Corporate Finance 10th Edition Ross Test Bank 1

Solution Manual for Corporate Finance 10th Edition by
Ross Westerfield Jaffe ISBN 0078034779

9780078034770
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Chapter 07
Risk Analysis, Real Options, and Capital Budgeting
Multiple Choice Questions
1. An analysis of what happens to the estimate of the net present value when you examine a number
of different likely situations is called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
2. An analysis of what happens to the estimate of net present value when only one variable is
changed is called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
3. An analysis which combines scenario analysis with sensitivity analysis is called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
7-1
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4. An analysis of the relationship between the sales volume and various measures of profitability is
called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
5. Variable costs:
A. change in direct relationship to the quantity of output produced.

B. are constant in the short-run regardless of the quantity of output produced.
C. are equal to the change in a variable when one more unit of output is produced.
D. are subtracted from fixed costs to compute the contribution margin.
E. form the basis that is used to determine the degree of operating leverage employed by a firm.
6. Fixed costs:
A. change as the quantity of output produced changes.

B. are constant over the short-run regardless of the quantity of output produced.
C. reflect the change in a variable when one more unit of output is produced.
D. are subtracted from sales to compute the contribution margin.
E. can be ignored in scenario analysis since they are constant over the life of a project.
7. The sales level that results in a project's net income exactly equaling zero is called the _____
break-even.
A. operational
B. leveraged
C. accounting
D. cash
E. present value
8. The sales level that results in a project's net present value exactly equaling zero is called the
_____ break-even.
A. operational
B. leveraged
C. accounting
D. cash
E. present value
7-2
9. Conducting scenario analysis helps managers see the:
A. impact of an individual variable on the outcome of a project.

B. potential range of outcomes from a proposed project.
C. changes in long-term debt over the course of a proposed project.
D. possible range of market prices for their firm's stock over the life of a project.
E. allocation distribution of funds for capital projects under conditions of hard rationing.
10. Sensitivity analysis helps you determine the:
A. range of possible outcomes given possible ranges for every 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 project is reliant upon the fixed costs.
E. level of variable costs in relation to the fixed costs of a project.
11. As the degree of sensitivity of a project to a single variable rises, the:
A. lower the forecasting risk of the project.

B. smaller the range of possible outcomes given a pre-defined range of values for the input.
C. more attention management should place on accurately forecasting the future value of that
variable.
D. lower the maximum potential value of the project.
E. lower the maximum potential loss of the project.
12. Sensitivity analysis is conducted by:
A. holding all variables at their base level and changing the required rate of return assigned to a
project.
B. changing the value of two variables to determine their interdependency.
C. changing the value of a single variable and computing the resulting change in the current value
of a project.
D. assigning either the best or the worst possible value to every variable and comparing the
results to those achieved by the base case.
E. managers after a project has been implemented to determine how each variable relates to the
level of output realized.
13. To ascertain whether the accuracy of the variable cost estimate for a project will have much effect
on the final outcome of the project, you should probably conduct _____ analysis.
A. leverage
B. scenario
C. break-even
D. sensitivity
E. cash flow
7-3
14. Simulation analysis is based on assigning a _____ and analyzing the results.
A. narrow range of values to a single variable

B. narrow range of values to multiple variables simultaneously
C. wide range of values to a single variable
D. wide range of values to multiple variables simultaneously
E. single value to each of the variables
15. The type of analysis that is most dependent upon the use of a computer is _____ analysis.
A. scenario
B. break-even
C. sensitivity
D. degree of operating leverage
E. simulation
16. Which one of the following is most likely a variable cost?
A. Office rent
B. Property taxes
C. Property insurance
D. Direct labor costs
E. Management salaries
17. Which of the following statements concerning variable costs is (are) correct?
I. Variable costs minus fixed costs equal marginal costs.

II. Variable costs are equal to zero when production is equal to zero.
III. An increase in variable costs increases the operating cash flow.
A. II only
B. III only
C. I and III only
D. II and III only
E. I and II only
18. All else constant, as the variable cost per unit increases, the:
A. contribution margin decreases.

B. sensitivity to fixed costs decreases.
C. degree of operating leverage decreases.
D. operating cash flow increases.
E. net profit increases.
7-4
19. Fixed costs:
I. are variable over long periods of time.

II. must be paid even if production is halted.
III. are generally affected by the amount of fixed assets owned by a firm.
IV. per unit remain constant over a given range of production output.
A. I and III only

B. II and IV only
C. I, II, and III only
D. I, II, and IV only
E. I, II, III, and IV
20. All else equal, the contribution margin must increase as:
A. both the sales price and variable cost per unit increase.
B. the fixed cost per unit declines.
C. the variable cost per unit declines.
D. sales price per unit declines.
E. the sales price minus the fixed cost per unit increases.
21. Which of the following statements are correct concerning the accounting break-even point?
I. The net income is equal to zero at the accounting break-even point.

II. The net present value is equal to zero at the accounting break-even point.
III. The quantity sold at the accounting break-even point is equal to the total fixed costs plus
depreciation divided by the contribution margin.
IV. The quantity sold at the accounting break-even point is equal to the total fixed costs divided by
the contribution margin.
A. I and III only

B. I and IV only
C. II and III only
D. II and IV only
E. I, II, and IV only
22. All else constant, the accounting break-even level of sales will decrease when the:
A. fixed costs increase.

B. depreciation expense decreases.
C. contribution margin decreases.
D. variable costs per unit increase.
E. selling price per unit decreases.
7-5
23. The point where a project produces a rate of return equal to the required return is known as the:
A. point of zero operating leverage.

B. internal break-even point.
C. accounting break-even point.
D. present value break-even point.
E. income break-even point.
24. Which of the following statements are correct concerning the present value break-even point of a
project?
I. The present value of the cash inflows equals the amount of the initial investment.
II. The payback period of the project is equal to the life of the project.
III. The operating cash flow is at a level that produces a net present value of zero.
IV. The project never pays back on a discounted basis.
A. I and II only
B. I and III only
C. II and IV only
D. III and IV only
E. I, III, and IV only
25. The investment timing decision relates to:
A. how long the cash flows last once a project is implemented.

B. the decision as to when a project should be started.
C. how frequently the cash flows of a project occur.
D. how frequently the interest on the debt incurred to finance a project is compounded.
E. the decision to either finance a project over time or pay out the initial cost in cash.
26. The timing option that gives the option to wait:
I. may be of minimal value if the project relates to a rapidly changing technology.

II. is partially dependent upon the discount rate applied to the project being evaluated.
III. is defined as the situation where operations are shut down for a period of time.
IV. has a value equal to the net present value of the project if it is started today versus the net
present value if it is started at some later date.
A. I and III only

B. II and IV only
C. I and II only
D. II, III, and IV only
7-6
27. 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. expand.
C. abandon.
D. contract.
E. withdraw.
28. Including the option to expand in your 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. increase the net present value of a project.
D. decrease the net present value of a project.
E. have no effect on either a project's cash flows or its net present value.
29. Theoretically, the NPV is the most appropriate method to determine the acceptability of a project.
A false sense of security can overcome the decision-maker when the procedure is applied
properly but the positive NPV results are accepted blindly. Sensitivity and scenario analysis aid in
the process by:
A. changing the underlying assumptions on which the decision is based.

B. highlights the areas where more and better data are needed.
C. providing a picture of how an event can affect the calculations.
D. All of these.
E. None of these.
30. In order to make a decision with a decision tree:
A. one starts farthest out in time to make the first decision.

B. one must begin at time 0.
C. any path can be taken to get to the end.
D. any path can be taken to get back to the beginning.
E. None of these.
31. In a decision tree, the NPV to make the yes/no decision is dependent on:
A. only the cash flows from successful path.

B. on the path where the probabilities add up to one.
C. all cash flows and probabilities.
D. only the cash flows and probabilities of the successful path.
E. None of these.
7-7
32. In a decision tree, caution should be used in the analysis because:
A. early stage decisions are probably riskier and should not likely use the same discount rate.
B. if a negative NPV is actually occurring, management should opt out of the project and minimize
the firm's loss.
C. decision trees are only used for financial planning.
D. Both early stage decisions are probably riskier and should not likely use the same discount
rate; and decision trees are only used for financial planning.
E. Both early stage decisions are probably riskier and should not likely use the same discount
rate; and if a negative NPV is actually occurring, management should opt out of the project and
minimize the firm's loss.
33. Sensitivity analysis evaluates the NPV with respect to:
A. changes in the underlying assumptions.

