Answers to Concepts Review Questions

1. What is forecasting risk? In general, would the degree of forecasting risk be

greater for a new product or a cost-cutting proposal? Why?
Ans: Forecasting risk is the risk that a poor decision is made because of errors in
projected cash flows. The danger is greatest with a new product because the cash
flows are probably harder to predict.

2. What is the essential difference between sensitivity analysis and scenario

analysis?
Ans: With a sensitivity analysis, one variable is examined over a broad range of
values. With a scenario analysis, all variables are examined for a limited range
of values.

3. A co-worker claims that looking at so much marginal this and incremental that is
a bunch of nonsense, and states, “Listen, if our average revenue doesn’t exceed
our average cost, then we will have a negative cash flow, and we will go broke!”
How do you respond?
Ans: It is true that if average revenue is less than average cost, the firm is losing
money. This much of the statement is correct. At the margin, however, accepting
a project with marginal revenue in excess of its marginal cost clearly acts to
increase operating cash flow.

4. As a shareholder of a firm that is contemplating a new project, would you be

more concerned with the accounting break-even point, the cash break-even point
(the point at which operating cash flow is zero), or the financial break-even point?
Why?
Ans: From the shareholder perspective, the financial break-even point is the most
important. A project can exceed the accounting and cash break-even points but
still be below the financial break-even point. This causes a reduction in
shareholder (your) wealth.

5. Assume a firm is considering a new typical project that requires an initial

investment with sales, variable costs, and fixed costs over its life. Will the project
usually reach the accounting, cash, or financial break-even point first? Which
will it reach next? Last? Will this order always apply?
Ans: The project will reach the cash break-even first, the accounting break-even
next, and finally the financial break-even. For a project with an initial investment
and sales afterwards, this ordering will always apply. The cash break-even is
achieved first since it excludes depreciation. The accounting break-even is next
since it includes depreciation. Finally, the financial break-even, which includes
the time value of money, is achieved.

6. Why does traditional NPV analysis tend to underestimate the true value of a
capital budgeting project?
Ans: Traditional NPV analysis is often too conservative because it ignores profitable
options such as the ability to expand the project if it is profitable, or abandon the
project if it is unprofitable. The option to alter a project when it has already been
accepted has a value, which increases the NPV of the project.

7. How does sensitivity analysis interact with break-even analysis?

Ans: Sensitivity analysis can determine how the financial break-even point changes
when some factors (such as fixed costs, variable costs, or revenue) change.

8. You are discussing a project analysis with a co-worker. The project involves real
options, such as expanding the project if successful or abandoning the project if
it fails. Your co-worker makes the following statement: “This analysis is
ridiculous. We looked at expanding or abandoning the project in two years, but
there are many other options we should consider. For example, we could expand
in one year and expand further in two years. Or we could expand in one year and
abandon the project in two years. There are too many options for us to examine.
Because of this, anything this analysis would give us is worthless.” How would
you evaluate this statement? Considering that with any capital budgeting project
there are an infinite number of real options, when do you stop the option analysis
on an individual project?
Ans: Option analysis should stop when the additional analysis has a negative NPV.
Since the additional analysis is likely to occur almost immediately, then it would
have a negative NPV when the benefits of the additional analysis outweigh the costs.
The benefits of the additional analysis are the reduction in the possibility of making
a bad decision. Of course, the additional benefits are often difficult, if not impossible,
to measure, so much of this decision is based on experience.
 Risk and Real options in Capital Budgeting (Class Notes)

1. We are evaluating a project that costs $604,000, has an 8-year life, and has no salvage
value. Assume that depreciation is straight-line to zero over the life of the project. Sales
are projected at 55,000 units per year. Price per unit is $36, variable cost per unit is $17,
and fixed costs are $685,000 per year. The tax rate is 21 percent and we require a return
of 15 percent on this project.
a. Calculate the accounting break-even point.
b. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to
changes in the sales figure? Explain what your answer tells you about a 500-unit
decrease in projected sales.
c. What is the sensitivity of OCF to changes in the variable cost figure? Explain what
your answer tells you about a $1 decrease in estimated variable costs.

