Question

1. What is break-even analysis and how is it used? 2. Explain the meaning of "real options." What are some of the real options associated with capital budgeting projects? Provide 2-3 and explain.

Answer 1

1. Break even analysis determines the various levels of costs, revenue the profits obtained at various levels of output. It helps us to determine the level of output which will equate the costs with the Revenue.

It helps us determine at what stage of the product , will be the product be successful. It calculated and helps to determine the number of products or services a company should sell to cover its costs , mostly the fixed costs.

Formula is = fixed costs / (total revenue - total costs for production )

Total sales revenue - costs to produce = contribution margin

Real options in capital budgeting :

• Option to expand: this is an option to make an investment or undertake a project for expansion. For example, a business owner thinking of expanding by setting more branches.
• Abandonment option : This option is shutting down a project completely or switching its use to an alternative product. For example a business may abandon a project with a negative NPV.
• option to wait : Sometimes it is beneficial to defer a project, even if it has positive NPV as there is greater value in waiting. It is best to wait, when the cash flows forgone by the waiting is less in comparison to the greater volatility of the expected future cash flows.