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

Answer: A
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: B

Pretax income = (43 − 30 − 3) = 10; Tax = 10(0.21) = 2.1; net profit = 10 − 2.10 = 7.90;
Explanation:

operating cash flow = 7.90 + 3 = $10.90.

Difficulty: 3 Hard
Topic: Operating Cash Flow
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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):

Pessimistic Most Likely Optimistic

Revenues 15 20 25
Costs 8 8 8

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:
A) −30, +20, +70.
[Pessimistic, Most Likely, Optimistic].)

B) −100, −50, +80.

C) −50, +50, +70.
D) +5, +11, +18.

Answer: A

Pessimistic NPV = [(15 − 8)/0.10] − 100 = −30.

Explanation:

Most Likely NPV = [(20 − 8)/0.10] − 100 = +20.

Optimistic NPV = [(25 − 8)/0.10] − 100 = +70.
Difficulty: 3 Hard
Topic: Operating Cash Flow
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: A

EBT = (100 − 30 − 50 − 10) = 10.

Explanation:

CF1 = 10 − 2.1 + 10 = $17.9.

T = 10(0.21) = 2.10.

Difficulty: 2 Medium
Topic: Operating Cash Flow
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: B

Change = 122,650 − 135, 410 = −12,750.

Explanation: NPV at 12% = 135,400, NPV at 15% = 122,650.

Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Pessimistic Most Likely Optimistic

Investment 80 80 80
Revenues 40 40 40
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].)

B) −100.00, +500.00, +800.00

A) +170.00, +232.50, +295.00

C) −90.00, −55.00, −20.00

D) −88.33, −50.00, −18.50

Answer: A

Pessimistic NPV = [(40 − 20)/0.08] − 80 = +170.00.

Explanation:

Most likely NPV = [(40 − 15)/0.08] − 80 = +232.50.

Optimistic NPV = [(40 − 10)/0.08] − 80 = +295.00.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

7) 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 50 50 50
Costs 25 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:

A) +50, −100, +400

[Pessimistic, Most Likely, Optimistic].)

B) −50, +300, +500

C) −100, +150, +350
D) +100, +150, +200

Answer: D

Pessimistic NPV = [(50 − 25)/0.10] − 150 = +100.

Explanation:

Expected NPV = [(50 − 20)/0.10] − 150 = +150.

Optimistic NPV = [(50 − 15)/0.10] − 150 = +200.

Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

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

the project are

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.

Explanation: Initial Investment = 90,000 + 10,000 = 100,000; CF0 = −100,000.

Answer: B

CF1 and CF2: (120,000 − 72,000 − 30,000)(1 − 0.21) + 30,000 = 44,220.

CF3: (120,000 − 72,000 − 30,000)(1 − 0.21) + 30,000 + (10,000)(1 − 0.21) + 10,000 = 62,120.
In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain.
Meanwhile, working capital of $10,000 is recouped in year 3.
Difficulty: 3 Hard
Topic: Operating Cash Flow
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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
Answer: B
Explanation: Initial investment = 90,000 + 10,000 = 100,000; CF0 = -100,000.

CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.21) + 30,000 = 44,220.

CF3: (120,000 - 72,000 - 30,000)(1 - 0.21) + 30,000 + (10,000)(1 - 0.21) + 10,000 = 62,120.
In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain.
Meanwhile, working capital of $10,000 is recouped in year 3.
NPV = -100,000 + 44,220/(1.15) + 44,220/(1.152) + 62,120/(1.153) = 12,734.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Explanation: Initial investment = 90,000 + 10,000 = 100,000; CF0 = −100,000.

Answer: A

CF1 and CF2: (120,000 − 72,000 − 30,000)(1 − 0.21) + 30,000 = 44,220.

CF3: (120,000 − 72,000 − 30,000)(1 − 0.21) + 30,000 + (10,000)(1 − 0.21) + 10,000 = 62,120.
In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain.
Meanwhile, working capital of $10,000 is recouped in year 3.
NPV = -100,000 + 44,220/(1.12) + 44,220/(1.122) + 62,120/(1.123) = 18,950.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
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

Explanation: Initial investment = 90,000 + 10,000 = 100,000; CF0 = −100,000.

Answer: C

CF1 and CF2: (132,000 − 85,800 − 30,000)(1 − 0.21) + 30,000 = 42,798.

CF3: (132,000 − 85,800 − 30,000)(1 − 0.21) + 30,000 + (10,000)(1 − 0.21) + 10,000 = 60,698.
In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain.
Meanwhile, working capital of $10,000 is recouped in year 3.
NPV = −100,000 + 42,798/(1.15) + 42,798/(1.152) + 60,698/(1.153) = 9,487.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Explanation: Initial investment = 90,000 + 10,000 = 100,000; CF0 = −100,000.

Answer: A
CF1 and CF2: (120,000 − 72,000 − 30,000)(1 − 0.21) + 30,000 = 44,220.

