Chapter 10 Test Bank - Static.docx

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1. Discounted cash-flow (DCF) analysis generally A. assumes that firms hold assets passively when they invest in a project. B. considers opportunities to expand a project if the project is successful. C. considers opportunities to expand a project if the project is successful and considers opportunities to abandon a project if the project is a failure. D. assumes that firms hold assets passively when they invest in a project, considers opportunities to expand a project if the project is successful, and considers opportunities to abandon a project if the project is a failure. Accessibility: Keyboard Navigation Difficulty: Intermediate 2. Most firms' capital investment proposals originate from A. senior management. B. planning staff in the corporate finance department. C. the board of directors. D. divisional management. Accessibility: Keyboard Navigation Difficulty: Basic 3. Generally, postaudits are conducted for large projects A. shortly after the completion of the project. B. several years after the completion of the project. C. shortly after the project has begun to operate. D. well before the start of the project. Accessibility: Keyboard Navigation Difficulty: Intermediate 4. Generally, postaudits for projects are conducted to A. identify problems that need fixing only. B. check the accuracy of forecasts only. C. identify problems that need fixing and check the accuracy of forecasts only. D. identify problems that need fixing, check the accuracy of forecasts, and generate questions that should have been asked before project commencement. Accessibility: Keyboard Navigation Difficulty: Challenge 5. You obtain the following data for year 1: Revenue = $43; variable costs = $30; depreciation = $3; tax rate = 30 percent. Calculate the operating cash flow for the project for year 1. A. $7 B. $10 C. $13 D. $16 Accessibility: Keyboard Navigation Difficulty: Challenge

6. A project has an initial investment of 100. You have come up with the following estimates of the project's cash flows (there are no taxes): Pessimistic Most Likely Optimistic Revenues 15 20 25 Costs 10 8 5 Suppose the cash flows are perpetuities and the cost of capital is 10 percent. Conduct a sensitivity analysis of the project’s NPV to variations in revenues. (Answers appear in order: [Pessimistic, Most Likely, Optimistic].) A. -30, +20, +70. B. -100, -50, +80. C. -50, +50, +70. D. +5, +11, +18. Accessibility: Keyboard Navigation Difficulty: Intermediate 7. You are given the following data for year 1: Revenues = 100; fixed costs = 30; total variable costs = 50; depreciation = $10; tax rate = 30 percent. Calculate the after-tax cash flow for the project for year 1. A. $17 B. $13 C. $10 D. $7 Accessibility: Keyboard Navigation Difficulty: Challenge 8. A project has the following cash flows: C 0 = -100,000; C 1 = 50,000; C 2 = 150,000; C 3 = 100,000. If the discount rate changes from 12 percent to 15 percent, what is the change in the NPV of the project (approximately)? A. 12,750 increase B. 12,750 decrease C. 14,240 increase D. 14,240 decrease Accessibility: Keyboard Navigation Difficulty: Challenge

9. You calculate the following estimates of project cash flows (there are no taxes): Pessimistic Most Likely Optimistic Investment 100 80 60 Revenues 30 40 50 Costs 20 15 10 The revenues and costs occur in perpetuity. The cost of capital is 8 percent. Conduct a sensitivity analysis of the project’s NPV to variations in costs. (Answers appear in order: [Pessimistic, Most Likely, Optimistic].) A. +170.00, +232.50, +295.00 B. -100.00, +500.00, +800.00 C. -90.00, -55.00, -20.00 D. -88.33, -50.00, -18.50 Accessibility: Keyboard Navigation Difficulty: Intermediate 10. A project requires an initial investment of $150. Your research generates the following estimates of revenues and costs (there are no taxes): Pessimistic Most Likely Optimistic Revenues 30 50 65 Costs 20 20 15 The cost of capital equals 10 percent. Assume that the cash flows occur in perpetuity. Conduct a sensitivity analysis of the project’s NPV to variations in costs. (Answers appear in order: [Pessimistic, Most Likely, Optimistic].) A. +50, -100, +400 B. -50, +300, +500 C. -100, +150, +350 D. +100, +150, +200 Accessibility: Keyboard Navigation Difficulty: Challenge