Solutions
1. Initial cost = $ 604,000
Life of project = 8 years
Sales per year = 55,000 units
Selling price(S) = $36
Variable cost (V) = $17
Fixed cost (FC) = $685,000
Tax rate (T) =21%
Required rate of return (K) = 15%
𝐹𝐶+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 $ 685,000+$75,500
a. Accounting BEP = = = 40,026
𝑆−𝑉 $36−$17

Annual depreciation = 604,000/8 = $ 75500

b. Base-case operating cash-flows (OCFbase) = [(S – V)Q – FC](1 – T) + TD
=[(36-17)55000- 685,000](1-0.21)+0.21×75500
= Rs 300,255
Now we can calculate the NPV using our base-case projections. There is no salvage value
so the NPV is:

NPVbase = $300,255(PVIFA15%,8) –$604,000

NPVbase = $743,340.720
 To calculate the sensitivity of the NPV to changes in the quantity sold, we will
calculate the NPV at a different quantity. We will use sales of 56,000 units. The
OCF at this sales level is:

OCFnew = [($36 – 17)(56,000) – $685,000](.79) + .21($75,500)

OCFnew = $315,265

And the NPV is: NPVnew = –$604,000 + $315,265(PVIFA15%,8)

NPVnew = $810,695.42
So, the change in NPV for every unit change in sales is:

NPV ($743,340.72 –$ 810,695.42)

= = +$67.355
S (55000−56000)

If sales were to drop by 500 units, then NPV would drop by:

NPV drop = $67.355(500) = $33,677.35

You may wonder why we chose 56,000 units. Because it doesn’t matter! Whatever
sales number we use, when we calculate the change in NPV per unit sold, the ratio
will be the same.

c. To find out how sensitive OCF is to a change in variable costs, we will compute
the OCF at a variable cost of $18. Again, the number we choose to use here is
irrelevant: We will get the same ratio of OCF to a one dollar change in variable
cost no matter what variable cost we use. So, using the tax shield approach, the
OCF at a variable cost of $18 is:

OCFnew = [($36 – 18)(55,000) – 685,000](1-0.21) + .21($75,500)

OCFnew = $256,805

So, the change in OCF for a $1 change in variable costs is:

OCF
= ($300,255 – 256,805)/($17 – 18) = –$43,450
V

If variable costs decrease by $1 then OCF would increase by $43,450

2. In the previous problem, suppose the projections given for price, quantity, variable
costs, and fixed costs are all accurate to within ±10 percent. Calculate the best-case and
worst-case NPV figures.
Solution: We will use the tax shield approach to calculate the OCF for the best- and
worst-case scenarios. For the best-case scenario, the price and quantity increase by 10
percent, so we will multiply the base case numbers by 1.1, a 10 percent increase. The
variable and fixed costs both decrease by 10 percent, so we will multiply the base case
numbers by .9, a 10 percent decrease.
For the worst-case scenario, the price and quantity decrease by 10 percent, so we will
multiply the base case numbers by .9, a 10 percent decrease. The variable and fixed
costs both increase by 10 percent, so we will multiply the base case numbers by 1.1, a
10 percent increase. Doing so, we get:

After 10% adjustment in Price, quantity, Variable cost and fixed cost:

Best case Worst Case

Price 39.6 32.4
Sales Quantity 60500 49500
Variable Cost 15.3 18.7
Fixed Cost 616500 753500

OCFbest = {[(39.6 – 32.4](60,500) – $616,500(1-0.21) + .21($75,500)

OCFbest = $690,238.50

The best-case NPV is:

NPVbest = $690,238.50(PVIFA15%,8) –$604,000

NPVbest = $2,493,322.07

OCFworst = {[($32.4 – $18.7)](49500) – 753500)}(1-0.21) + .21($75,500)

OCFworst = –$43,671.50

The worst-case NPV is:

NPVworst = – $43,671.50(PVIFA15%,8) –$604,000

NPVworst = –$799,968.06
3. In each of the following cases, find the unknown variable. Ignore taxes.