CF3: (120,000 − 72,000 − 30,000)(1 − 0.21) + 30,000 + (10,000)(1 − 0.21) + 10,000 = 62,120.
In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain.
Meanwhile, working capital of $10,000 is recouped in year 3.
NPV at 16.5% = −100,000 + (44,220/1.165) + (44,220/(1.1652)) + (62,120/(1.1653)) = $9,826.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: C
Difficulty: 2 Medium
Topic: Sensitivity Analysis
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: C
Difficulty: 2 Medium
Topic: Scenario Analysis
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: C
Explanation: First, find the annual cash flow that justifies a $12 million investment using the
equivalent annual cost (EAC) method. The 4-year annuity factor @ 20% equals 2.5887346.

EAC = 12/2.5887346 = $4,635,469 million. The plant must net this amount of cash flow each
year. Given $3 million of annual fixed costs, let X = the annual sales rate.

X (30 − 10) − 3,000,000 = 4,635,469.

X = 7,635,469/20 = 381,773.45 or approximately 382,000 units.

Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: B
Explanation: First, find the annual cash flow that justifies a $5 million investment using the
equivalent annual cost (EAC) method. The 3-year annuity factor @ 12% equals 2.40183127.

EAC = 5,000,000/2.40183127 = 2,081,745 million. The plant must net this amount of cash flow
each year. Given $2 million of annual fixed costs, let X = the annual sales rate:

(X) (20 − 5) − 2,000,000 = 2,081,745;

X = (4,081,745/15) = 272,117 units or about 272,000 units.

Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: A
Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: C
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: A
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: A

sales rate. Let p equal the price and v equal the variable cost. X = (FC + D)/(p − v) = (3,000,000
Explanation: Fixed costs and depreciation both equal $3 million per year. Let X = the annual

+ 3,000,000)/(30 − 10) = 300,000.

Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: C
Explanation: Fixed costs and depreciation equal $2 million and $1.67 million per year,
respectively. Let X = the annual sales rate. Given a price of $20 and variable cost of $5.

X = (2,000,000 + 1,666,667)/(20 − 5) = 244,444 units.

Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: B
Explanation: First, find the annual cash flow that justifies a $3 million investment using the
equivalent annual cost (EAC) method. The 5-year annuity factor @ 20 percent equals 2.9906.

EAC = $3 million/2.9906 = $1 million. The tour must net this amount of cash flow each year.
Given $1 million of annual fixed costs, let X = the annual sales rate: (X) × (1,500 - 500) -
1,000,000 = 1,000,000.

X (1,000) = 2,000,000.

X = 2,000,000/1,000 = 2,000.
Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: A
Explanation: First, find the annual cash flow that justifies a $6 million investment using the
equivalent annual cost (EAC) method. The 5-year annuity factor @ 20 percent equals 2.9906.

EAC = 6/2.9906 = 2 million.

The equipment must net this amount of cash flow each year. Given $0.5 million of annual fixed
costs, let X = the annual sales rate.

X (6 − 1) − 500,000 = 2,000,000.
X = 2,500,000/5 = 500,000 units.
Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: C
Explanation: First, find the annual cash flow that justifies a $6 million investment using the
equivalent annual cost (EAC) method. The 5-year annuity factor @ 20 percent equals 2.9906.

EAC = 6/2.9906 = 2 million. The equipment must net this amount of cash flow each year. Given
$1 million of annual fixed costs, let X = the annual sales rate.

X (6 − 1) − 1,000,000 = 2,000,000.
X = 3,000,000/5 = 600,000 units.
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: D
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: D
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: D
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: D
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: D
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: C
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: C
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: A
Difficulty: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: A
Explanation: Easiest to do computations in $ million:

NPV today = −500 + (1.2)(100 − 50)/0.10 = +100.

Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: B
Explanation: Easiest to do computations in $ million:

NPV(at t = 1, oil price = $120/bbl.) = −500 + (1.2)(120 − 50)/0.10 = +340.

NPV(at t = 1, oil price = $80/bbl.) = −500 + (1.2)(80 − 50)/0.10 = −140 (reject so NPV = 0).
Expected NPV(at t = 0) = ((0.5)(0) + (0.5)(340))/1.10 = 154.5.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

35) The following are real options except

A) stock options.
B) timing options.
C) options to expand.
D) options to abandon.

Answer: A
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: C
Explanation: Easiest to do computations in $ million:

NPV today = −500 + (1.2) × ((0.5 × 120 + 0.5 × 80) − 50)/0.10 = +100.

NPV(at t = 1, oil price = $120/bbl.) = −500 + (1.2)(120 − 50)/0.10 = +340.

NPV(at t = 1, oil price = $80/bbl.) = −500 + (1.2)(80 − 50)/0.10 = −140 (reject so NPV = 0).

NPV(at t = 1, oil price = $80/bbl.) = 0.

Expected NPV(at t = 0) = ((0.5)(0) + (0.5)(340))/1.10 = 154.5.

Value of the option to wait = 154 − 100 = $54 million.

Difficulty: 3 Hard
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
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.

Answer: D
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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.