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11. A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60 percent of revenues. (Assume all revenues and costs occur at year-end [i.e., t = 1, t = 2, and t = 3]). The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30 percent and the cost of capital is 15 percent. Cash flows from the project are A. CF 0 : -90,000; CF 1 : 12,600; CF 2 : 12,600; CF 3 : 29,600. B. CF 0 : -100,000; CF 1 : 42,600; CF 2 : 42,600; CF 3 : 59,600. C. CF 0 : -100,000; CF 1 : 42,600; CF 2 : 42,600; CF 3 : 42,600. D. CF 0 : -100,000; CF 1 : 42,600; CF 2 : 42,600; CF 3 : 49,600. Accessibility: Keyboard Navigation Difficulty: Challenge 12. A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60 percent of revenues. (Assume all revenues and costs occur at year-end [i.e., t = 1, t = 2, and t = 3]). The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30 percent and the cost of capital is 15 percent. Calculate the NPV of the project. A. $3,840 B. $8,443 C. $-2,735 D. $7,342 Accessibility: Keyboard Navigation Difficulty: Challenge 13. A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60 percent of revenues. (Assume all revenues and costs occur at year-end [i.e., t = 1, t = 2, and t = 3]). The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30 percent and the cost of capital is 12 percent. Calculate the NPV of the project. A. $14,418 B. $8,443 C. $-2,735 D. $12,873 Accessibility: Keyboard Navigation Difficulty: Challenge

14. A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60 percent of revenues. (Assume all revenues and costs occur at year-end [i.e., t = 1, t = 2, and t = 3]). The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30 percent and the cost of capital is 15 percent. What is the NPV of the project if the revenues were higher by 10 percent and the costs were 65 percent of the revenues? A. $8,443 B. $964 C. $5,566 D. $4,840 Accessibility: Keyboard Navigation Difficulty: Challenge 15. A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60 percent of revenues. (Assume all revenues and costs occur at year-end [i.e., t = 1, t = 2, and t = 3]). The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30 percent and the cost of capital is 16.5 percent. Calculate the NPV of the project. A. $5,648 B. $3,840 C. -$2,735 D. $4,848 Accessibility: Keyboard Navigation Difficulty: Challenge 16. The following are drawbacks of sensitivity analysis except A. it can provide ambiguous results. B. the underlying variables are likely interrelated. C. it can help identify the project's most important variables. D. All of these statements are drawbacks of sensitivity analysis. Accessibility: Keyboard Navigation Difficulty: Intermediate 17. Which of the following statements most appropriately describes scenario analysis? A. It looks at the project by changing one variable at a time. B. It provides the break-even level of sales for the project. C. It looks at different but consistent combinations of variables. D. Each of these statements describes scenario analysis correctly. Accessibility: Keyboard Navigation Difficulty: Basic 18. The Financial Calculator Company proposes to invest $12 million in a new calculator-making plant. Fixed costs are $3 million per year. A financial calculator costs $10 per unit to manufacture and sells for $30 per unit. If the plant lasts for four years and the cost of capital is 20 percent, what is the break-even level (i.e., NPV = 0) of annual sales? (Assume that revenues and costs occur at the end of each year. Assume no taxes.) Round to the nearest 1,000 units. A. 150,000 units B. 342,000 units C. 382,000 units D. 300,000 units Accessibility: Keyboard Navigation Difficulty: Challenge

