Adam Test Bank Answers Chapter 11 Risk And Capital Budgeting

Chapter 11 – Risk and capital budgeting

MULTIPLE CHOICE

1. Operating leverage describes the relationship between:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire an understanding of risk and return

2. Everything else being equal, a higher corporate tax rate:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

3. A manager who wants to find out at which point a project’s profits and costs are equal will conduct a:

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

4. The appropriate cost of capital for a project depends on:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

5. When a company’s sales are $20 000, EBIT is $5 500 and operating leverage is 2.5. If sales increase to $24 000, what is the new level of EBIT?

2.5 = (Change EBIT/5 500)/(4000/20 000)

Change EBIT = 2750

New EBIT = 6875

PTS: 1 DIF: H

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire an understanding of risk and return

6. Bavarian Sausage, Inc. has a cost of equity of 21% and a beta of 1.9. The expected market return is 12%. What is the risk-free rate?

0.21 = r_f + 1.9(0.12 – r_f)

r_f = 0.02

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

7. Bavarian Sausage has a beta of 1.9. The risk-free rate is 4% and the expected market risk premium is 11%. What is the company’s cost of equity?

E(r_i) = 0.04 + 1.9(0.12)

E(r_i) = 0.249

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

Use the following information to answer questions 8 to 11.

Never-Crash Airlines has a capital structure that consists of 20% debt and 80% equity. The company’s cost of debt is 7%. The company has a beta of 1.9. The risk-free rate equals 4.5% and the expected return on the market portfolio is 15%.

8. Assuming no taxes, what is Never-Crash Airline’s WACC?

r_i = 0.045 + 1.9(0.15 – 0.045) = 0.2445

WACC = (0.8)(0.2445) + (0.2)(0.07) = 0.2096

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

9. If its marginal tax rate equals 30%, what is Never-Crash Airlines’ WACC?

r_i = 0.045 + 1.9(0.15 – 0.045) = 0.2445

WACC = (0.8)(0.2445) + (0.2)(0.07)(1 – 0.30) = 0.20544

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

10. What is Never-Crash Airlines’ after-tax cost of debt?

After-tax r_d = 0.07(1 – 0.30) = 0.049

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

11. What is Never-Crash Airlines’ cost of equity?

r_i = 0.045 + 1.9(0.15 – 0.045) = 0.2445

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

Use the following information to answer questions 12 to 17.

Capital structure information for Bavarian Brewhouse:

12. What is Bavarian Brewhouse’s cost of preferred shares?

r_p = 2.50/16.13 = 0.155

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

13. What is Bavarian Brewhouse’s cost of ordinary equity?

r_i = 0.0375 + 0.85(0.1755 – 0.0375) = 0.1548

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

14. If its marginal tax rate equals 34%, what is Bavarian Brewhouse’s after-tax cost of debt?

After-tax r_d = 0.08(1 – 0.34) = 0.0528

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

15. What percentage of Bavarian Brewhouse’s capital structure consists of total equity?

Total equity = 5 + 45 = 50

50/75 = 0.6667

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

16. Assuming no corporate taxes, what is Bavarian Brewhouse’s WACC?

r_p = 0.155

r_d = 0.08

r_e = 0.1548

WACC = (45/75)0.1548 + (25/75)0.08 + (5/75)0.155 = 0.1299

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

17. If its marginal tax rate equals 34%, what is Bavarian Brewhouse’s WACC?

r_p = 0.155

r_d = 0.08

r_e = 0.1548

WACC = (45/75)0.1548 + (25/75)0.08(1 – 0.34) + (5/75)0.155 = 0.1208

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

18. As a result of a company’s 15% increase in sale, its EBIT increased by 25%. What is the company’s operating leverage?

Operating leverage = 0.25/0.15 = 1.67

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire an understanding of risk and return

19. Miller’s Dairy Products reported sales of $2.2 million in 2016 and $3.25 million in 2017. Its EBIT in 2002 was $550 000 and it rose to $925 000 in 2017. What is the company’s operating leverage?

Operating leverage = [(925 – 550)/550]/[(3.25 – 2.2)/2.2] = 1.43

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire an understanding of risk and return

20. If the sale price per unit is $60, the variable cost per unit is $40 and the fixed costs are $55 000, what is the breakeven point?