Answer: A
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

A) −9.15
percent, calculate Hillary's NPV.

B) +13.99

D) −14.40
C) +5.15

Answer: A
Explanation: Calculate the PV of cash inflows. The 3-year annuity factor at 10 percent equals
2.48685. The 2-year annuity factor at 10 percent equals 1.73554.

PV(Success) = 50 (2.48685) = 124.3426.

PV(Failure) = 10 (1.73554) = 17.3554.

NPV = −80 + (124.3426)(0.5) + (17.3554)(0.5) = -9.15.
Difficulty: 3 Hard
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

A) −9.10
resold at the end of the first year.)

B) +9.10

D) −14.40
C) +13.99

Answer: C
Explanation: Calculate the PV of cash inflows. The 3-year annuity factor at 10 percent equals
2.48685.

NPV with abandonment option:

PV(success) = 50(2.48685) = 124.3426.

PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 (assuming that the equipment will be sold if the action
figure is a failure).

NPV = −80 + (124.3426)(0.5) + (63.6364)(0.5) = +13.99.

Difficulty: 3 Hard
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

A) −9.15
abandonment option. (The discount rate is 10 percent.)

B) +13.99
C) +23.14
D) 0.00

Answer: C
Explanation:
1. Calculate the NPV of the project without an abandonment option.

Calculate the PV of cash inflows. The 3-year annuity factor at 10 percent equals 2.48685. The 2-
year annuity factor at 10 percent equals 1.73554.

PV(Success) = 50 (2.48685) = 124.3426.

NPV = −80 + (124.3426)(0.5) + (17.3554)(0.5) = −9.15.

PV(Failure) = 10 (1.73554) = 17.3554.

2. Calculate the NPV of the project with an abandonment option.

Calculate the PV of cash inflows. The 3-year annuity factor at 10 percent equals 2.48685.

NPV with abandonment option:

PV(success) = 50(2.48685) = 124.3426.
PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 (assuming that the equipment will be sold if the action
figure is a failure).

NPV = −80 + (124.3426)(0.5) + (63.6364)(0.5) = +13.99.

3. Value of the abandonment option = NPV (with the option) − NPV (without the option) =
13.99 − (−9.15) = 23.14.
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: C
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

43) You are given the following net future values for harvesting trees from a plot of forestland.
(This is a one-time harvest.)

Year 0 1 2 3 4 5
Net Future Value 100 125 150 175 195 210

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

Answer: C
Explanation:
Year 0 1 2 3 4 5
Net Future Value 100 125 150 175 195 210
Present Value 100 108.7 113.4 115.1 111.5 104.4

Harvesting in Year-3 provides the highest PV.

Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

product is a failure (40 percent) and withdrawn from the market, then NPV = −$100,000. A
chance that the product will be successful. If successful, the project has a NPV = $500,000. If the

consumer survey will cost $60,000 and delay the introduction by one year. With a survey, there is

other hand, the product is a failure (20 percent) and withdrawn from the market, then NPV = −
an 80 percent chance of consumer acceptance, in which case the NPV = $500,000. If, on the

$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

Answer: A
Explanation: No survey: Expected NPV = 500,000 (0.6) − 100,000 (0.4) = +260,000.

With the survey: Expected NPV = −60,000 + [(500,000)(0.8) − (100,000)(0.2)]/(1.10) =

+285,455.

Increase in NPV by the survey = 285,455 − 260,000 = 25,455.

Difficulty: 3 Hard
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: D
Explanation: PVAF of 12% over three years = 2.4018. Let X = the annual sales volume.

Solve for X if NPV = 0. NPV = −150,000 + 2.4018 × ((150 − 30)X − 30,000)).

150,000/2.4018 = 120X − 30,000.

X = 771
Difficulty: 3 Hard
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: FALSE
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: FALSE
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: FALSE
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: FALSE
Difficulty: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
52) Monte Carlo simulation should be used to get the distribution of NPV values for a project.

Answer: FALSE
Difficulty: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: FALSE
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Operating Leverage
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: TRUE
Difficulty: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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: 2 Medium
Topic: Project Analysis and Evaluation
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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: 2 Medium
Topic: Scenario Analysis
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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: 2 Medium
Topic: Net Present Value
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

62) Briefly discuss break-even analysis.

Answer: 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: 2 Medium
Topic: Break-Even Analysis
Learning Objective: 10-02 Break-Even Analysis and Operating Leverage
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-03 Monte Carlo Simulation
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

64) Briefly explain the term real options.

Answer: 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: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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: 3 Hard
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

66) Define the term abandonment value.

Answer: 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: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

67) Briefly explain timing options.

Answer: 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: 2 Medium
Topic: Project Evaluation
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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: 2 Medium
Topic: Real Options
Learning Objective: 10-04 Real Options and Decision Trees
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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

Answer: 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) are almost always more complex.
Difficulty: 3 Hard
Topic: Sensitivity Analysis
Learning Objective: 10-01 Sensitivity and Scenario Analysis
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation