Project Analysis Chapter.10 Verified Test Bank

Principles of Corporate Finance, 13e (Brealey)

Chapter 10 Project Analysis

1) Discounted cash-flow (DCF) analysis generally

I) assumes that firms hold assets passively when it invests in a project;

II) considers opportunities to expand a project if the project is successful;

III) considers opportunities to abandon a project if the project is a failure

A) I only

B) II only

C) II and III only

D) I, II, and III

2) You obtain the following data for year 1: Revenue = $43; Variable costs = $30; Depreciation = $3; Tax rate = 21 percent. Calculate the operating cash flow for the project for year 1.

A) $7.80

B) $10.90

C) $13.00

D) $16.10

3) 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):

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.

4) You are given the following data for year 1: Revenues = 100; Fixed costs = 30; Total variable costs = 50; Depreciation = $10; Tax rate = 21 percent. Calculate the after-tax cash flow for the project for year 1.

A) $17.90

B) $13.10

C) $10.00

D) $7.30

5) A project has the following cash flows: C0 = −100,000; C1 = 50,000; C2 = 150,000; C3 = 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

6) You calculate the following estimates of project cash flows (there are no taxes):

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

7) A project requires an initial investment of $150. Your research generates the following estimates of revenues and costs (there are no taxes):

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

8) 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 21 percent and the cost of capital is 15 percent. Cash flows from the project are

A) CF0: −90,000;CF1: 12,600; CF2: 12,600; CF3: 29,600.

B) CF0: −100,000; CF1: 44,220; CF2: 44,220; CF3: 62,120.

C) CF0: −100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600.

D) CF0: −100,000; CF1: 42,600; CF2: 42,600; CF3: 49,600.

9) 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 21 percent and the cost of capital is 15 percent. Calculate the NPV of the project.

A) $3,840

B) $12,734

C) $-2,735

D) $7,342

10) 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 21 percent and the cost of capital is 12 percent.

Calculate the NPV of the project.

A) $18,950

B) $8,443

C) $-2,735

D) $12,873

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 21 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) $9,487

D) $4,840

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. The corporate tax rate is 21 percent and the cost of capital is 16.5 percent. Calculate the NPV of the project.

A) $9,826

B) $3,840

C) -$2,735

D) $4,848

13) 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.

14) 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.

15) 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

16) 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

17) 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.

18) 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.

19) 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.

20) 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

21) 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

22) 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

23) 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

24) 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

25) All else equal, an increase in fixed costs

I) increases the break-even point based on NPV;

II) increases the accounting break-even point;

III) decreases the break-even point based on NPV;

IV) decreases the accounting break-even point

A) I and IV only

B) III and IV only

C) II and III only

D) I and II only

26) Project analysis, beyond simply calculating NPV, includes the following procedures:

I) sensitivity analysis;

II) break-even analysis;

III) Monte Carlo simulation;

IV) scenario analysis

A) I only

B) I and II only

C) I, II, and III only

D) I, II, III, and IV

27) One can employ simulation models to

I) understand the project better;

II) better understand forecasted cash flows;

III) assess the project risk

A) I only

B) II only

C) III only

D) I, II, and III

28) Monte Carlo simulation involves the following steps:

I) Step 1: Modeling the project;

II) Step 2: Specifying probabilities;

III) Step 3: Simulating cash flows;

IV) Step 4: Calculating present value

A) I and II only

B) I, II, and III only

C) II, III, and IV only

D) I, II, III, and IV

29) 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

30) 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.

31) 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

32) 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.

33) 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

34) 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

35) The following are real options except

A) stock options.

B) timing options.

C) options to expand.

D) options to abandon.

36) 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

37) 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.

38) 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.

39) 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

40) 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

41) 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

42) The following options associated with a project increase managerial flexibility:

I) option to expand;

II) option to abandon;

III) production options;

IV) timing options

A) I only

B) II only

C) I, II, III, and IV

D) IV only

43) 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

44) 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

45) 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

46) Expansion options generally show as an asset on a corporation's balance sheet.

47) Projects with higher fixed costs have lower break-even points.

48) The break-even point in terms of NPV is usually lower than the break-even point on an accounting profit basis.

49) Firms that operate at break-even on an accounting profit basis are really losing the opportunity cost of capital on their investments.

50) Monte Carlo simulation is a tool intended to consider all possible combinations of variables.

51) In constructing a Monte Carlo simulation model of an investment project, one typically ignores possible interdependencies between variables.

52) Monte Carlo simulation should be used to get the distribution of NPV values for a project.

53) Tangible assets usually have higher abandonment values than intangible ones.

54) The option to wait is a type of abandonment option.

55) Firms with higher fixed costs tend to have higher degrees of operating leverage.

56) Adding a fudge factor to the cost of capital will penalize longer-term projects more due to compounding.

57) In most cases the net present value break-even quantity is higher than the accounting profit break-even quantity.

58) Monte Carlo simulation is mostly an advanced version of scenario analysis.

59) Indicate some of the problems associated with the capital investment process.

60) Briefly describe sensitivity analysis as used for project analysis.

61) How do managers supplement the NPV analysis of a project to gain a better understanding of a project?

62) Briefly discuss break-even analysis.

63) Briefly discuss the usefulness of Monte Carlo simulation in project analysis.

64) Briefly explain the term real options.

65) Briefly discuss various real options associated with capital budgeting projects.

66) Define the term abandonment value.

67) Briefly explain timing options.

68) Explain the usefulness of decision trees in project analysis.

69) Why is sensitivity analysis less realistic than Monte Carlo simulation?