B. one variable changing while holding the others constant.
C. different economic conditions.
D. All of these.
E. None of these.
34. Sensitivity analysis provides information on:
A. whether the NPV should be trusted and may provide a false sense of security if all NPVs are
positive.
B. the need for additional information as it tests each variable in isolation.
C. the degree of difficulty in changing multiple variables together.
D. Both whether the NPV should be trusted and may provide a false sense of security if all NPVs
are positive; and the need for additional information as it tests each variable in isolation.
E. Both whether the NPV should be trusted and may provide a false sense of security if all NPVs
are positive; and the degree of difficulty in changing multiple variables together.
35. Fixed production costs are:
A. directly related to labor costs.

B. measured as cost per unit of time.
C. measured as cost per unit of output.
D. dependent on the amount of goods or services produced.
E. None of these.
36. Variable costs:
A. change as the quantity of output changes.

B. are zero when production is zero.
C. are exemplified by direct labor and raw materials.
D. All of these.
E. None of these.
7-8
37. An investigation of the degree to which NPV depends on assumptions made about any singular
critical variable is called a(n):
A. operating analysis.
B. sensitivity analysis.
C. marginal benefit analysis.
D. decision tree analysis.
E. None of these.
38. Scenario analysis is different than sensitivity analysis:
A. because no economic forecasts are changed.

B. because several variables are changed together.
C. because scenario analysis deals with actual data versus sensitivity analysis which deals with a
forecast.
D. because it is short and simple.
E. because it is a "by the seat of the pants" technique.
39. In the present-value break-even the EAC is used to:
A. determine the opportunity cost of investment.

B. allocate depreciation over the life of the project.
C. allocate the initial investment at its opportunity cost over the life of the project.
D. determine the contribution margin to fixed costs.
E. None of these.
40. The present value break-even point is superior to the accounting break-even point because:
A. present value break-even is more complicated to calculate.

B. present value break-even covers the economic opportunity costs of the investment.
C. present value break-even is the same as sensitivity analysis.
D. present value break-even covers the fixed costs of production, which the accounting break-
even does not.
E. present value break-even covers the variable costs of production, which the accounting break-
even does not.
41. The potential decision to abandon a project has option value because:
A. abandonment can occur at any future point in time.

B. a project may be worth more dead than alive.
C. management is not locked into a negative outcome.
D. All of these.
E. None of these.
7-9
42. Which of the following are types of break-even analysis?
A. Present value break-even

B. Accounting profit break-even
C. Market value break-even
D. Both present value break-even; and accounting profit break-even
E. Both present value break-even; and market value break-even
43. The approach that further attempts to model real world uncertainty by analyzing projects the way
one might analyze gambling strategies is called:
A. gambler's approach.
B. blackjack approach.
C. Monte Carlo simulation.
D. scenario analysis.
E. sensitivity analysis.
44. Monte Carlo simulation is:
A. the method of analysis most widely used by executives.

B. a very simple formula.
C. more complex than sensitivity or scenario analysis.
D. the oldest capital budgeting technique.
E. None of these.
45. Which of the following are hidden options in capital budgeting?
A. Option to expand.
B. Timing option.
C. Option to abandon.
D. All of these.
E. None of these.
46. The Adept Co. is analyzing a proposed project. The company expects to sell 2,500 units, give or
take 10%. The expected variable cost per unit is $8 and the expected fixed costs are $12,500.
Cost estimates are considered accurate within a plus or minus 5% range. The depreciation
expense is $4,000. The sale price is estimated at $16 a unit, give or take 2%. The company bases
its sensitivity analysis on the expected case scenario
What is the sales revenue under the optimistic case scenario?
A. $40,000
B. $43,120
C. $44,000
D. $44,880
E. $48,400
7-10
What is the contribution margin under the expected case scenario?
A. $2.67
B. $3.00
C. $7.92
D. $8.00
E. $8.72
What is the amount of the fixed cost per unit under the pessimistic case scenario?
A. $4.55
B. $5.00
C. $5.83
D. $6.02
E. $6.55
its sensitivity analysis on the expected case scenario.
The company is conducting a sensitivity analysis on the sales price using a sales price estimate of
$17. Using this value, the earnings before interest and taxes will be:
A. $4,000
B. $6,000
C. $8,500
D. $10,000
E. $18,500
7-11
The company conducts a sensitivity analysis using a variable cost of $9. The total variable cost
estimate will be:
A. $21,375
B. $22,500
C. $23,625
D. $24,125
E. $24,750
51. The Can-Do Co. is analyzing a proposed project. The company expects to sell 12,000 units, give
or take 4%. The expected variable cost per unit is $7 and the expected fixed cost is $36,000. The
fixed and variable cost estimates are considered accurate within a plus or minus 6% range. The
depreciation expense is $30,000. The tax rate is 34%. The sale price is estimated at $14 a unit,
give or take 5%. The company bases its sensitivity analysis on the expected case scenario.
What is the earnings before interest and taxes under the expected case scenario?
A. $18,000
B. $24,000
C. $36,000
D. $48,000
E. $54,000
What is the earnings before interest and taxes under the optimistic case scenario?
A. $22,694.40
B. $24,854.40
C. $37,497.60
D. $52,694.40
E. $67,947.60
7-12
What is the earnings before interest and taxes under the pessimistic case scenario?
A. -$566.02
B. -$422.40
C. -$278.78
D. $3,554.50
E. $5,385.60
What is the operating cash flow for a sensitivity analysis using total fixed costs of
$32,000?
A. $14,520
B. $16,520
C. $22,000
D. $44,520
E. $52,000
What is the contribution margin for a sensitivity analysis using a variable cost per unit of $8?
A. $3
B. $4
C. $5
D. $6
E. $7
7-13
56. The Meldrum Co. is analyzing a proposed project. The company expects to sell 3,000 units, give
or take 15%. The expected variable cost per unit is $8 and the expected fixed costs are $12,500.
A. $54,400
B. $55,080
C. $62,100
D. $63,342
E. $65,030
A. $8
B. $8.32
C. $10
D. $16
E. $18
A. $4.17
B. $4.66
C. $5.15
D. $5.35
E. $6.02
7-14
The company is conducting a sensitivity analysis on the sales price using a sales price estimate of
$17. Using this value, the earnings before interest and taxes will be:
A. $7,500
B. $8,000
C. $10,500
D. $14,000
E. $23,500
estimate will be:
A. $22,950
B. $24,000
C. $25,500
D. $27,000
E. $31,050
61. A firm is reviewing a project with a labor cost of $8.90 per unit, raw materials cost of $21.63 a unit,
and fixed costs of $8,000 a month. Sales are projected at 10,000 units over the three-month life of
the project. What are the total variable costs of the project?
A. $216,300
B. $297,300
C. $305,300
D. $313,300
E. $329,300
62. A project has earnings before interest and taxes of $5,750, fixed costs of $50,000, a selling price
of $13 a unit, and a sales quantity of 11,500 units. Depreciation is $7,500.
What is the variable cost per unit?
A. $6.75
B. $7.00
C. $7.25
D. $7.50
E. $7.75
7-15
63. At a production level of 5,600 units a project has total costs of $89,000. The variable cost per unit
is $11.20. What is the amount of the total fixed costs?
A. $24,126
B. $26,280
C. $27,090
D. $27,820
E. $28,626
64. At a production level of 6,000 units a project has total costs of $120,000. The variable cost per unit
is $14.50. What is the amount of the total fixed costs?
A. $25,165
B. $28,200
C. $30,570
D. $32,000
E. $33,000
65. Wilson's Meats has computed its fixed costs to be $.60 for every pound of meat it sells given an
average daily sales level of 500 pounds. It charges $3.89 per pound of top-grade ground beef.
The variable cost per pound is $2.99. What is the contribution margin per pound of ground beef
sold?
A. $0.30
B. $0.60
C. $0.90
D. $2.99
E. $3.89
66. Ralph and Emma's is considering a project with total sales of $17,500, total variable costs of
$9,800, total fixed costs of $3,500, and estimated production of 400 units. The depreciation
expense is $2,400 a year. What is the contribution margin per unit?
A. $4.50
B. $10.50
C. $14.14
D. $19.09
E. $19.25
7-16
67. You are considering a new project. The project has projected depreciation of $720, fixed costs of
$6,000, and total sales of $11,760. The variable cost per unit is $4.20. What is the accounting
break-even level of production?
A. 1,200 units
B. 1,334 units
C. 1,372 units
D. 1,889 units
E. 1,910 units
68. The accounting break-even production quantity for a project is 5,425 units. The fixed costs are
$31,600 and the contribution margin is $6. What is the projected depreciation expense?
A. $700
B. $950
C. $1,025
D. $1,053
E. $1,100
A. $4,480
B. $5,100
C. $5,150
D. $5,320
E. $5,600
70. A project has an accounting break-even point of 2,000 units. The fixed costs are $4,200 and the
depreciation expense is $400. The projected variable cost per unit is $23.10. What is the projected
sales price?
A. $20.80
B. $21.00
C. $21.20
D. $25.40
E. $25.60
71. A proposed project has fixed costs of $3,600, depreciation expense of $1,500, and a sales
quantity of 1,300 units. What is the contribution margin if the projected level of sales is the
accounting break-even point?
A. $3.92
B. $4.14
C. $4.50
D. $4.80
E. $5.00
7-17
72. A project has a contribution margin of $5, projected fixed costs of $12,000, a projected variable
cost per unit of $12, and a projected present value break-even point of 5,000 units. What is the
operating cash flow at this level of output?
A. $1,000
B. $12,000
C. $13,000
D. $68,000
E. $73,000
73. Thompson & Son has been busy analyzing a new product. It has determined that an operating
cash flow of $16,700 will result in a zero net present value, which is a company requirement for
project acceptance. The fixed costs are $12,378 and the contribution margin is $6.20. The
company feels that it can realistically capture 10% of the 50,000 unit market for this product.
Should the company develop the new product? Why or why not?
A. Yes; because 5,000 units of sales exceeds the quantity required for a zero net present value
B. Yes; because the internal break-even point is less than 5,000 units
C. No; because the firm cannot generate sufficient sales to obtain at least a zero net present value
D. No; because the project has an expected internal rate of return of negative 100%
E. No; because the project will not pay back on a discounted basis
74. Kurt Neal and Son is considering a project with a discounted payback just equal to the project's
life. The projections include a sales price of $11, variable cost per unit of $8.50, and fixed costs of
$4,500. The operating cash flow is $6,200. What is the break-even quantity?
A. 1,800 units
B. 2,480 units
C. 3,057 units
D. 3,750 units
E. 4,280 units
75. At stage 2 of the decision tree it shows that if a project is successful, the payoff will be $53,000
with a 2/3 chance of occurrence. There is also the 1/3 chance of a $-24,000 payoff. The cost of
getting to stage 2 (1 year out) is $44,000. The cost of capital is 15%. What is the NPV of the
project at stage 1?
A. $-13,275
B. $-20,232
C. $2,087
D. $7,536
E. Cannot be calculated without the exact timing of future cash flows
7-18
76. The Quick-Start Company has the following pattern of potential cash flows with its planned
investment in a new cold weather starting system for fuel injected cars.
If the company has a discount rate of 17%, what is the value closest to time 1 net present value?
A. $48.6 million
B. $80.9 million
C. $108.2 million
D. $181.4 million
E. None of these
If the company has a discount rate of 17%, should it decide to invest?
A. Yes, NPV = $2.2 million

B. Yes, NPV = $21.6 million
C. No, NPV = -$1.9 million
D. Yes, NPV = $8.6 million
E. No, since more than one branch is NPV = 0 or negative, the firm must reject.
7-19
78. The Mini-Max Company has the following cost information on its new prospective project.
Calculate the accounting break-even point.
Initial investment: $700

Fixed costs: $200 per year
Variable costs: $3 per unit
Depreciation: $140 per year
Price: $8 per unit
Discount rate: 12%
Project life: 5 years
Tax rate: 34%
A. 25 units per year

B. 68 units per year
C. 103 units per year
D. 113 units per year
E. None of these
79. The Highlight Company has the following cost information on its new prospective project.

Price: $8 per unit
Discount rate: 12%
Tax rate: 34%

E. 110 units per year
7-20
Calculate the present value break-even point.

Fixed costs are $200 per year
Price: $8 per unit
Discount rate: 12%
Tax rate: 34%

E. None of these
81. The Quorum Company has the following cost information on its new prospective project. Calculate
the present value break-even point.

Price: $8 per unit
Discount rate: 12%
Tax rate: 34%

7-21
82. From the information below, calculate the accounting break-even point.
Initial investment: $2,000

Fixed costs are $2,000 per year
Price: $20 per unit
Discount rate: 10%
Tax rate: 34%

E. None of these

Price: $25 per unit
Discount rate: 10%
Tax rate: 34%

84. Given the following information, calculate the present value break-even point.

Fixed costs: $2,000 per year
Price: $20 per unit
Discount rate: 10%
Tax rate: 34%

E. None of these
7-22
85. You are considering a project which has been assigned a discount rate of 8%. If you start the
project today, you will incur an initial cost of $480 and will receive cash inflows of $350 a year for
three years. If you wait one year to start the project, the initial cost will rise to $520 and the cash
flows will increase to $385 a year for three years. What is the value of the option to wait?
A. $15.23
B. $17.08
C. $18.67
D. $20.20
E. $50.20
86. Wilson's Antiques is considering a project that has an initial cost today of $10,000. The project has
a two-year life with cash inflows of $6,500 a year. Should Wilson's decide to wait one year to
commence this project, the initial cost will increase by 5% and the cash inflows will increase to
$7,500 a year. What is the value of the option to wait if the applicable discount rate is 10%?
A. $1,006.76
B. $1,235.54
C. $1,509.28
D. $1,606.76
E. $1,735.54
87. Your firm is considering a project with a five-year life and an initial cost of $120,000. The discount
rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow per unit is
$20. The firm will have the option to abandon this project after three years at which time it expects
it could sell the project for $50,000. At what level of sales should the firm be willing to abandon this
project?
A. 420 units
B. 1,041 units
C. 1,479 units
D. 1,618 units
E. 2,500 units
88. Your firm is considering a project with a five-year life and an initial cost of $120,000. The discount
rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow per unit is
$20. The firm will have the option to abandon this project after three years at which time it expects
it could sell the project for $50,000. You are interested in knowing how the project will perform if
the sales forecasts for years four and five of the project are revised such that there is a 50%
chance that the sales will be either 1,400 or 2,500 units a year. What is the net present value of
this project given your sales forecasts?
A. $23,617
B. $23,719
C. $25,002
D. $26,877
E. $28,746
7-23
89. Marguerite is reviewing a project with projected sales of 1,500 units a year, a cash flow of $40 a
unit and a three-year project life. The initial cost of the project is $95,000. The relevant discount
rate is 15%. Marguerite has the option to abandon the project after one year at which time she
feels she could sell the project for $60,000. At what level of sales should she be willing to abandon
the project?
A. 899 units
B. 923 units
C. 967 units
D. 1,199 units
E. 1,206 units
A. $2,000
B. $10,000
C. $20,000
D. $30,000
E. $120,000
91. Quirk and Company has been busy analyzing a new product. It has determined that an operating
A. No; because 4,000 units of sales is less than the quantity required for a zero net present value
B. No; because the internal break-even point is greater than 4,000 units
C. Yes; because the firm can generate sufficient sales to obtain at least a zero net present value
D. Yes; because the project has an expected internal rate of return of 100%
E. Yes; because the project will pay back on a discounted basis
92. Ryan Industries is considering a project with a discounted payback just equal to the project's life.
The projections include a sales price of $12, variable cost per unit of $9, and fixed costs of $5,000.
The operating cash flow is $8,000. What is the break-even quantity?
A. 1,900 units
B. 2,679 units
C. 3,250 units
D. 4,000 units
E. 4,333 units
Essay Questions
7-24
93. What is the benefit of scenario analysis if it does not produce an accept or reject decision for a
proposed project?
94. Consider the following statement by a project analyst: "I analyzed my project using scenarios for
the base case, best case, and worst case. I computed break-evens and degrees of operating
leverage. I did sensitivity analysis and simulation analysis. I computed NPV, IRR, payback, AAR,
and PI. In the end, I have over a hundred different estimates and am more confused than ever. I
would have been better off just sticking with my first estimate and going by my gut reaction."
Critique this statement.
95. The Marx Brewing Company recently installed a new bottling machine. The machine's initial cost
is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years. The
machine's fixed cost per year is $1,800, and its variable cost is $0.50 per unit. The selling price
per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. Calculate the accounting
break-even point on the new machine, as well as the present value break-even point on the new
machine.
7-25
96. Discuss two shortcomings in the standard decision tree analysis that a financial manager should
be cognizant of?
97. Sensitivity analysis is a method which allows for evaluation of the NPV given a series of changes
to the underlying assumptions. Discuss why and how scenario analysis is used in addition to
sensitivity analysis.
98. The market value of an investment project should be viewed as the sum of the standard NPV and
the value of managerial options. Explain three different real or managerial options that
management may have, what they are, and how they would influence market value.
99. Can different discount rates be used for different stages in a decision tree? If so, what would be
the benefit of such action?
7-26
Chapter 07 Risk Analysis, Real Options, and Capital Budgeting Answer
Key
Multiple Choice Questions
1. An analysis of what happens to the estimate of the net present value when you examine a
number of different likely situations is called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis
2. An analysis of what happens to the estimate of net present value when only one variable is
changed is called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
AACSB: Analytic
Blooms: Remember
3. An analysis which combines scenario analysis with sensitivity analysis is called _____
analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
AACSB: Analytic
Blooms: Remember
Topic: Monte Carlo Simulation
7-27
4. An analysis of the relationship between the sales volume and various measures of profitability
is called _____ analysis.
A. forecasting
B. scenario
C. sensitivity
D. simulation
E. break-even
AACSB: Analytic
Blooms: Remember
5. Variable costs:
A. change in direct relationship to the quantity of output produced.

B. are constant in the short-run regardless of the quantity of output produced.
C. are equal to the change in a variable when one more unit of output is produced.
D. are subtracted from fixed costs to compute the contribution margin.
E. form the basis that is used to determine the degree of operating leverage employed by a
firm.
AACSB: Analytic
Blooms: Remember
6. Fixed costs:
A. change as the quantity of output produced changes.

B. are constant over the short-run regardless of the quantity of output produced.
C. reflect the change in a variable when one more unit of output is produced.
D. are subtracted from sales to compute the contribution margin.
E. can be ignored in scenario analysis since they are constant over the life of a project.
AACSB: Analytic
Blooms: Remember
7-28
7. The sales level that results in a project's net income exactly equaling zero is called the _____
break-even.
A. operational
B. leveraged
C. accounting
D. cash
E. present value
AACSB: Analytic
Blooms: Remember
8. The sales level that results in a project's net present value exactly equaling zero is called the
_____ break-even.
A. operational
B. leveraged
C. accounting
D. cash
E. present value
AACSB: Analytic
Blooms: Remember
9. Conducting scenario analysis helps managers see the:
A. impact of an individual variable on the outcome of a project.

B. potential range of outcomes from a proposed project.
C. changes in long-term debt over the course of a proposed project.
D. possible range of market prices for their firm's stock over the life of a project.
E. allocation distribution of funds for capital projects under conditions of hard rationing.
AACSB: Analytic
Blooms: Understand
7-29
10. Sensitivity analysis helps you determine the:
A. range of possible outcomes given possible ranges for every 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 project is reliant upon the fixed costs.
E. level of variable costs in relation to the fixed costs of a project.
AACSB: Analytic
Blooms: Understand
11. As the degree of sensitivity of a project to a single variable rises, the:
A. lower the forecasting risk of the project.

B. smaller the range of possible outcomes given a pre-defined range of values for the input.
C. more attention management should place on accurately forecasting the future value of that
variable.
D. lower the maximum potential value of the project.
E. lower the maximum potential loss of the project.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
12. Sensitivity analysis is conducted by:
A. holding all variables at their base level and changing the required rate of return assigned to
a project.
B. changing the value of two variables to determine their interdependency.
C. changing the value of a single variable and computing the resulting change in the current
value of a project.
D. assigning either the best or the worst possible value to every variable and comparing the
results to those achieved by the base case.
E. managers after a project has been implemented to determine how each variable relates to
the level of output realized.
AACSB: Analytic
Blooms: Understand
7-30
13. To ascertain whether the accuracy of the variable cost estimate for a project will have much
effect on the final outcome of the project, you should probably conduct _____ analysis.
A. leverage
B. scenario
C. break-even
D. sensitivity
E. cash flow
AACSB: Analytic
Blooms: Understand
14. Simulation analysis is based on assigning a _____ and analyzing the results.
A. narrow range of values to a single variable

B. narrow range of values to multiple variables simultaneously
C. wide range of values to a single variable
D. wide range of values to multiple variables simultaneously
E. single value to each of the variables
AACSB: Analytic
Blooms: Understand
15. The type of analysis that is most dependent upon the use of a computer is _____ analysis.
A. scenario
B. break-even
C. sensitivity
D. degree of operating leverage
E. simulation
AACSB: Analytic
Blooms: Understand
16. Which one of the following is most likely a variable cost?
A. Office rent
B. Property taxes
C. Property insurance
D. Direct labor costs
E. Management salaries
AACSB: Analytic
Blooms: Understand
7-31
17. Which of the following statements concerning variable costs is (are) correct?
I. Variable costs minus fixed costs equal marginal costs.

II. Variable costs are equal to zero when production is equal to zero.
III. An increase in variable costs increases the operating cash flow.
A. II only
B. III only
C. I and III only
D. II and III only
E. I and II only
AACSB: Analytic
Blooms: Understand
18. All else constant, as the variable cost per unit increases, the:
A. contribution margin decreases.

B. sensitivity to fixed costs decreases.
C. degree of operating leverage decreases.
D. operating cash flow increases.
E. net profit increases.
AACSB: Analytic
Blooms: Understand
19. Fixed costs:
I. are variable over long periods of time.

II. must be paid even if production is halted.
III. are generally affected by the amount of fixed assets owned by a firm.
IV. per unit remain constant over a given range of production output.
A. I and III only

B. II and IV only
C. I, II, and III only
D. I, II, and IV only
E. I, II, III, and IV
AACSB: Analytic
Blooms: Understand
7-32
20. All else equal, the contribution margin must increase as:
A. both the sales price and variable cost per unit increase.
B. the fixed cost per unit declines.
C. the variable cost per unit declines.
D. sales price per unit declines.
E. the sales price minus the fixed cost per unit increases.
AACSB: Analytic
Blooms: Understand
21. Which of the following statements are correct concerning the accounting break-even point?
I. The net income is equal to zero at the accounting break-even point.

II. The net present value is equal to zero at the accounting break-even point.
III. The quantity sold at the accounting break-even point is equal to the total fixed costs plus
depreciation divided by the contribution margin.
IV. The quantity sold at the accounting break-even point is equal to the total fixed costs divided
by the contribution margin.
A. I and III only

B. I and IV only
C. II and III only
D. II and IV only
AACSB: Analytic
Blooms: Understand
22. All else constant, the accounting break-even level of sales will decrease when the:
A. fixed costs increase.

B. depreciation expense decreases.
C. contribution margin decreases.
D. variable costs per unit increase.
E. selling price per unit decreases.
AACSB: Analytic
Blooms: Understand
7-33
23. The point where a project produces a rate of return equal to the required return is known as
the:
A. point of zero operating leverage.

