978-1259709685 Chapter 7 Solution Manual Part 1

subject Type Homework Help
subject Pages 9
subject Words 2476
subject Authors Jeffrey Jaffe, Randolph Westerfield, Stephen Ross

Unlock document.

This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
page-pf1
CHAPTER 7
RISK ANALYSIS, REAL OPTIONS, AND
CAPITAL BUDGETING
Answers to Concepts Review and Critical Thinking Questions
1. Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows.
2. With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario
3. It is true that if average revenue is less than average cost, the firm is losing money. This much of the
4. From the shareholder perspective, the financial break-even point is the most important. A project can
5. The project will reach the cash break-even first, the accounting break-even next, and finally the
financial break-even. For a project with an initial investment and sales afterwards, this ordering will
6. Traditional NPV analysis is often too conservative because it ignores profitable options such as the
7. The type of option most likely to affect the decision is the option to expand. If the country just
liberalized its markets, there is likely the potential for growth. First entry into a market, whether an
8. Sensitivity analysis can determine how the financial break-even point changes when some factors
9. There are two sources of value with this decision to wait. The price of the timber can potentially
increase, and the amount of timber will almost definitely increase, barring a natural catastrophe or
page-pf2
10. Option analysis should stop when the additional analysis has a negative NPV. Since the additional
analysis is likely to occur almost immediately, this means when the benefits of the additional
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. a. To calculate the accounting breakeven, we first need to find the depreciation for each year. The
depreciation is:
b. We will use the tax shield approach to calculate the OCF. The OCF is:
OCFbase = [(P – v)Q – FC](1 – tc) + tcD
Now we can calculate the NPV using our base-case projections. There is no salvage value or
NWC, so the NPV is:
To calculate the sensitivity of the NPV to changes in the quantity sold, we will calculate the
NPV at a different quantity. We will use sales of 71,000 units. The OCF at this sales level is:
And the NPV is:
So, the change in NPV for every unit change in sales is:
page-pf3
If sales were to drop by 500 units, then NPV would drop by:
c. To find out how sensitive OCF is to a change in variable costs, we will compute the OCF at a
variable cost of $21. Again, the number we choose to use here is irrelevant: We will get the
same ratio of OCF to a one dollar change in variable cost no matter what variable cost we use.
So, using the tax shield approach, the OCF at a variable cost of $21 is:
So, the change in OCF for a $1 change in variable costs is:
If variable costs decrease by $1 then OCF would increase by $45,500
2. We will use the tax shield approach to calculate the OCF for the best- and worst-case scenarios. For
the best-case scenario, the price and quantity increase by 10 percent, so we will multiply the base
case numbers by 1.1, a 10 percent increase. The variable and fixed costs both decrease by 10 percent,
so we will multiply the base case numbers by .9, a 10 percent decrease. Doing so, we get:
The best-case NPV is:
For the worst-case scenario, the price and quantity decrease by 10 percent, so we will multiply the
base case numbers by .9, a 10 percent decrease. The variable and fixed costs both increase by 10
percent, so we will multiply the base case numbers by 1.1, a 10 percent increase. Doing so, we get:
3. We can use the accounting breakeven equation:
page-pf4
QA = (FC + D) / (P – v)
to solve for the unknown variable in each case. Doing so, we find:
4. When calculating the financial breakeven point, we express the initial investment as an equivalent
annual cost (EAC). Dividing the initial investment by the five-year annuity factor, discounted at 12
percent, the EAC of the initial investment is:
EAC = Initial Investment / PVIFA12%,5
Note that this calculation solves for the annuity payment with the initial investment as the present
value of the annuity. In other words:
PVA = C({1 – [1/(1 + R)]t } / R)
The annual depreciation is the cost of the equipment divided by the economic life, or:
Now we can calculate the financial breakeven point. The financial breakeven point for this project is:
QF = [EAC + FC(1 – tC) – D(tC)] / [(P – VC)(1 – tC)]
5. If we purchase the machine today, the NPV is the cost plus the present value of the increased cash
flows, so:
NPV0 = –$3,400,000 + $530,000(PVIFA9%,10)
NPV0 = $1,358.58
We should not necessarily purchase the machine today. We would want to purchase the machine when
the NPV is the highest. So, we need to calculate the NPV each year. The NPV each year will be the
page-pf5
Year 1: NPV1 = [–$3,150,000 + $530,000(PVIFA9%,9)] / 1.09
NPV1 = $25,211.79
The company should purchase the machine in Year 2 when the NPV is the highest.
6. We need to calculate the NPV of the two options: Go directly to market now, or utilize test
marketing first. The NPV of going directly to market now is:
NPV = CSuccess (Prob. of Success) + CFailure (Prob. of Failure)
Now we can calculate the NPV of test marketing first. Test marketing requires a $1.3 million cash