19. The Solar Calculator Company proposes to invest $5 million in a new calculator-making plant. Fixed costs are $2 million per year. A solar calculator costs $5 per unit to manufacture and sells for $20 per unit. If the plant lasts for three years and the cost of capital is 12 percent, what is the break-even level (i.e., NPV = 0) of annual sales? (Assume that revenues and costs occur at the end of each year. Assume no taxes.) Round to the nearest 1,000 units. A. 133,000 units B. 272,000 units C. 228,000 units D. 244,000 units Accessibility: Keyboard Navigation Difficulty: Challenge 20. Firms often calculate a project's break-even sales using accounting profit. However, break-even sales based on NPV is generally A. higher than the one calculated using accounting profit. B. lower than the one calculated using accounting profit. C. equal to the one calculated using accounting profit. D. not related to the one calculated using accounting profit. Accessibility: Keyboard Navigation Difficulty: Challenge 21. The accounting break-even point occurs when A. the total revenue line cuts the fixed cost line. B. the present value of inflows line cuts the present value of outflows line. C. the total revenue line cuts the total cost line. D. total revenue is large enough to recapture depreciation expense. Accessibility: Keyboard Navigation Difficulty: Intermediate 22. The NPV break-even point occurs when A. the present value of inflows line cuts the present value of outflows line. B. the total revenue line cuts the fixed cost line. C. the total revenue line cuts the total cost line. D. the present value of inflows cuts the total cost line. Accessibility: Keyboard Navigation Difficulty: Intermediate 23. The Financial Calculator Company proposes to invest $12 million in a new calculator-making plant that will depreciate on a straight-line basis. Fixed costs are $3 million per year. A financial calculator costs $10 per unit to manufacture and sells for $30 per unit. If the plant lasts for four years and the cost of capital is 20 percent, what is the accounting break-even level of annual sales? (Assume no taxes.) A. 300,000 units B. 150,000 units C. 381,777 units D. 750,000 units Accessibility: Keyboard Navigation Difficulty: Challenge

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24. The Solar Calculator Company proposes to invest $5 million in a new calculator-making plant that will depreciate on a straight-line basis. Fixed costs are $2 million per year. A calculator costs $5 per unit to manufacture and sells for $20 per unit. If the plant lasts for three years and the cost of capital is 12 percent, what is the accounting break-even level of annual sales? (Assume no taxes.) A. 133,334 units B. 272,117 units C. 244,444 units D. 466,666 units Accessibility: Keyboard Navigation Difficulty: Challenge 25. The Taj Mahal Tour Company proposes to invest $3 million in a new tour package project. Fixed costs are $1 million per year. The tour package costs the company $500 to produce and can be sold at $1,500 per package to tourists. This tour package will last for the next five years. If the cost of capital is 20 percent, what is the NPV break-even number of tourists per year? (Ignore taxes. Round to the nearest 1,000.) A. 1,000 B. 2,000 C. 3,000 D. 4,000 Accessibility: Keyboard Navigation Difficulty: Challenge 26. The Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $0.5 million per year. The equipment will last for five years. The manufacturing cost per hammer is $1 and each hammer sells for $6. The cost of capital is 20 percent. Calculate the break-even (i.e., NPV = 0) sales volume per year. (Ignore taxes. Round to the nearest 1,000.) A. 500,000 units B. 600,000 units C. 450,000 units D. 550,000 units Accessibility: Keyboard Navigation Difficulty: Challenge 27. Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $1 million per year. The equipment will last for five years. The manufacturing cost per hammer is $1 and each hammer sells for $6. The cost of capital is 20 percent. Calculate the break-even (i.e., NPV = 0) sales volume per year. (Ignore taxes. Round to the nearest 1,000.) A. 500,000 units B. 550,000 units C. 600,000 units D. 650,000 units Accessibility: Keyboard Navigation Difficulty: Challenge 28. All else equal, an increase in fixed costs A. increases the break-even point based on NPV and decreases the accounting break-even point. B. decreases the break-even point based on NPV and decreases the accounting break-even point. C. increases the accounting break-even point and decreases the break-even point based on NPV. D. increases the break-even point based on NPV and increases the accounting break-even point. Accessibility: Keyboard Navigation Difficulty: Intermediate