Accounting Break- Unit Unite Variable Fixed Depreciation

even price Costs Costs
95,800 $42 $30 820,000 ?
143,806 ? 64 2750,000 1150,000
7,835 97 ? 245,000 105,000

Solution:
𝐹𝐶+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Accounting BEP =
𝑆−𝑉
Accounting Break- Unit Unite Variable Fixed Depreciation
even price Costs Costs
95,800 $42 $30 820,000 329,000?
143,806 91.12 ? 64 2750,000 1150,000
7,835 97 52.33 ? 245,000 105,000

4. Ayden’s Toys, Inc., purchased a $435,000 machine to produce toy cars. The machine
will be fully depreciated by the straight-line method over its 5-year economic life. Each
toy sells for $16. The variable cost per toy is $5 and the firm incurs fixed costs of
$295,000 per year. The corporate tax rate for the company is 24 percent. The
appropriate discount rate is 12 percent. What is the financial break-even point for the
project?
Solution: Initial Cost = $ 435,000
Life of asset(n) 5 years
Selling price (s) = $16
Variable cost (V) = $5 and Fixed cost (FC) = $ 295,000
Tax rate (T) = 24% , Discount Rate (K) = 12%
Financial break-even point = ?
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 435,000
Equivalent annual Cost (EAC) = = = $ 120,672
𝑃𝑉𝐼𝐹𝐴12%,5 3.6048

𝐸𝐴𝐶+𝐹𝐶(1−𝑇)−𝑇(𝐷𝐸𝑃)
Financial BEP =
(𝑆−𝑉)(1−𝑇)
120,000+295000(1−0.24)−0.24(87000)
= (16−5)(1−0.24)
= 38,755 units.
5. Option to Wait Your Company is deciding whether to invest in a new machine. The
new machine will increase cash flow by $435,000 per year. You believe the technology
used in the machine has a 10-year life; in other words, no matter when you purchase
 the machine, it will be obsolete 10 years from today. The machine is currently priced
at $2.8 million. The cost of the machine will decline by $215,000 per year until it
reaches $2.155 million, where it will remain. If your required return is 9 percent, should
you purchase the machine? If so, when should you purchase it?
Solution: If this machine is purchased today, the NPV
= $ 435,000(PVIFA9%, 10) – Initial cost
= $ 435,000( 6.4177) - $ 2800,000= -$8300.50
We should not necessarily purchase the machine today. We should want to purchase
the machine when the NPV is the highest. So we need to calculate NPV each year.
Year NPV NPV
1 NPV1 = [435,000( PVIFA9%,9) – (2800,000-215,000)]/ (1.09)1 $ 21038.9
2 NPV2 = [435,000( PVIFA9%,8) – (2585,000-215,000)]/ (1.09)2 $ 31686.15
3 NPV3 = [435,000( PVIFA9%,7) – (2370,000-215,000)]/ (1.09)3 $ 26,512.52
4 NPV4 = [435,000( PVIFA9%,6) – 2155,000]/ (1.09)4 -$ 144,253.38
5 NPV4 = [435,000( PVIFA9%,5) – 2155,000]/ (1.09) 5
-$ 300,919.34
6 NPV4 = [435,000( PVIFA9%4) – 2155,000]/ (1.09)6 -$ 444,649.58
The company should purchase the machine in year 2 when the NPV is the highest.

6. Decision Trees Ang Electronics, Inc., has developed a new DVDR. If successful, the
present value of the payoff (when the product is brought to market) is $24 million. If
the DVDR fails, the present value of the payoff is $8.5 million. If the product goes
directly to market, there is a 50 percent chance of success. Alternatively, the company
can delay the launch by one year and spend $1.2 million to test market the DVDR. Test
marketing would allow the firm to improve the product and increase the probability of
success to 80 percent. The appropriate discount rate is 11 percent. Should the firm
conduct test marketing?
Solution: We need to calculate the NPV of the two options:
Go directly to market now or utilities test marketing first.
The NPV of going directly to the market now is:

NPV = PV of success (Prob. Of success)+ PV of failure ( Prob. Of failure)

= 24000,000(0.5)+ 8500,000(0.5) = $ 16250,000

NPV of test marketing first

=[ CF success ( Prob of success) + CF of failure ( Prob failure](PV factor) – Initial cost

=[ 24000,000(0.80) + 8500,000(0.20)][ PVIF11%,1] – 1200,000

= $ 17,625,828.83

Hence, The Company should test marketing first.