outlay. Choosing the test marketing option will also delay the launch of the product by one year.
Thus, the expected payoff is delayed by one year and must be discounted back to Year 0.
7. We need to calculate the NPV of each option, and choose the option with the highest NPV. So, the
NPV of going directly to market is:
NPV = CSuccess (Prob. of Success)
The NPV of the focus group is:
NPV = C0 + CSuccess (Prob. of Success)
And the NPV of using the consulting firm is:
page-pf6
NPV = C0 + CSuccess (Prob. of Success)
8. The company should analyze both options, and choose the option with the greatest NPV. So, if the
company goes to market immediately, the NPV is:
NPV = CSuccess (Prob. of Success) + CFailure (Prob. of Failure)
Customer segment research requires a $950,000 cash outlay. Choosing the research option will also
delay the launch of the product by one year. Thus, the expected payoff is delayed by one year and
must be discounted back to Year 0. So, the NPV of the customer segment research is:
The company should go to market now since it has the largest NPV.
9. a. The accounting breakeven is the aftertax sum of the fixed costs and depreciation charge divided
by the aftertax contribution margin (selling price minus variable cost). So, the accounting
breakeven level of sales is:
QA = [(FC + Depreciation)(1 – tC)] / [(PVC)(1 – tC)]
b. When calculating the financial breakeven point, we express the initial investment as an
equivalent annual cost (EAC). Dividing the initial investment by the seven-year annuity factor,
discounted at 15 percent, the EAC of the initial investment is:
EAC = Initial Investment / PVIFA15%,7
Note that this calculation solves for the annuity payment with the initial investment as the
present value of the annuity. In other words:
Now we can calculate the financial breakeven point. The financial breakeven point for this
project is:
page-pf7
10. When calculating the financial breakeven point, we express the initial investment as an equivalent
annual cost (EAC). Dividing the initial investment by the five-year annuity factor, discounted at 8
percent, the EAC of the initial investment is:
EAC = Initial Investment / PVIFA8%,5
Note that this calculation solves for the annuity payment with the initial investment as the present
value of the annuity. In other words:
The annual depreciation is the cost of the equipment divided by the economic life, or:
Now we can calculate the financial breakeven point. The financial breakeven point for this project is:
Intermediate
11. a. At the accounting breakeven, the IRR is zero percent since the project recovers the initial
investment. The payback period is N years, the length of the project since the initial investment
b. At the cash breakeven level, the IRR is –100 percent, the payback period is negative, and the
c. The definition of the financial breakeven is where the NPV of the project is zero. If this is true,
then the IRR of the project is equal to the required return. It is impossible to state the payback
12. Using the tax shield approach, the OCF at 90,000 units will be:
OCF = [(P – v)Q – FC](1 – tC) + tC(D)
page-pf8
We will calculate the OCF at 91,000 units. The choice of the second level of quantity sold is
arbitrary and irrelevant. No matter what level of units sold we choose we will still get the same
sensitivity. So, the OCF at this level of sales is:
The sensitivity of the OCF to changes in the quantity sold is:
OCF will increase by $7.92 for every additional unit sold.
13. a. The base-case, best-case, and worst-case values are shown below. Remember that in the best-
case, unit sales increase, while costs decrease. In the worst-case, unit sales decrease and costs
increase.
Scenario Unit sales Variable cost Fixed costs
Using the tax shield approach, the OCF and NPV for the base case estimate are:
OCFbase = [($17,200 – 14,300)(420) – $640,000](.65) + .35($760,000 / 4)
The OCF and NPV for the worst case estimate are:
OCFworst = [($17,200 – 15,730)(378) – $704,000](.65) + .35($760,000 / 4)
OCFworst = –$29,921
page-pf9
b. To calculate the sensitivity of the NPV to changes in fixed costs, we choose another level of
fixed costs. We will use fixed costs of $650,000. The OCF using this level of fixed costs and
the other base case values with the tax shield approach is:
And the NPV is:
The sensitivity of NPV to changes in fixed costs is:
c. The accounting breakeven is:
QA = (FC + D) / (P – v)
14. The marketing study and the research and development are both sunk costs and should be ignored.
We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs
and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new
project will be:
Sales
New clubs $850 60,000 = $51,000,000
For the variable costs, we must include the units gained or lost from the existing clubs. Note that the
variable costs of the expensive clubs are an inflow. If we are not producing the sets any more, we
will save these variable costs, which is an inflow. So:
Var. costs
The pro forma income statement will be:
Sales $43,800,000
page-pfa
Variable costs 21,510,000
Fixed costs 9,300,000
Using the bottom up OCF calculation, we get:
OCF = NI + Depreciation = $5,334,000 + 4,100,000
OCF = $9,434,000
So, the payback period is:
The NPV is:

Trusted by Thousands of
Students

Here are what students say about us.

Copyright ©2022 All rights reserved. | CoursePaper is not sponsored or endorsed by any college or university.