B. internal break-even point.
C. accounting break-even point.
D. present value break-even point.
E. income break-even point.
AACSB: Analytic
Blooms: Understand
24. Which of the following statements are correct concerning the present value break-even point of
a project?
I. The present value of the cash inflows equals the amount of the initial investment.
II. The payback period of the project is equal to the life of the project.
III. The operating cash flow is at a level that produces a net present value of zero.
IV. The project never pays back on a discounted basis.
A. I and II only
B. I and III only
C. II and IV only
D. III and IV only
E. I, III, and IV only
AACSB: Analytic
Blooms: Understand
25. The investment timing decision relates to:
A. how long the cash flows last once a project is implemented.

B. the decision as to when a project should be started.
C. how frequently the cash flows of a project occur.
D. how frequently the interest on the debt incurred to finance a project is compounded.
E. the decision to either finance a project over time or pay out the initial cost in cash.
AACSB: Analytic
Blooms: Understand
Topic: Real Options
7-34
26. The timing option that gives the option to wait:
I. may be of minimal value if the project relates to a rapidly changing technology.

II. is partially dependent upon the discount rate applied to the project being evaluated.
III. is defined as the situation where operations are shut down for a period of time.
IV. has a value equal to the net present value of the project if it is started today versus the net
present value if it is started at some later date.
A. I and III only

B. II and IV only
C. I and II only
D. II, III, and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Real Options
27. 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. expand.
C. abandon.
D. contract.
E. withdraw.
AACSB: Analytic
Blooms: Understand
Topic: Real Options
28. Including the option to expand in your 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. increase the net present value of a project.
D. decrease the net present value of a project.
E. have no effect on either a project's cash flows or its net present value.
AACSB: Analytic
Blooms: Understand
Topic: Real Options
7-35
29. Theoretically, the NPV is the most appropriate method to determine the acceptability of a
project. A false sense of security can overcome the decision-maker when the procedure is
applied properly but the positive NPV results are accepted blindly. Sensitivity and scenario
analysis aid in the process by:
A. changing the underlying assumptions on which the decision is based.

B. highlights the areas where more and better data are needed.
C. providing a picture of how an event can affect the calculations.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
30. In order to make a decision with a decision tree:
A. one starts farthest out in time to make the first decision.

B. one must begin at time 0.
C. any path can be taken to get to the end.
D. any path can be taken to get back to the beginning.
E. None of these.
AACSB: Analytic
Blooms: Understand
Topic: Decision Trees
31. In a decision tree, the NPV to make the yes/no decision is dependent on:
A. only the cash flows from successful path.

B. on the path where the probabilities add up to one.
C. all cash flows and probabilities.
D. only the cash flows and probabilities of the successful path.
E. None of these.
AACSB: Analytic
Blooms: Understand
7-36
32. In a decision tree, caution should be used in the analysis because:
A. early stage decisions are probably riskier and should not likely use the same discount rate.
B. if a negative NPV is actually occurring, management should opt out of the project and
minimize the firm's loss.
C. decision trees are only used for financial planning.
D. Both early stage decisions are probably riskier and should not likely use the same discount
rate; and decision trees are only used for financial planning.
E. Both early stage decisions are probably riskier and should not likely use the same discount
rate; and if a negative NPV is actually occurring, management should opt out of the project
and minimize the firm's loss.
AACSB: Analytic
Blooms: Understand
33. Sensitivity analysis evaluates the NPV with respect to:
A. changes in the underlying assumptions.

B. one variable changing while holding the others constant.
C. different economic conditions.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
34. Sensitivity analysis provides information on:
A. whether the NPV should be trusted and may provide a false sense of security if all NPVs
are positive.
B. the need for additional information as it tests each variable in isolation.
C. the degree of difficulty in changing multiple variables together.
D. Both whether the NPV should be trusted and may provide a false sense of security if all
NPVs are positive; and the need for additional information as it tests each variable in
isolation.
E. Both whether the NPV should be trusted and may provide a false sense of security if all
NPVs are positive; and the degree of difficulty in changing multiple variables together.
AACSB: Analytic
Blooms: Understand
7-37
35. Fixed production costs are:
A. directly related to labor costs.

B. measured as cost per unit of time.
C. measured as cost per unit of output.
D. dependent on the amount of goods or services produced.
E. None of these.
AACSB: Analytic
Blooms: Understand
36. Variable costs:
A. change as the quantity of output changes.

B. are zero when production is zero.
C. are exemplified by direct labor and raw materials.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
37. An investigation of the degree to which NPV depends on assumptions made about any singular
critical variable is called a(n):
A. operating analysis.
B. sensitivity analysis.
C. marginal benefit analysis.
D. decision tree analysis.
E. None of these.
AACSB: Analytic
Blooms: Understand
7-38
38. Scenario analysis is different than sensitivity analysis:
A. because no economic forecasts are changed.

B. because several variables are changed together.
C. because scenario analysis deals with actual data versus sensitivity analysis which deals
with a forecast.
D. because it is short and simple.
E. because it is a "by the seat of the pants" technique.
AACSB: Analytic
Blooms: Understand
39. In the present-value break-even the EAC is used to:
A. determine the opportunity cost of investment.

B. allocate depreciation over the life of the project.
C. allocate the initial investment at its opportunity cost over the life of the project.
D. determine the contribution margin to fixed costs.
E. None of these.
AACSB: Analytic
Blooms: Understand
40. The present value break-even point is superior to the accounting break-even point because:
A. present value break-even is more complicated to calculate.

B. present value break-even covers the economic opportunity costs of the investment.
C. present value break-even is the same as sensitivity analysis.
D. present value break-even covers the fixed costs of production, which the accounting break-
even does not.
E. present value break-even covers the variable costs of production, which the accounting
break-even does not.
AACSB: Analytic
Blooms: Understand
7-39
41. The potential decision to abandon a project has option value because:
A. abandonment can occur at any future point in time.

B. a project may be worth more dead than alive.
C. management is not locked into a negative outcome.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
Topic: Real Options
42. Which of the following are types of break-even analysis?
A. Present value break-even

B. Accounting profit break-even
C. Market value break-even
D. Both present value break-even; and accounting profit break-even
E. Both present value break-even; and market value break-even
AACSB: Analytic
Blooms: Understand
43. The approach that further attempts to model real world uncertainty by analyzing projects the
way one might analyze gambling strategies is called:
A. gambler's approach.
B. blackjack approach.
C. Monte Carlo simulation.
D. scenario analysis.
E. sensitivity analysis.
AACSB: Analytic
Blooms: Understand
44. Monte Carlo simulation is:
A. the method of analysis most widely used by executives.