29. Project analysis, beyond simply calculating NPV, includes the following procedures: A. sensitivity analysis only. B. sensitivity analysis and break-even analysis only. C. sensitivity analysis, break-even analysis, and Monte Carlo simulation. D. sensitivity analysis, break-even analysis, Monte Carlo simulation, and scenario analysis. Accessibility: Keyboard Navigation Difficulty: Basic 30. One can employ simulation models to A. understand the project better. B. better understand forecasted cash flows. C. assess the project risk. D. understand the project better, better understand forecasted cash flows, and assess the project risk. Accessibility: Keyboard Navigation Difficulty: Basic 31. Monte Carlo simulation involves the following steps: A. Step 1: Modeling the project and Step 2: Specifying probabilities. B. Step 1: Modeling the project, Step 2: Specifying probabilities, and Step 3: Simulating cash flows. C. Step 2: Specifying probabilities, Step 3: Simulating cash flows, and Step 4: Calculating present value. D. Step 1: Modeling the project, Step 2: Specifying probabilities, Step 3: Simulating cash flows, and Step 4: Calculating present value. Accessibility: Keyboard Navigation Difficulty: Intermediate 32. After completing a project analysis, an analyst should rely on which tool to make a final recommendation on the project? A. Sensitivity analysis B. Break-even analysis C. Decision trees D. NPV Accessibility: Keyboard Navigation Difficulty: Challenge 33. Which of the following simulation outputs is likely to be most useful and easy to interpret? The output that shows the distribution(s) of the project's A. sales. B. internal rate of return. C. cash flows. D. profits. Accessibility: Keyboard Navigation Difficulty: Intermediate 34. Generally, Monte Carlo models, for project analysis, use which device to generate simulations? A. Pair of dice B. Roulette wheel C. Computer D. Pack of cards Accessibility: Keyboard Navigation Difficulty: Basic

35. Monte Carlo simulation is likely to be most useful A. for very complex projects. B. for projects of moderate complexity. C. for very simple projects. D. regardless of the project's complexity. Accessibility: Keyboard Navigation Difficulty: Basic 36. Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects prices and costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10 percent per year, which is also the cost of capital. (Ignore taxes). Calculate the NPV to invest today. A. +100,000,000 B. +80,000,000 C. +60,000,000 D. +40,000,000 Accessibility: Keyboard Navigation Difficulty: Challenge 37. Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10 percent per year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Calculate today's NPV of the project (i.e., NPV @ t = 0) if it were postponed by one year. A. +$100 million B. +$154 million C. +$170 million D. +$187 million Accessibility: Keyboard Navigation Difficulty: Challenge 38. The following are real options except A. stock options. B. timing options. C. options to expand. D. options to abandon. Accessibility: Keyboard Navigation Difficulty: Intermediate 39. Petroleum Inc. (PI) controls off-shore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10 percent per year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Suppose that PI has the option to postpone the project by one year. Calculate the value of the real option to postpone the project for one year. (There is some rounding in the answer.) A. +$30 million B. +$50 million C. +$54 million D. +$70 million Accessibility: Keyboard Navigation Difficulty: Challenge

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40. Which of the following does not represent an option to expand a project? A. A firm leases more office space than it forecasts it will need. B. A company engages in test marketing for a new product. C. Your university builds an administrators' parking garage having more parking spaces than administrators. D. A dry cleaner purchases equipment that can be readily sold to other dry cleaners. Accessibility: Keyboard Navigation Difficulty: Intermediate 41. Which of the following does not represent an option to abandon a project? A. Your friend builds a custom-made home. B. You enroll in five classes, planning to drop one class before the semester ends. C. A dry cleaner purchases equipment that can be readily sold to other dry cleaners. D. You purchase a fully refundable airplane ticket. Accessibility: Keyboard Navigation Difficulty: Intermediate 42. You are planning to produce a new action figure called "Hillary." However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for three years (starting next year [i.e., at t = 1]). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50 percent). You will not know whether it is a hit or a failure until after the first year's cash flows are in (i.e., at t = 1). You have to spend $80 million immediately for equipment and the rights to produce the figure. If the discount rate is 10 percent, calculate Hillary's NPV. A. -9.15 B. +13.99 C. +5.15 D. -14.40 Accessibility: Keyboard Navigation Difficulty: Challenge 43. You are planning to produce a new action figure called "Hillary." However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for three years (starting next year [i.e., at t = 1]). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50 percent). You will not know whether it is a hit or a failure until the first year's cash flows are in (i.e., at t = 1). You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million immediately after the first year's cash flows are received, calculate Hillary's NPV with this abandonment option. (The discount rate is 10 percent. The equipment can only be resold at the end of the first year.) A. -9.10 B. +9.10 C. +13.99 D. -14.40 Accessibility: Keyboard Navigation Difficulty: Challenge