7. (9. Financial Break-Even Analysis) You are considering investing in a company

that cultivates abalone to sell to local restaurants. Use the following information:
Sales price per abalone = $43
Variable costs per abalone = $10.45
Fixed costs per year = $435,000
Depreciation per year = $130,000
Tax rate = 21%
The discount rate for the company is 15 percent, the initial investment in equipment is
$910,000, and the project’s economic life is seven years. Assume the equipment is
depreciated on a straight-line basis over the project’s life and has no salvage value.
a. What is the accounting break-even level for the project?
b. What is the financial break-even level for the project?

Answer: a. Accounting BEP=17358 units & b. Financial BEP = 20,808 units

8. (10. Financial Break-Even) James, Inc., has purchased a brand new machine to
produce its High Flight line of shoes. The machine has an economic life of five years.
The depreciation schedule for the machine is straight-line with no salvage value. The
machine costs $530,000. The sales price per pair of shoes is $75, while the variable cost
is $27. Fixed costs of $235,000 per year are attributed to the machine. The corporate
tax rate is 21 percent and the appropriate discount rate is 8 percent. What is the financial
break-even point?
Answer: Financial BEP = 7809 units
9. (12. Sensitivity Analysis) Consider a project with the following information:
Initial fixed asset investment = $485,000; straight-line depreciation to zero over the 4-
year life; zero salvage value; price = $41; variable costs = $24; fixed costs = $189,000;
quantity sold = 90,000 units; tax rate = 23 percent. How sensitive is OCF to changes in
quantity sold?

Answer: OCF at 90,000 units = 10,60,457.5 and OCF at 91,000 units = 10,73,547.50
ΔOCF/ΔQ = 13.09

10. ( 25. Scenario Analysis) you are the financial analyst for a tennis racket
manufacturer. The company is considering using graphite like material in its tennis
rackets. The company has estimated the information in the following table about the
market for a racket with the new material. The company expects to sell the racket for
 six years. The equipment required for the project will be depreciated on a straight-line
basis and has no salvage value. The required return for projects of this type is 13 percent
and the company has a 21 percent tax rate. Should you recommend the project?

Pessimistic Expected Optimistic

Market size 110,000 120,000 132,000
Market share 20% 23% 25%
Selling price $ 139 $ 143 $ 147
Variable costs per unit $ 77 $ 73 $ 70
Fixed costs per year $ 975,000 $ 920,000 $ 890,000
Initial investment $2,300,000 $2,150,000 $1,950,000

Solution: Calculation of operating cash flows (OCF)

Pessimistic Expected Optimistic

Units per year ( Q) 22,000 27,600 33,000
Revenue ( Q×S) $3,058,000.00 $3,946,800.00 $4,851,000.00
Variable costs ( Q×V) 1,694,000.00 2,014,800.00 2,310,000.00
Fixed costs (FC) 975,000.00 920,000.00 890,000.00
Depreciation (Dep) 383,333.33 358,333.33 325,000.00
EBT $5,666.67 $653,666.67 $1,326,000.00
Tax (21%) 1,190.00 137,270.00 278,460.00
Net income $4,476.67 $516,396.67 $1,047,540.00
OCF ( Net income + Dep) $387,810.00 $874,730.00 $1,372,540.00

Now we can calculate the NPV under each scenario, which will be:

NPVPessimistic = –$2,300,000 + $387,810(PVIFA13%,6)

NPV = –$749,710.22

NPVExpected = –$2,150,000 + $874,730(PVIFA13%,6)

NPV = $1,346,776.73
 NPVOptimistic = –$1,950,000 + $1,372,540(PVIFA13%,6)
NPV = $3,536,796.99

The NPV under the pessimistic scenario is negative, but the company should
probably accept the project.
11. ( 26. Scenario Analysis) Consider a project to supply Detroit with 26,000 tons of
machine screws annually for automobile production. You will need an initial
$2,900,000 investment in threading equipment to get the project started; the project will
last for five years. The accounting department estimates that annual fixed costs will be
$345,000 and that variable costs should be $295 per ton; accounting will depreciate the
initial fixed asset investment straight-line to zero over the 5-year project life. It also
estimates a salvage value of $275,000 after dismantling costs. The marketing
department estimates that the automakers will let the contract at a selling price of $375
per ton. The engineering department estimates you will need an initial net working
capital investment of $500,000. You require a 13 percent return and face a marginal tax
rate of 24 percent on this project.
a. What is the estimated OCF for this project? The NPV? Should you pursue this project?
b. Suppose you believe that the accounting department’s initial cost and salvage value
projections are accurate only to within ±15 percent; the marketing department’s price
estimate is accurate only to within ±10 percent; and the engineering department’s net
working capital estimate is accurate only to within ±5 percent. What is your worst-case
scenario for this project? Your best-case scenario? Do you still want to pursue the
project?
Solution:

a. Using the tax shield approach, the OCF is:

OCF = [($375 – 295)(26,000) – $345,000](1-0.24) + .24($2,900,000/5)

OCF = $1,457,800
And the NPV is:
NPV = –$2,900,000 – 500,000 + $1,457,800(PVIFA13%,5)
+ [$500,000 + 275,000(1 – .24)]/1.135
NPV = $2,112,236.53
b. In the worst-case, the OCF is:
OCFworst = {[($375)(.9) – 295](26,000) – $345,000}(.76) + .24($3,335,000/5)
OCFworst = $737,680
And the worst-case NPV is:
NPVworst = –$3,335,000 – 500,000(1.05) + $737,680(PVIFA13%,5) +
 [$500,000(1.05) + 275,000(.85)(1 – .24)]/1.135
NPVworst = –$884,038.57
The best-case OCF is:
OCFbest = {[$375(1.1) – 295](26,000) – $345,000}(.76) + .24($2,465,000/5)
OCFbest = $2,177,920
And the best-case NPV is:
NPVbest = –$2,465,000 – 500,000(.95) + $2,177,920(PVIFA13%,5) +
[$500,000(.95) + 275,000(1.15)(1 – .24)]/1.135
NPVbest = $5,108,511.63
12. (27.Sensitivity Analysis) in Problem 26, suppose you’re confident about your own
projections, but you’re a little unsure about Detroit’s actual machine screw
requirements. What is the sensitivity of the project OCF to changes in the quantity
supplied? What about the sensitivity of NPV to changes in quantity supplied? Given
the sensitivity number you calculated, is there some minimum level of output below
which you wouldn’t want to operate? Why?
Solution: To calculate the sensitivity to changes in quantity sold, we will choose a
quantity of 27,000. The OCF at this level of sales is:
OCF = [(S-V)Q-FC](1- T) + T(dep)

OCF = [($375 – 295)(27,000) – $345,000](.76) + .24($2,900,000/5)

OCF = $1,457,800

The sensitivity of changes in the OCF to quantity sold is:

OCF/Q = ($1,457,800 – 1,518,600)/(26,000 – 27,000)

OCF/Q = +$60.80

The NPV at this level of sales is:

NPV = –$2,900,000 – 500,000 + $1,518,600(PVIFA13%,5) + [$500,000 + 275,000(1 –

.24)]/1.135
NPV = $2,326,084.19

And the sensitivity of NPV to changes in the quantity sold is:

NPV/Q = ($2,112,236.53 – 2,326,084.19)/(26,000 – 27,000)

 NPV/Q = +$213.85

You wouldn’t want the quantity to fall below the point where the NPV is zero. We
know the NPV changes $213.85 for every unit sale, so we can divide the NPV for
26,000 units by the sensitivity to get a change in quantity. Doing so, we get:

$2,112,236.53 = $213.85(Q)
Q = 9,877

For a zero NPV, sales would have to decrease 9,877 units, so the minimum quantity
is:

QMin = 26,000 – 9,877

QMin = 16,123

13. (30 Financial Break-Even) The Corn chopper Company is considering the purchase
of a new harvester. Corn chopper has hired you to determine the break-even purchase
price in terms of present value of the harvester. This break-even purchase price is the
price at which the project’s NPV is zero. Base your analysis on the following facts:
 The new harvester is not expected to affect revenue, but pre-tax operating expenses
will be reduced by $13,000 per year for 10 years.
 The old harvester is now 5 years old, with 10 years of its scheduled life remaining.
It was originally purchased for $65,000 and has been depreciated by the straight-line
method.
 The old harvester can be sold for $21,000 today.
 The new harvester will be depreciated by the straight-line method over its 10-year
life.
 The corporate tax rate is 22 percent.
 The firm’s required rate of return is 15 percent.
 The initial investment, the proceeds from selling the old harvester and any resulting
tax effects occur immediately.
 All other cash flows occur at year-end.
 The market value of each harvester at the end of its economic life is zero.