BEP = 55 000/(60 – 40) = 2750

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

21. If total costs are $180 000, the sale price per unit is $35, the variable cost per unit is $20 and 10 000 units have been sold, what is the breakeven point?

Fixed costs = 180 000 – 15(10 000) = 30 000

BEP = 30 000/(35 – 20) = 2000

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

Use the following information to answer questions 22 to 29.

Bavarian Sausage, Inc. is considering starting production of a new chocolate-filled sausage. The company is not sure what the exact sales potential and costs of the product will be. Bavarian Sausage has determined the following three possible scenarios:

22. What is the best-case scenario breakeven point for Bavarian Sausage?

3800/(12 – 4) = 475

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

23. What is Bavarian Sausage’s breakeven point in the most likely scenario?

4500/(10 – 5) = 900

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

24. What is Bavarian Sausage’s breakeven point in the worst-case scenario?

4000/(4 – 3) = 4000

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

25. If each of Bavarian Sausage’s three scenarios is equally likely, what is the expected breakeven point?

4500/(10 – 5) = 900

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

26. By how much would Bavarian Sausage’s breakeven point change in the best-case scenario if variable costs increase by $3?

Old BEP = 3800/(12 – 4) = 475

New BEP = 3800/(12 – 7) = 760

Change in BEP = 760 – 475 = +285

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

27. By how much would Bavarian Sausage’s breakeven point change in the most likely scenario if the price per unit turns out to be only $8?

Old BEP = 4500/5 = 900

New BEP = 4500/3 = 1500

Change in BEP = 1500 – 1900 = +600

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

28. What is the percentage change in Bavarian Sausage’s breakeven point in the worst-case scenario if it turns out that the company can charge $7 per unit?

Old BEP = 4000/(4 – 3) = 4000

New BEP = 4000/(7 – 3) = 1000

Change in BEP = –1000/4000 = –0.25

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

29. How much would Bavarian Sausage have to charge per unit in the most likely scenario to break even if it expected to be able to sell 1000 units (everything else being equal)?

1000 = 4500/(Price – 5)

Price = 9.50

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

30. A company can sell its product for $6 per unit. The variable costs for each unit are $2, while the fixed costs of operation are $1200. What is the breakeven point for this product?

BEP = 1200/(6 – 2) = 300 units

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

31. Hollywood Productions has a $4 contribution margin for a new DVD it is releasing to the general public. The DVD sells for $20. If the fixed costs to produce the DVD were $500 000, how many units must be sold for Hollywood Productions to break even?

BEP = 500 000/4 = 125 000

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

Use the following information to answer questions 32 to 34.

Running Shoes, Inc. has 2 million shares outstanding. A share currently sells for $12.50. The company’s debt is publicly traded and was recently quoted at 90% of face value. It has a total face value of $10 million, and it is currently priced to yield 8%. The risk-free rate is 2% and the market risk premium is 8%. You have estimated that the company has a beta of 1.20. The corporate tax rate is 40%.

32. Refer to Running Shoes, Inc. What is the cost of equity?

Cost of equity = 0.02 + 1.20 × 0.08 = 0.1160

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

33. What is the percentage of equity used by Running Shoes, Inc.?

Debt:

FV = 10 million

MV = 0.9 × 10 million = 9 million

Equity:

MV = 2 million × 12.50 = 25 million

% equity =25/34 = 0.7353

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

34. What is the WACC for Running Shoes, Inc.?

Debt:

FV = 10 million

MV = 0.9 × 10 million = 9 million

Cost of debt = 8%

Equity:

MV = 2 million × 12.50 = 25 million

Cost of equity = 0.02 + 1.20 × 0.08 = 11.60

% equity = 25/34 = 0.7353

WACC = (9/34) × 0.08 × (1 – 0.40) + (25/34) × 0.116 = 0.098

PTS: 1 DIF: H

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

35. A company has a capital structure of 25% debt and 75% equity. Debt can be issued at a return of 9%, while the cost of equity for the company is 12%. The company is considering a $50 million expansion of its production facility. The project has the same risk as the company overall and will earn $10 million per year for seven years. What is the NPV of the expansion if the tax rate facing the company is 40%?

WACC = 0.25 × 0.09 × (1 – 0.4) + 0.75 × 0.12 = .01035

N = 7

I = 10.35%

PMT = 10

FV = 0

PV = 48.10

NPV = 48.1 million – 50 million = –1.9 million

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

36. Consider the following financial leverage information for ABC Corporation. The debt pays 10% annually in interest and the tax rate is 40%. For what EBIT will the EPS be equal for either capital structure?

EPS = Net income/Number of shares

EPS = (EBIT – Interest) × (1 – T)/Number of shares

(EBIT – 0) × 0.60/100 000 = (EBIT – 25 000) × 0.60/50 000

EBIT = $50 000

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate

NAT: Analytic skills

LOC: acquire an understanding of risk and return

37. The operating leverage for ABC Corporation is 125% in 2016. Given the information below, what was the growth rate in sales for 2017?

(3/12)/(x/30) = 1.25

x = 6

6/30 = 0.20

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire an understanding of risk and return

38. The EBIT for ABC Corporation for 2016 and 2017 is shown below. Sales grew at a rate of 10% for 2017. If 2016 sales were $25 million, what is the operating leverage for ABC?

2004 sales = 25 × (1.10) = 27.50

Operating leverage = (2.5/10)/(2.5/25) = 2.50

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire an understanding of risk and return

39. A project under consideration for a company has several possible outcomes shown in the table below. Given the assumptions below, what is the expected NPV for the project?

= 0.40 × 20 + 0.35 × 2 + 0.25 × (–30) = 1.20

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

40. A company is considering investing $10 million today to start a new product line. The future of the project is unclear and depends on the state of the economy. The project will last five years. The yearly cash flows for the project are shown below for different states of the economy. What is the expected NPV for the project if the cost of capital is 12%?

NPV of each outcome:

Good:

N = 5

I =12%

PMT = 8

PV = 30.33

NPV = 18.84

Average:

N = 5

I =12%

PMT = 3
PV = 11.37

NPV = 0.81

Bad:

N = 5

I =12%

PMT = –2

PV = –7.58

NPV = –17.21

Expected NPV = 0.25 × 18.84 + 0.50 × 0.81 + 0.25 × (–17.21) = 0.81

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

41. A company is considering investing $10 million today to start a new product line. The future of the project is unclear however and depends on the state of the economy. The project will last four years. The yearly cash flows for the project are shown below for different states of the economy. What is the expected NPV for the project if the cost of capital is 15%?

NPV of each outcome:

Good:

N = 4

I = 15%

PMT = 7

PV = 19.98

NPV = 9.98

Bad:

N = 4

I = 15%

PMT = –2.50

PV = –7.14

NPV = –17.14

Expected NPV = 0.25 × 9.98 + 0.75 × (–17.14) = –10.36

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

42. Which answer describes an analysis of what happens to NPV estimates when we change the values of one variable at a time?

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

43. Which approach estimates NPV by taking a distribution of values for each of the model’s assumptions?

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

44. Which approach estimates NPV by changing the value of several assumptions at once to represent possible outcomes of the project?

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

45. As a young entrepreneur, you are considering opening a new restaurant. You plan on operating the restaurant for four years and then either expanding the business or closing the restaurant to move onto something else. An economist has estimated the value of your option to expand at $300 000 in today’s dollars. Given the estimates below, what is the project value of the new restaurant business if cash flows are discounted at 12%?

PV of $25 000:

N = 4

I = 12%

PMT = 25 000

PV = 75 933

NPV = 75 933 – 200 000 + 300 000 = 175 933

PTS: 1 DIF: M

REF: 11.3 Real Options NAT: Analytic skills

LOC: understand derivative markets

46. A company has estimated the NPV of a new product release as –$100 000. However, if the product is a failure, the company estimates it can sell off the equipment to help cash flow. An analyst estimates the value of abandoning the product release at $125 000. The cost of capital for the company is 10%. What is the project value for the company?

REF: 11.3 Real Options NAT: Analytic skills

LOC: understand derivative markets

47. A company has a capital structure containing 40% debt, 10% preferred share equity, and 50% ordinary share equity. The company’s debt has a yield to maturity of 9.50%. Its preferred share’s annual dividend is $7.50 and the preferred share’s current market price is $50.00 per share. The company’s ordinary share has a beta of 0.90, and the risk-free rate and the market return are currently 4.0% and 13.5%, respectively. The company is subject to a 40% marginal tax rate. The market value of debt is $100 million. How many preferred shares should be outstanding for the capital structure to be correct?

Debt = 40% of total value

100 = 0.40 × Company value

Company value = 100/0.40 = 250

Preferred market value = 0.10 × 250 = 25 million

MV = Number of shares × Price = 25 million = x × 50

x = 500 000

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

48. A company has a capital structure containing 40% debt, 10% preferred share equity, and 50% ordinary share equity. The company’s debt has a yield to maturity of 9.50%. Its preferred share’s annual dividend is $7.50 and the preferred share’s current market price is $50.00 per share. The company’s ordinary share has a beta of 0.90, and the risk-free rate and the market return are currently 4.0% and 13.5%, respectively. The company is subject to a 40% marginal tax rate. What is the WACC for the company?

Cost of preferred shares = 7.50/50.00 = 0.15

WACC = 0.40 × 0.095 × (1 – 0.40) + 0.10 × 0.15 + 0.50 × [0.04 + 0.90 × (0.135 – 0.04)]

WACC = 0.1006

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

49. A company has a capital structure of 40% debt and 60% equity. The company has bonds outstanding with a face value of $20 million. The bonds pay, on average, an 8% annual coupon and have an average maturity length of seven years. The market value of the bonds is 110% of face value and the tax rate facing the company is 40%. The company has ordinary shares with a beta of 1.25. The risk-free rate on Treasury bonds is 2%, while the market risk premium is 8%. What is the WACC for the company?

Cost of debt:

N = 7

PV = –1000 × 1.10

PMT = 80

FV = 1000

r = YTM = 6.20%

Cost of equity = 0.02 + 1.25 × 0.08 = 0.12

WACC = 0.40 × 0.062 × (1 – 0.40) + 0.60 × 0.12 = 0.0869

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

50. Which statement is false regarding the WACC and its components?

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

51. Which statement is true about a company that earns zero economic profit?

REF: 11.3 Real Options NAT: Reflective thinking

LOC: understand derivative markets

52. A project’s discount rate must be:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

53. Nalcoa Corp. is financing a project that is in the same industry as its current portfolio of projects. Nalcoa has a beta of 1.5, the expected market risk premium is 8% and the risk-free rate is 5%. What is the weighted average cost of capital for Nalcoa if it is and plans to continue being an all-equity financed company?

Cost of equity = 0.05 + 1.5(0.08) = 0.17

WACC = 0.17(1) + R_D(1 – T_c)(0) = 0.17

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

54. Operating leverage measures the effect of:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire an understanding of risk and return

55. Purple Bell Butter Company increased its sales by $2000 over the previous year’s figure of $50 000. Consequently, Purple Bell’s earnings before interest and taxes increased from $3000 to $3300 during the same period. Calculate Purple Bell’s operating leverage.

Operating leverage = (Change in EBIT/EBIT)/(Change in sales/Sales)

Operating leverage = (300/3300)/(2000/50 000) = 2.5

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire an understanding of risk and return

56. A high degree of operating leverage suggests that:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire an understanding of risk and return

57. Which of the following industries would you expect to have the highest degree of operating leverage?

Electricity providers should have the largest percentage of fixed costs which would make them have the highest degree of operating leverage.

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire an understanding of risk and return

58. A company’s weighted average cost of capital is:

REF: 11.1 Choosing the Right Discount Rate NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

59. CapCo has a capital structure that is composed of $10 million of debt and $30 million of ordinary equity. If CapCo has a 30% marginal tax rate, what is its WACC if the yield to investors on CapCo debt is 8% and the cost of CapCo ordinary equity is 12%?

WACC = [10/(10 + 30)](0.08)(1 – 0.3) + [30/(10 + 30)](0.12) = 0.104

PTS: 1 DIF: M

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

60. WidgetMaker has discovered that its fixed costs are $100 000 per month. If WidgetMaker sells its widgets for $35 per unit based upon a cost of $15 per unit to manufacture (variable costs), then how many widgets per year must WidgetMaker sell in order to break even?

Yearly units = 12[100 000/(35 – 15)] = 60 000

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

61. WidgetMaker has discovered that its fixed costs are $100 000 per month. If WidgetMaker sells its widgets for $35 per unit based upon a cost of $15 per unit to manufacture (variable costs), then what dollar sales per year must WidgetMaker sell in order to break even?

Yearly sales = 35{12 [100 000/(35 – 15)]} = 2 100 000

PTS: 1 DIF: H

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

62. If a company decides to change one input at a time in its net present value analysis in order to measure the NPV impact of such a change, then the company is performing:

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

63. A company prefers to assume a probability distribution concerning each of the major inputs for the net present value of a project and then randomly draw those inputs over and over again until a distribution is generated for the net present value of an entire project. The company is performing:

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

64. You are given the opportunity to play a game involving high stakes gambling. The game begins by you paying an entry fee of $35 000 000 followed by a fair coin toss. If the coin toss is heads, then you have an 80% probability of receiving a perpetuity of $10 000 000 per year and a 20% probability of receiving a perpetuity of $1 000 000 per year. Assume that the proper discount rate for the perpetual cash flow is 10%. If the coin toss is tails, you can continue to play but you will lose $50 000 000 with certainty. Alternatively, you can make a make an opt-out payment of $10 000 000 after tails to prevent you from going down such a costly path. What is the present value of playing such a game?

Value of heads node = 0.8(10 000 000/0.1) + 0.2(1 000 000/0.1) = 82 000 000

Value of tails node = –10 000 000 (since you will always opt for that instead of the 50 000 000 payment)

Present value = –35 000 000 + 0.5(82 000 000) + 0.5(–10 000 000) = 1 000 000

PTS: 1 DIF: H

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

65. The right but not the obligation to produce oil from one of your existing oil wells can be described as:

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: understand derivative markets

66. You are the owner of a natural gas well that can produce exactly (at today’s prices) $1 000 000 worth of gas per year for exactly five years. You also know (with certainty) that the correct discount rate for these revenues is 10%. An oil and gas production company offers you $5 000 000 today for the natural gas well. What is the implied value of the real option to produce or not produce natural gas?

Value of revenue stream = 1 000 000 × PVIFA(5,10%) 

Value of revenue stream = 1 000 000 × 3.7907868 = 3 790 787

Value of option = 5 000 000 – 3 790 787

Value of option = 1 209 213

PTS: 1 DIF: H

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: understand derivative markets

67. The going rate for paying a CEO in the widget industry is $1 000 000 per year. You find that the CEO of MasterWidgets has a contract that pays him $1 200 000 per year for five years, but he cannot work for any other company for any reason during the contractual period. What is the value of a real option for a CEO to not work for a company other than MasterWidgets? Assume a discount rate of 10%.

Value of revenue stream = 1 000 000 × PVIFA(5,10%)

Value of revenue stream = 1 000 000 × 3.7907868 = 3 790 787

Value of contract = 1 200 000 × PVIFA(5,10%) = 1 200 000 × 3.7907868 = 4 548 944

Value of contract = 1 200 000 × 3.7907868 = 4 548 944

Value of option = 4 548 944 – 3 790 787 = 758 157

PTS: 1 DIF: H

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: understand derivative markets

68. You are a professional football player who is eligible to be a free agent. You are offered a two-year contract to play for your current team for $3 000 000. If you accept that contract, the company retains your rights and you will not be able to play for another team at the conclusion of the contract. Otherwise, you can play for you current team for two years at a price of $2 000 000, but you have the ability to play for any team at the expiration of this agreement. What is the value of the option to pay for any team you like after two years? Assume a discount rate of 5%.

Retain rights contract = 3 000 000 × PVIFA(2,5%) 

Retain rights contract = 3 000 000 × 1.8594104 = 5 578 231

Open rights contract = 2 000 000 × PVIFA(2,5%)
Open rights contract = 2 000 000 × 1.8594104 = 3 718 821

Value of option = 5 578 231 – 3 718 821= 1 859 410

PTS: 1 DIF: M

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: understand derivative markets

69. You are considering the purchase of a business that produces net cash flows of $350 000 per year in perpetuity. In a perfectly competitive market, what should be the asking price for the business if the company’s cost of capital is 15%?

350 000/0.15 = 2 333 333

PTS: 1 DIF: E

REF: 11.4 Strategy and Capital Budgeting NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

70. You are a gold producer and have noticed that the value of your business may increase even though the price of gold falls. Your explanation for this phenomenon is:

REF: 11.4 Strategy and Capital Budgeting NAT: Reflective thinking

LOC: understand derivative markets

71. You are considering a production volume of 100 000 widgets per year. You can either purchase a single 100 000-widget-per-year machine that costs $1 000 000, or buy a 50 000-widget-per-year machine and then if sales volume permits, purchase another machine later. If widget production volume costs the same per unit to produce and there is a real option to expand production, what should the cost of the 50 000-widget-per-year machine be (to you)?

The real option should not be free and should therefore make the cost of the 50 000-widget-per-year machine greater than half the price of the 100 000 per year machine.

PTS: 1 DIF: H

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: understand derivative markets

72. You are about to embark on a project that has an equal 50% probability of generating a $10 000 windfall or a loss of $4000. However, an insurance company will sell you an indemnification policy in the event that you incur the $4000 loss. If the insurance company is basing its charge for the policy on real option analysis, what will it charge you for the policy?

No policy value = 0.5(10 000 – 4000) = 3000

With policy value = 0.5(10 000) = 5000

Value of option to eliminate negative value = 5000 – 3000 = 2000

PTS: 1 DIF: H

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: understand derivative markets

73. Jupitor Surfboards has annual fixed costs of $5000 with a variable cost of $10 per unit and a sales price of $20 per unit. Jupitor expects to sell 1000 units this year without much trouble. However, Jupitor is concerned about the scenario that all costs will increase 10% this year. If that happens, what will be Jupitor’s earnings before interest and taxes?

Current: 1000(20 – 10) – 5000 = 5000

VC increases from $10 to $11. FC increases from 5000 to 5500.

Then: 1000(20 – 11) – 5500 = 3500

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk NAT: Analytic skills

LOC: acquire an understanding of risk and return

74. Which of the following describes a visual representation of the sequential choices that managers face over time with regard to a particular investment?

REF: 11.2 A Closer Look at Risk NAT: Reflective thinking

LOC: acquire an understanding of risk and return

75. The right to invest additional resources in investments that enjoy early success is known as:

REF: 11.3 Real Options NAT: Reflective thinking

LOC: understand derivative markets

76. The option to withdraw resources from projects that fail to live up to short-run expectations is known as:

REF: 11.3 Real Options NAT: Reflective thinking

LOC: understand derivative markets

77. The option to make additional investments should earlier investments prove to be successful is known as:

REF: 11.3 Real Options NAT: Reflective thinking

LOC: understand derivative markets

78. Options that offer a company the ability to adapt to changes in inputs, outputs and maintaining excess production capacity are known as:

REF: 11.3 Real Options NAT: Reflective thinking

LOC: understand derivative markets

79. Which of the following statements is true?

REF: 11.3 Real Options NAT: Reflective thinking

LOC: understand derivative markets

80. If any project is to have a positive NPV, advocates of that project:

REF: 11.4 Strategy and Capital Budgeting NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

81. The market value of a Louis ordinary share is $15 (with 5 000 000 shares outstanding and the next annual dividend is expected to be $1.25); the bonds are currently selling for $920 (semi-annual coupon payments of $30; maturing in 20 years; 200 000 bonds in the market); and a preferred share currently is $25 (paying dividends of $3 in perpetuity, 100 000 shares outstanding). If the tax rate is 40%, what is the company’s WACC?

PTS: 1 DIF: H

REF: 11.1 Choosing the Right Discount Rate NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

SHORT ANSWER

1. What are the tools that can assist mangers to analyse the uncertainty in a project’s cash flows?

PTS: 1 DIF: E

REF: 11.2 A Closer Look at Risk

2. What is real option?

PTS: 1 DIF: E

REF: 11.3 Real Options

3. What are the types of real options that are available to managers?

PTS: 1 DIF: E

REF: 11.3 Real Options

4. What is financial leverage?

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate

5. What method should a company use to calculate its cost of capital when it is funded by equity and debt financing?

PTS: 1 DIF: E

REF: 11.1 Choosing the Right Discount Rate

6. Briefly explain the factors that could affect the cost of equity of a company.

PTS: 1 DIF: E

REF: 11.3 Real Options