B. a very simple formula.
C. more complex than sensitivity or scenario analysis.
D. the oldest capital budgeting technique.
E. None of these.
AACSB: Analytic
Blooms: Understand
7-40
45. Which of the following are hidden options in capital budgeting?
A. Option to expand.
B. Timing option.
C. Option to abandon.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
Topic: Real Options
46. The Adept Co. is analyzing a proposed project. The company expects to sell 2,500 units, give
or take 10%. The expected variable cost per unit is $8 and the expected fixed costs are
$12,500. Cost estimates are considered accurate within a plus or minus 5% range. The
depreciation expense is $4,000. The sale price is estimated at $16 a unit, give or take 2%. The
company bases its sensitivity analysis on the expected case scenario
A. $40,000
B. $43,120
C. $44,000
D. $44,880
E. $48,400
Sales revenue for the best case = 2,500 × 1.1 × $16 × 1.02 = $44,880
AACSB: Analytic
Blooms: Apply
7-41
A. $2.67
B. $3.00
C. $7.92
D. $8.00
E. $8.72
Contribution margin for the base case = $16 - $8 = $8
AACSB: Analytic
Blooms: Apply
A. $4.55
B. $5.00
C. $5.83
D. $6.02
E. $6.55
Fixed cost per unit for the worst case = ($12,500 × 1.05) ÷ (2,500 × .9) = $5.83
AACSB: Analytic
Blooms: Apply
7-42
company bases its sensitivity analysis on the expected case scenario.
The company is conducting a sensitivity analysis on the sales price using a sales price
estimate of $17. Using this value, the earnings before interest and taxes will be:
A. $4,000
B. $6,000
C. $8,500
D. $10,000
E. $18,500
EBIT = [($17 - $8) × 2,500] - $12,500 - $4,000 = $6,000
AACSB: Analytic
Blooms: Apply
estimate will be:
A. $21,375
B. $22,500
C. $23,625
D. $24,125
E. $24,750
Total variable cost = $9 × 2,500 = $22,500
AACSB: Analytic
Blooms: Apply
7-43
51. The Can-Do Co. is analyzing a proposed project. The company expects to sell 12,000 units,
give or take 4%. The expected variable cost per unit is $7 and the expected fixed cost is
$36,000. The fixed and variable cost estimates are considered accurate within a plus or minus
6% range. The depreciation expense is $30,000. The tax rate is 34%. The sale price is
estimated at $14 a unit, give or take 5%. The company bases its sensitivity analysis on the
expected case scenario.
What is the earnings before interest and taxes under the expected case scenario?
A. $18,000
B. $24,000
C. $36,000
D. $48,000
E. $54,000
EBIT for base case = [12,000 × ($14 - $7)] - $36,000 - $30,000 = $18,000
AACSB: Analytic
Blooms: Apply
What is the earnings before interest and taxes under the optimistic case scenario?
A. $22,694.40
B. $24,854.40
C. $37,497.60
D. $52,694.40
E. $67,947.60
EBIT for best case = (12,000 × 1.04) × [($14 × 1.05) - ($7 × .94)] - ($36,000 × .94) - $30,000 =
$37,497.60
AACSB: Analytic
Blooms: Apply
7-44
What is the earnings before interest and taxes under the pessimistic case scenario?
A. -$566.02
B. -$422.40
C. -$278.78
D. $3,554.50
E. $5,385.60
Net income for worst case = {[12,000 × .96] × [($14 × .95) - ($7 × 1.06)] - ($36,000 × 1.06) -
$30,000} × (1 - .34} = -$422.40
AACSB: Analytic
Blooms: Apply
What is the operating cash flow for a sensitivity analysis using total fixed costs of
$32,000?
A. $14,520
B. $16,520
C. $22,000
D. $44,520
E. $52,000
EBIT = [(12,000 × ($14 - $7)] - $32,000 - $30,000 = $22,000

Tax = $22,000 × .34 = $7,480
OCF = $22,000 + $30,000 - $7,480 = $44,520
AACSB: Analytic
Blooms: Apply
7-45
What is the contribution margin for a sensitivity analysis using a variable cost per unit of $8?
A. $3
B. $4
C. $5
D. $6
E. $7
Contribution margin = $14 - $8 = $6
AACSB: Analytic
Blooms: Apply
56. The Meldrum Co. is analyzing a proposed project. The company expects to sell 3,000 units,
give or take 15%. The expected variable cost per unit is $8 and the expected fixed costs are
A. $54,400
B. $55,080
C. $62,100
D. $63,342
E. $65,030
Sales revenue for the best case = 3,000 × 1.15 × $18 × 1.02 = $63,342
AACSB: Analytic
Blooms: Apply
7-46
A. $8
B. $8.32
C. $10
D. $16
E. $18
Contribution margin for the base case = $18 - $8 = $10
AACSB: Analytic
Blooms: Apply
A. $4.17
B. $4.66
C. $5.15
D. $5.35
E. $6.02
Fixed cost per unit for the worst case = ($12,500 × 1.05) ÷ (3,000 × .85) = $5.15
AACSB: Analytic
Blooms: Apply
7-47
The company is conducting a sensitivity analysis on the sales price using a sales price
estimate of $17. Using this value, the earnings before interest and taxes will be:
A. $7,500
B. $8,000
C. $10,500
D. $14,000
E. $23,500
EBIT = [($17 - $8) × 3,000] - $12,500 - $4,000 = $10,500
AACSB: Analytic
Blooms: Apply
estimate will be:
A. $22,950
B. $24,000
C. $25,500
D. $27,000
E. $31,050
Total variable cost = $9 × 3,000 = $27,000
AACSB: Analytic
Blooms: Apply
7-48
61. A firm is reviewing a project with a labor cost of $8.90 per unit, raw materials cost of $21.63 a
unit, and fixed costs of $8,000 a month. Sales are projected at 10,000 units over the three-
month life of the project. What are the total variable costs of the project?
A. $216,300
B. $297,300
C. $305,300
D. $313,300
E. $329,300
Total variable costs = ($8.90 + $21.63) × 10,000 = $305,300
AACSB: Analytic
Blooms: Apply
62. A project has earnings before interest and taxes of $5,750, fixed costs of $50,000, a selling
price of $13 a unit, and a sales quantity of 11,500 units. Depreciation is $7,500.
What is the variable cost per unit?
A. $6.75
B. $7.00
C. $7.25
D. $7.50
E. $7.75
[11,500 × ($13.00 - v)] - $50,000 - $7,500 = $5,750; v = $7.50
AACSB: Analytic
Blooms: Apply
63. At a production level of 5,600 units a project has total costs of $89,000. The variable cost per
unit is $11.20. What is the amount of the total fixed costs?
A. $24,126
B. $26,280
C. $27,090
D. $27,820
E. $28,626
Total fixed cost = $89,000 - (5,600 × $11.20) = $26,280
AACSB: Analytic
Blooms: Apply
7-49
64. At a production level of 6,000 units a project has total costs of $120,000. The variable cost per
unit is $14.50. What is the amount of the total fixed costs?
A. $25,165
B. $28,200
C. $30,570
D. $32,000
E. $33,000
Total fixed cost = $120,000 - (6,000 × $14.50) = $33,000
AACSB: Analytic
Blooms: Apply
65. Wilson's Meats has computed its fixed costs to be $.60 for every pound of meat it sells given
an average daily sales level of 500 pounds. It charges $3.89 per pound of top-grade ground
beef. The variable cost per pound is $2.99. What is the contribution margin per pound of
ground beef sold?
A. $0.30
B. $0.60
C. $0.90
D. $2.99
E. $3.89
Contribution margin = $3.89 - $2.99 = $.90
AACSB: Analytic
Blooms: Apply
7-50
66. Ralph and Emma's is considering a project with total sales of $17,500, total variable costs of
$9,800, total fixed costs of $3,500, and estimated production of 400 units. The depreciation
expense is $2,400 a year. What is the contribution margin per unit?
A. $4.50
B. $10.50
C. $14.14
D. $19.09
E. $19.25
Contribution margin = ($17,500 - $9,800) ÷ 400 = $19.25
AACSB: Analytic
Blooms: Apply
67. You are considering a new project. The project has projected depreciation of $720, fixed costs
of $6,000, and total sales of $11,760. The variable cost per unit is $4.20. What is the
accounting break-even level of production?
A. 1,200 units
B. 1,334 units
C. 1,372 units
D. 1,889 units
E. 1,910 units
Accounting break-even Q = ($6,000 + $720) ÷ [($11,760 ÷ Q) - $4.20]; Q = 1,200
AACSB: Analytic
Blooms: Apply
A. $700
B. $950
C. $1,025
D. $1,053
E. $1,100
Depreciation at the accounting break-even = (5,425 × $6) - $31,600 = $950
AACSB: Analytic
Blooms: Apply
7-51
A. $4,480
B. $5,100
C. $5,150
D. $5,320
E. $5,600
Depreciation at the accounting break-even = (5,600 × $8) - $39,650 = $5,150
AACSB: Analytic
Blooms: Apply
70. A project has an accounting break-even point of 2,000 units. The fixed costs are $4,200 and
the depreciation expense is $400. The projected variable cost per unit is $23.10. What is the
projected sales price?
A. $20.80
B. $21.00
C. $21.20
D. $25.40
E. $25.60
Accounting break-even Q = 2,000 = ($4,200 + $400) ÷ (P - $23.10); P = $25.40
AACSB: Analytic
Blooms: Apply
71. A proposed project has fixed costs of $3,600, depreciation expense of $1,500, and a sales
quantity of 1,300 units. What is the contribution margin if the projected level of sales is the
accounting break-even point?
A. $3.92
B. $4.14
C. $4.50
D. $4.80
E. $5.00
Contribution margin = ($3,600 + $1,500) ÷ 1,300 = $3.92
AACSB: Analytic
Blooms: Apply
7-52
A. $1,000
B. $12,000
C. $13,000
D. $68,000
E. $73,000
Operating cash flow at the financial break-even point = (5,000 × $5) - $12,000 = $13,000
AACSB: Analytic
Blooms: Apply
73. Thompson & Son has been busy analyzing a new product. It has determined that an operating
A. Yes; because 5,000 units of sales exceeds the quantity required for a zero net present
value
B. Yes; because the internal break-even point is less than 5,000 units
C. No; because the firm cannot generate sufficient sales to obtain at least a zero net present
value
D. No; because the project has an expected internal rate of return of negative 100%
E. No; because the project will not pay back on a discounted basis
Financial break-even point = ($12,378 + $16,700) ÷ $6.20 = 4,690; The product should be
accepted because the expected level of sales exceeds the financial break-even point.
AACSB: Analytic
Blooms: Apply
7-53
74. Kurt Neal and Son is considering a project with a discounted payback just equal to the project's
life. The projections include a sales price of $11, variable cost per unit of $8.50, and fixed costs
of $4,500. The operating cash flow is $6,200. What is the break-even quantity?
A. 1,800 units
B. 2,480 units
C. 3,057 units
D. 3,750 units
E. 4,280 units
Financial break-even point = ($4,500 + $6,200) ÷ ($11 - $8.50) = 4,280
AACSB: Analytic
Blooms: Apply
75. At stage 2 of the decision tree it shows that if a project is successful, the payoff will be $53,000
with a 2/3 chance of occurrence. There is also the 1/3 chance of a $-24,000 payoff. The cost of
getting to stage 2 (1 year out) is $44,000. The cost of capital is 15%. What is the NPV of the
project at stage 1?
A. $-13,275
B. $-20,232
C. $2,087
D. $7,536
E. Cannot be calculated without the exact timing of future cash flows
$-44,000 + [((2/3($53,000)) + (1/3($-24,000)))/1.15] = $-20,232
AACSB: Analytic
Blooms: Apply
7-54
If the company has a discount rate of 17%, what is the value closest to time 1 net present
value?
A. $48.6 million
B. $80.9 million
C. $108.2 million
D. $181.4 million
E. None of these
NPV1 = Pr[COST + CFAT*A.17,4] = NPV1 = .6[$-100,000,000 + $66,000,000(2.7432)] =