44. You are planning to produce a new action figure called "Hillary." However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for three years (starting next year [i.e., at t = 1]). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50 percent). You will not know whether it is a hit or a failure until the first year's cash flows are in (i.e., at t = 1). You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million once the first year's cash flows are received, calculate the value of the abandonment option. (The discount rate is 10 percent.) A. -9.15 B. +13.99 C. +23.14 D. 0.00 Accessibility: Keyboard Navigation Difficulty: Challenge 45. The following options associated with a project increase managerial flexibility: A. option to expand only B. option to abandon only C. option to expand, option to abandon, production options, and timing options D. timing options only Accessibility: Keyboard Navigation Difficulty: Basic 46. You are given the following net future values for harvesting trees from a plot of forestland. (This is a one-time harvest.) If the cost of capital is 15 percent, calculate the optimal year to harvest. A. Year 1 B. Year 2 C. Year 3 D. Year 4 Difficulty: Challenge

47. The Consumer-Mart Company is going to introduce a new consumer product. If it is brought to market without research about consumer tastes, the firm believes that there is a 60 percent chance that the product will be successful. If successful, the project has a NPV = $500,000. If the product is a failure (40 percent) and withdrawn from the market, then NPV = -$100,000. A consumer survey will cost $60,000 and delay the introduction by one year. With a survey, there is an 80 percent chance of consumer acceptance, in which case the NPV = $500,000. If, on the other hand, the product is a failure (20 percent) and withdrawn from the market, then NPV = -$100,000. The discount rate is 10 percent. By how much does the marketing survey change the expected net present value of the project? A. Increases the NPV by $25,455 B. Decreases the NPV by $5,950 C. Increases the NPV by $8,955 D. Decreases the NPV by $25,455 Accessibility: Keyboard Navigation Difficulty: Challenge 48. KMW Inc. sells finance textbooks for $150 each. The variable cost per book is $30 and the fixed cost per year is $30,000. The process of creating a textbook costs $150,000 and the average book has a life span of three years. What is the economic or NPV break-even number of books that must be sold each year given a discount rate of 12 percent? A. 156 B. 191 C. 235 D. 771 Accessibility: Keyboard Navigation Difficulty: Challenge 49. Expansion options generally show as an asset on a corporation's balance sheet. FALSE Accessibility: Keyboard Navigation Difficulty: Basic 50. Postaudits are conducted before the start of projects. FALSE Accessibility: Keyboard Navigation Difficulty: Basic 51. Most firms keep track of the progress of projects by conducting postaudits shortly after the projects have begun to operate. TRUE Accessibility: Keyboard Navigation Difficulty: Basic 52. Projects with higher fixed costs have lower break-even points. FALSE Accessibility: Keyboard Navigation Difficulty: Intermediate

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53. The break-even point in terms of NPV is usually lower than the break-even point on an accounting profit basis. FALSE Accessibility: Keyboard Navigation Difficulty: Intermediate 54. Firms that operate at break-even on an accounting profit basis are really losing the opportunity cost of capital on their investments. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate 55. Monte Carlo simulation is a tool intended to consider all possible combinations of variables. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate 56. In constructing a Monte Carlo simulation model of an investment project, one typically ignores possible interdependencies between variables. FALSE Accessibility: Keyboard Navigation Difficulty: Intermediate 57. Monte Carlo simulation should be used to get the distribution of NPV values for a project. FALSE Accessibility: Keyboard Navigation Difficulty: Intermediate 58. Tangible assets usually have higher abandonment values than intangible ones. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate 59. The option to wait is a type of abandonment option. FALSE Accessibility: Keyboard Navigation Difficulty: Intermediate 60. Firms with higher fixed costs tend to have higher degrees of operating leverage. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate 61. Adding a fudge factor to the cost of capital will penalize longer-term projects more due to compounding. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate

62. In most cases, the net present value break-even quantity is higher than the accounting profit break-even quantity. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate 63. Monte Carlo simulation is mostly an advanced version of scenario analysis. TRUE Accessibility: Keyboard Navigation Difficulty: Intermediate 64. Indicate some of the problems associated with the capital investment process. There are several problems associated with capital budgeting. Among them are establishing consistent forecasts, forecast bias, getting senior management timely and relevant information, and conflicts of interest. Difficulty: Intermediate 65. Discuss the importance of conducting postaudits. Postaudits are important for several reasons: They identify actionable problems in the capital budgeting process; they provide a check on the accuracy of the cash-flow forecasts; they raise questions that are relevant for future projects. Difficulty: Intermediate 66. Briefly describe sensitivity analysis as used for project analysis. By using sensitivity analysis, one can determine the factors that may have the largest impact on project cash flows. For some projects, say, labor costs might have a large impact on the cash flows. That means that small changes in labor costs will cause a large change in the cash flows of the project. This helps the financial manager and the project manager to focus on a few key variables and take corrective or preventive actions wherever possible. One drawback of sensitivity analysis is that it gives ambiguous results because variables are often interrelated. Difficulty: Intermediate 67. How do managers supplement the NPV analysis of a project to gain a better understanding of a project? Generally, managers supplement the NPV analysis of a project through project analysis to get a better insight into the project. Project analysis includes sensitivity analysis, break-even analysis, Monte Carlo simulation, and decision trees. The final decision should always rely on NPV analysis. Difficulty: Intermediate 68. Briefly discuss break-even analysis. Break-even analysis provides the minimum level of periodic sales or output above which a project has a positive net present value. Managers frequently calculate break-even points in terms of accounting profits rather than NPV. However, this does not consider the opportunity cost of capital and hence provides a misleadingly low number. Difficulty: Intermediate

69. Briefly discuss the usefulness of Monte Carlo simulation in project analysis. Monte Carlo simulation can provide an exhaustive analysis of project outcomes. The main problem is that developing the model is time consuming, expensive, and difficult to verify. Monte Carlo simulation generally involves three steps: modeling the project, specifying probabilities, and simulating cash flows. This is generally done using commercially available computer software. Difficulty: Intermediate 70. Briefly explain the term real options. Real options are options to modify projects in the future. These have value as they provide managers with the flexibility to change decisions in the face of new information. There are several types of real options. They are options to expand, options to abandon, timing options, and production options. Difficulty: Intermediate 71. Briefly discuss various real options associated with capital budgeting projects. There are four types of real options. They are the following: options to expand. options to abandon. production options. timing options. Options to expand provide a firm with flexibility to expand but do not commit the firm to expand. Therefore, they add value to the project. These are call options. In many cases, the ability to terminate a project or abandon a project adds flexibility to the project. This is useful when the project fails to be profitable. Abandonment options are put options. Production options provide a firm with additional flexibility to alter inputs or processes. These have value when an input becomes scarce and needs to be replaced with an alternative. These production options add value to the project. In many cases, a positive-NPV project need not be undertaken right away. It might be even more valuable if undertaken in the future. The ability to postpone a project also provides a firm with additional flexibility. These options add value to the project. A project may have multiple real options associated with it. Many projects might become positive-NPV projects if the real options associated with them are properly recognized and evaluated. Difficulty: Challenge

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72. Define the term abandonment value . The value of the option to bail out of a project is called its abandonment value. This is a simple concept, which has broad practical implications. Generally, an abandonment option increases the value of a project. Generally, tangible assets have higher abandonment value than intangible assets and general-purpose machines have higher abandonment value than special-purpose machines. Difficulty: Intermediate 73. Briefly explain timing options. Companies with positive-NPV projects need not undertake them right away. If there are uncertainties associated with the project, costly mistakes might be avoided by waiting to resolve them. These types of options to postpone investment are called timing options. Difficulty: Intermediate 74. Explain the usefulness of decision trees in project analysis. Financial managers use decision trees in order to analyze projects involving sequential decisions. Firms often build prototypes or pilot plants before embarking on large projects requiring huge investments. These involve expansion and abandonment decisions. These types of sequential decisions can be analyzed using decision trees. Difficulty: Intermediate 75. Why is sensitivity analysis less realistic than Monte Carlo simulation? Sensitivity analysis only changes one variable at a time. Reality almost never involves only one variable changing at a time. Reality involves many variables changing from the current state to an infinite number of possible outcomes. Monte Carlo simulation more closely approximates reality, given its many outcomes with many variables. In economic modeling, there is a trade-off between simplicity and realism. More realistic economic modeling [e.g., Monte Carlo models) is almost always more complex. Difficulty: Challenge