III only
31) If the option to abandon is ignored, the
A) initial cash flow of a project may be overstated.
B) net present value of a project may be understated.
C) net present value of a project will be stated at a time other than Time 0.
D) net present value of a project will be overstated.
E) initial cash flow of a project will be understated.
32) A project with a current negative net present value
A) might have a positive net present value at a later date in time.
B) should still be accepted if it can breakeven on an accounting profit basis.
C) should still be accepted if its projected sales quantity is less than the financial breakeven point.
D) should be permanently rejected.
E) will always have a higher (less negative) net present value at a later time.
33) Assume a project currently has a negative net present value. Which one of these expectations
would indicate that the timing option for that project may have a positive value?
A) The life of the project’s product is expected to decrease each year.
B) Competition in the project’s product market is on the increase.
C) The demand for the project’s product is expected to decrease within 6 months.
D) The project’s cash flow projections are expected to remain constant over time.
E) The contribution margin for the project is expected to improve next year.
34) Which one of these criticisms applies to net present value analysis?
A) Net present value is too nearsighted.
B) Net present value analysis cannot be integrated with sensitivity analysis.
C) Real options cannot be included in net present value analysis.
D) Managers may acquire a false sense of security based on a project’s net present value.
E) Net present value analysis cannot be integrated with scenario analysis.
35) Last month, you introduced a new product to the market. Consumer demand has been
overwhelming, and it appears that strong demand will exist over the long-term. Given this
situation, management should consider the option to
A) suspend.
B) contract.
C) withdraw.
D) abandon.
E) expand.
36) Including the option to expand in project analysis will tend to
A) extend the duration of a project but not affect the project’s net present value.
B) increase the cash flows of a project but decrease the project’s net present value.
C) decrease the net present value of a project.
D) increase the net present value of a project.
E) have no effect on either a project’s cash flows or its net present value.
37) Which real options have the ability to increase a project’s NPV if they are included in project
analysis?
A) Options to wait and to abandon
B) Options to expand and to wait
C) Options to abandon and to expand
D) Options to wait, abandon, and expand
E) Real options do not affect a project’s NPV
38) Recently, DB Miller & Co. implemented a positive NPV project. The project has a projected
life of 4 years and an estimated rate of return of 14 percent. The project can be expanded by simply
incurring additional variable costs or shut down without incurring any penalties or additional
costs. Today, the government ruled that projects of this type are now subject to a new per unit tax,
the total cost of which will exceed the projected NPV. The most logical move for the company
would be to
A) continue the project as planned since the NPV was positive and the project has been
implemented.
B) suspend the project until the following year to allow the company time to absorb the additional
cost.
C) double the size of the project as soon as it is feasible to do so.
D) end the project immediately unless the additional tax can be passed on to Miller & Co.
customers.
E) decrease the required return on the project so the NPV can remain positive given the additional
cost.
39) Which one of these would increase the value of a single-family housing development project if
that development were delayed?
A) Decrease in demand for housing
B) Increase in unemployment
C) Decrease in property taxes
D) Increase in building costs
E) Increase in insurance costs
40) Real options are options that
A) apply only to projects that are classified as high risk.
B) apply only to projects involving vacant land.
C) rarely are used in actual practice.
D) describe actions that can be taken once a project has commenced.
E) are guaranteed to increase a project’s value if implemented within the first year of the project.
41) The project defined by the following decision tree has a required discount rate of 14 percent.
What is the Time 1 net present value of a successful investment?
A) $89,406,415
B) $92,305,012
C) $87,342,087
D) $122,008,054
E) $126,583,344
42) The project defined by the following decision tree has a required discount rate of 17 percent.
What is the Time 0 net present value of a successful test and investment?
A) $21,565,903
B) $26,997,143
C) $32,288,788
D) $16,997,143
E) $42,997,143
43) Roy is analyzing a 5-year project with an initial cost of $210,000, a required return of 16
percent, and a probability of success of 62 percent. If the project fails, it will generate an annual
after-tax cash flow of –$48,500. If the project succeeds, the annual after-tax cash flow will be
$79,000. He has further determined that if the project fails, he will shut it down after the first year
and lose all of his original investment. If, however, the project is a success, he can expand it with
no additional investment and increase the after-tax cash flow to $154,000 a year for Years 2–5. At
the end of Year 5, the project would be terminated and have no salvage value. What is the net
present value of this project at Time 0?
A) $46,655.42
B) $32,560.35
C) $47,297.19
D) $62,543.35
E) $59,297.19
44) Ernestine is analyzing a 4-year project with an initial cost of $87,000, a required rate of return
of 14 percent, and a chance of success of 4 percent. If the project succeeds, the annual cash flow
will be $1,789,000. If the project fails, the annual cash flow will be –$131,000. The project can be
shut down after the first 2 years but all monies invested will be lost. None of the initial cost can be
recouped after 4 years. What is the net present value of this project at Time 0?
A) $150,050.32
B) –$49,666.71
C) –$238,212.04
D) –$85,578.77
E) $59,412.95
45) William’s Co. is considering spending $29,000 at Time 0 to test a new product. Depending on
the test results, the firm may decide to spend $64,000 at Time 1 to start production. If the product is
introduced and it is successful, it will produce after-tax cash flows of $48,000 a year for Years 2
through 4. If it is unsuccessful, there will be no cash flow in Year 1, after which the project will be
terminated. There are no recovery costs at the end of Year 4. The probability of a successful test
and investment is 58 percent. What is the net present value at Time 0 given a discount rate of 16
percent?
A) $5,881.15
B) $8,407.70
C) –$7,098.65
D) $1,133.15
E) –$3,594.43
46) Nu-Tek is analyzing a proposed project with expected sales of 5,800 units, ±6 percent. The
expected variable cost per unit is $11 and the expected fixed costs are $15,600. Cost estimates are
considered accurate within a range of ±4 percent. The depreciation expense is $5,700. The sale
price is estimated at $21 a unit, ±1 percent. What is the sales revenue under the pessimistic case
scenario?
A) $120,582.00
B) $116,120.21
C) $113,347.08
D) $108,110.00
E) $114,492.00
47) Appalachian Crafts is analyzing a project with expected sales of 18,900 units, ±2 percent. The
expected variable cost per unit is $23 and the expected fixed costs are $52,000. Cost estimates are
considered accurate within a range of ±1 percent. The depreciation expense is $18,400. The sale
price is estimated at $54 a unit, ±2 percent. What is the total dollar difference between the revenue
using the optimistic sale price versus the expected sale price?
A) $24,600
B) $16,800
C) $20,412
D) $17,894
E) $22,200