$48,632,106
AACSB: Analytic
Blooms: Apply
7-55
If the company has a discount rate of 17%, should it decide to invest?
A. Yes, NPV = $2.2 million

B. Yes, NPV = $21.6 million
C. No, NPV = -$1.9 million
D. Yes, NPV = $8.6 million
E. No, since more than one branch is NPV = 0 or negative, the firm must reject.
NPV0 = NPV1/(1 + r) C0 = ($48,632,106/1.17) - $20,000,000) = $21,565,903
AACSB: Analytic
Blooms: Apply
7-56

Price: $8 per unit
Discount rate: 12%
Tax rate: 34%

E. None of these
Contribution Margin = ($8 - $3) = $5

(Fixed Cost + Depreciation) = ($200 + $140) = $340
Accounting BEP = $340/$5 = 68 units
AACSB: Analytic
Blooms: Apply
7-57
79. The Highlight Company has the following cost information on its new prospective project.

Price: $8 per unit
Discount rate: 12%
Tax rate: 34%


(Fixed Cost + Depreciation) = ($300 + $140) = $440
Accounting BEP = $440/$4 = 110 units
AACSB: Analytic
Blooms: Apply
7-58

Price: $8 per unit
Discount rate: 12%
Tax rate: 34%

E. None of these
EAC = $700/A.12,3 = $700/2.4018 = $291.45

PV BEP = [EAC + FC(1 - Tc) - Dep(Tc)]/(CM(1 - Tc)) = [$291.45 + $200(.66) - $140(.34)]/5(.66)
= 113.89 units = 114 units
AACSB: Analytic
Blooms: Apply
7-59
81. The Quorum Company has the following cost information on its new prospective project.

Price: $8 per unit
Discount rate: 12%
Tax rate: 34%

EAC = $700/A.12,3 = $700/2.4018 = $291.45

PV BEP = [EAC + FC(1 - Tc) - Dep(Tc)]/(CM(1 - Tc)) = [$291.45 + $300(.66) - $100(.34)]/5(.66)
= 138.015 units = 139 units
AACSB: Analytic
Blooms: Apply
7-60

Price: $20 per unit
Discount rate: 10%
Tax rate: 34%

E. None of these

After tax (Fixed Cost + Depreciation) = ($2,000 + $250) = $2,250
Accounting BEP = $2,250/$14 = 160.71 units = 161 units
AACSB: Analytic
Blooms: Apply

Price: $25 per unit
Discount rate: 10%
Tax rate: 34%


After tax (Fixed Cost + Depreciation) = ($2,000 + $300) = $2,300
Accounting BEP = $2,300/$17 = 135.29 units = 136 units
AACSB: Analytic
Blooms: Apply
7-61
84. Given the following information, calculate the present value break-even point.

Fixed costs: $2,000 per year
Price: $20 per unit
Discount rate: 10%
Tax rate: 34%

E. None of these
EAC = $2,000/(PVIFA.10,4) = $2,000/3.1699 = $630.93

PV BEP = [EAC + FC(1 - Tc) - Dep(Tc)]/(CM(1 - Tc)) = [$630.93 + $2,000(1 - 0.34) -
$250(.34)]/[($20 - $6)(1 - 0.34)] = 201.94 = 202 units
AACSB: Analytic
Blooms: Apply
85. You are considering a project which has been assigned a discount rate of 8%. If you start the
project today, you will incur an initial cost of $480 and will receive cash inflows of $350 a year
for three years. If you wait one year to start the project, the initial cost will rise to $520 and the
cash flows will increase to $385 a year for three years. What is the value of the option to wait?
A. $15.23
B. $17.08
C. $18.67
D. $20.20
E. $50.20
Value of option to wait = $437.21 - $421.98 = $15.23
AACSB: Analytic
Blooms: Apply
Topic: Real Options
7-62
86. Wilson's Antiques is considering a project that has an initial cost today of $10,000. The project
has a two-year life with cash inflows of $6,500 a year. Should Wilson's decide to wait one year
to commence this project, the initial cost will increase by 5% and the cash inflows will increase
to $7,500 a year. What is the value of the option to wait if the applicable discount rate is 10%?
A. $1,006.76
B. $1,235.54
C. $1,509.28
D. $1,606.76
E. $1,735.54
Value of option to wait = $2,287.75 - $1,280.99 = $1,006.76
AACSB: Analytic
Blooms: Apply
Topic: Real Options
87. Your firm is considering a project with a five-year life and an initial cost of $120,000. The
discount rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow
per unit is $20. The firm will have the option to abandon this project after three years at which
time it expects it could sell the project for $50,000. At what level of sales should the firm be
willing to abandon this project?
A. 420 units
B. 1,041 units
C. 1,479 units
D. 1,618 units
E. 2,500 units
AACSB: Analytic
Blooms: Apply
Topic: Real Options
7-63
88. Your firm is considering a project with a five-year life and an initial cost of $120,000. The
discount rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow
per unit is $20. The firm will have the option to abandon this project after three years at which
time it expects it could sell the project for $50,000. You are interested in knowing how the
project will perform if the sales forecasts for years four and five of the project are revised such
that there is a 50% chance that the sales will be either 1,400 or 2,500 units a year. What is the
net present value of this project given your sales forecasts?
A. $23,617
B. $23,719
C. $25,002
D. $26,877
E. $28,746
Level to abandon =
At 1,400 units you will abandon the project and receive $50,000.
At 2,500 you will continue the project and the NPV will be:
AACSB: Analytic
Blooms: Apply
Topic: Real Options
7-64
89. Marguerite is reviewing a project with projected sales of 1,500 units a year, a cash flow of $40
a unit and a three-year project life. The initial cost of the project is $95,000. The relevant
discount rate is 15%. Marguerite has the option to abandon the project after one year at which
time she feels she could sell the project for $60,000. At what level of sales should she be
willing to abandon the project?
A. 899 units
B. 923 units
C. 967 units
D. 1,199 units
E. 1,206 units
AACSB: Analytic
Blooms: Apply
Topic: Real Options
A. $2,000
B. $10,000
C. $20,000
D. $30,000
E. $120,000
Operating cash flow at the financial break-even point = (6,000 × $5) - $10,000 = $20,000
AACSB: Analytic
Blooms: Apply
7-65
91. Quirk and Company has been busy analyzing a new product. It has determined that an
operating cash flow of $18,500 will result in a zero net present value, which is a company
requirement for project acceptance. The fixed costs are $14,000 and the contribution margin is
$8.00. The company feels that it can realistically capture 10% of the 40,000 unit market for this
product. Should the company develop the new product? Why or why not?
A. No; because 4,000 units of sales is less than the quantity required for a zero net present
value
B. No; because the internal break-even point is greater than 4,000 units
C. Yes; because the firm can generate sufficient sales to obtain at least a zero net present
value
D. Yes; because the project has an expected internal rate of return of 100%
E. Yes; because the project will pay back on a discounted basis
Financial break-even point = ($14,000 + $18,500) ÷ $8.00 = 4,062.50; The product should not
be accepted because the expected level of sales is less than the financial break-even point.
AACSB: Analytic
Blooms: Apply
92. Ryan Industries is considering a project with a discounted payback just equal to the project's
life. The projections include a sales price of $12, variable cost per unit of $9, and fixed costs of
$5,000. The operating cash flow is $8,000. What is the break-even quantity?
A. 1,900 units
B. 2,679 units
C. 3,250 units
D. 4,000 units
E. 4,333 units
Financial break-even point = ($5,000 + $8,000) ÷ ($12 - $9) = 4,333
AACSB: Analytic
Blooms: Apply
Essay Questions
7-66
93. What is the benefit of scenario analysis if it does not produce an accept or reject decision for a
proposed project?
Scenario analysis provides management with a look at potential outcomes given various
assumptions and helps measure the potential for project failure. This information provides a
basis upon which management can apply their wisdom and knowledge to make the accept or
reject decision. However, the final decision does require human judgment.
AACSB: Reflective Thinking

Blooms: Analyze
94. Consider the following statement by a project analyst: "I analyzed my project using scenarios
for the base case, best case, and worst case. I computed break-evens and degrees of
operating leverage. I did sensitivity analysis and simulation analysis. I computed NPV, IRR,
payback, AAR, and PI. In the end, I have over a hundred different estimates and am more
confused than ever. I would have been better off just sticking with my first estimate and going
by my gut reaction." Critique this statement.
The goal of evaluating an NPV estimate or other decision criteria is to determine the
reasonableness of it. If done properly, the added analysis will heighten either the degree of
comfort or the degree of discomfort about a project. Ultimately, this type of analysis reveals
both the weaknesses and the strengths of a project. Furthermore, it helps isolate potential
trouble areas and sharpens the focus on which variables are most crucial for forecasting. The
very nature of the process still leaves a great deal of uncertainty even after all of the analysis is
complete. However, in the end, the analyst should be better informed and more comfortable in
making a decision, not less so.

Blooms: Evaluate
7-67
95. The Marx Brewing Company recently installed a new bottling machine. The machine's initial
cost is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years.
The machine's fixed cost per year is $1,800, and its variable cost is $0.50 per unit. The selling
price per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. Calculate the
accounting break-even point on the new machine, as well as the present value break-even
point on the new machine.
Accounting break-even is:

($1,800 + $400)(1 - 0.34)/($1.50 - $0.5)(1 - .34) = 2,200 units
Present value break-even is:
EAC = $2,000/(PVIFA.16,5) = $2,000/3.2743 = $610.81
PV BEP = [EAC + FC(1 - Tc) - Dep(Tc)]/(CM(1 - Tc))
= [$610.81 + $1,800(1 - .34) - $400(.34)]/($1.50 - $0.50)(1 - .34) = 2,519 units

Blooms: Apply
96. Discuss two shortcomings in the standard decision tree analysis that a financial manager
should be cognizant of?
First, there is differential risk at various stages of the tree should imply the use of different
discount rates. Second, the firm has different options than following a negative NPV path and
may alter the total outcome under poor future stages.

Blooms: Analyze
7-68
97. Sensitivity analysis is a method which allows for evaluation of the NPV given a series of
changes to the underlying assumptions. Discuss why and how scenario analysis is used in
addition to sensitivity analysis.
Sensitivity analysis:
measures result of changing one input at a time.
variables may change simultaneously in reality.
estimates may be overly optimistic or pessimistic.
Scenario analysis:
a variant of sensitivity analysis.
allows for multiple factor influences.
examines a number of different scenarios.
minimizes the false sense of security that may come from sensitivity analysis.

Blooms: Analyze
98. The market value of an investment project should be viewed as the sum of the standard NPV
and the value of managerial options. Explain three different real or managerial options that
management may have, what they are, and how they would influence market value.
There are three commonly used real options in capital budgeting. They are
To expand project — would expect a favorable market reaction
Contract business — under conditions of poor demand, etc., market reaction indeterminate,
likely poor unless the market sees the contraction is a positive NPV project for the firm.
Abandonment, equipment replacement, opening and closing facilities, market reaction
indeterminate, likely poor unless the market sees the abandonment as a positive NPV
decrease in investment for the firm.

Blooms: Analyze
Topic: Real Options
7-69
99. Can different discount rates be used for different stages in a decision tree? If so, what would be
the benefit of such action?
One of the benefits of a multi-stage capital budgeting tool like a decision tree is to allow for the
use of different discount rates to reflect different risks at the various stages. For example, initial
testing of a product is likely to carry more risk than the rollout of a product so the first stage
discount rate may easily be higher than latter discount rates.

Blooms: Evaluate
7-70

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Solution Manual for Corporate Finance 10th Edition by

Ross Westerfield Jaffe ISBN 0078034779

Multiple Choice Questions

A. change in direct relationship to the quantity of output produced.

A. change as the quantity of output produced changes.

A. impact of an individual variable on the outcome of a project.

10. Sensitivity analysis helps you determine the:

A. range of possible outcomes given possible ranges for every variable.

11. As the degree of sensitivity of a project to a single variable rises, the:

A. lower the forecasting risk of the project.

12. Sensitivity analysis is conducted by:

A. narrow range of values to a single variable

16. Which one of the following is most likely a variable cost?

I. Variable costs minus fixed costs equal marginal costs.

A. contribution margin decreases.

I. are variable over long periods of time.

A. I and III only

I. The net income is equal to zero at the accounting break-even point.

A. I and III only

A. fixed costs increase.

A. point of zero operating leverage.

25. The investment timing decision relates to:

A. how long the cash flows last once a project is implemented.

26. The timing option that gives the option to wait:

I. may be of minimal value if the project relates to a rapidly changing technology.

A. I and III only

A. changing the underlying assumptions on which the decision is based.

30. In order to make a decision with a decision tree:

A. one starts farthest out in time to make the first decision.

A. only the cash flows from successful path.

33. Sensitivity analysis evaluates the NPV with respect to:

A. changes in the underlying assumptions.

34. Sensitivity analysis provides information on:

35. Fixed production costs are:

A. directly related to labor costs.

36. Variable costs:

A. change as the quantity of output changes.

38. Scenario analysis is different than sensitivity analysis:

A. because no economic forecasts are changed.

39. In the present-value break-even the EAC is used to:

A. determine the opportunity cost of investment.

A. present value break-even is more complicated to calculate.

A. abandonment can occur at any future point in time.

A. Present value break-even

44. Monte Carlo simulation is:

A. the method of analysis most widely used by executives.

45. Which of the following are hidden options in capital budgeting?

What is the sales revenue under the optimistic case scenario?

What is the contribution margin under the expected case scenario?

What is the sales revenue under the optimistic case scenario?

What is the contribution margin under the expected case scenario?

If the company has a discount rate of 17%, should it decide to invest?

A. Yes, NPV = $2.2 million

Initial investment: $700

A. 25 units per year

Initial investment: $800

A. 62 units per year

Initial investment: $700

A. 68 units per year