Question

1. If a 20% reduction in a project’s forecast sales would still result in a positive NPV, then sensitivity analysis would suggest:

a. that there is little point in further market research.

b. that a more detailed sales forecast is required.

c. that the initial sales forecasts were inflated.

d. that more of the company’s overhead costs can be allocated to this product.

2. A firm has a tract of timber. The future growth rate of the trees and the price of lumber are uncertain. The firm:

a. has an expansion option.

b. has an option to vary the production technology.

c. should harvest the timber immediately if NPV is positive.

d. has a timing option.

3. The greater the ratio of variable costs to sales, the:

a. more each additional sale contributes to the coverage of fixed costs.

b. lower the level of profitability.

c. more units that must be sold to cover fixed charges.

d. lower the benefit of conducting a sensitivity analysis.

4. The option to switch between using oil or natural gas in a power station is:

a. an option to expand.

b. an option to abandon.

c.a production flexibility option.

d. a timing option.

5. Assume a 5-year project has a base-case NPV of $213,000, a tax rate of 34%, and a cost of capital of 14%. What will be the worst-case NPV if the annual after-tax cash flows are reduced in that scenario by $35,000 for each of the 5 years?

a. ?$92,842.17

b. ?$120,157.83

c. $92,842.17

d. $120,157.83

6. Which one of these projects would you always reject?

a.High operating leverage, sales projected at the accounting break-even level, and no option to abandon or expand.

b.High operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand.

c.Low operating leverage, sales projected at the accounting break-even level, and an option to abandon or expand.

d.Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand.

7. If project sales exceed the accounting break-even point, but the project has a negative EVA, then the project has a:

a.positive NPV but earns less than the discount rate.

b.negative NPV but earns more than the discount rate.

c.net loss on the income statement.

d. net profit but negative NPV.

8. What is the economic break-even level of sales for a project costing $4,000,000 and generating annual cash flows equal to 0.30 × sales ? $450,000? Assume the project will last 10 years and require a discount rate of 12%.

a.$2,093,654

b.$2,359,047

c.$3,859,789

d. $13,783,333

9. If the firm's degree of operating leverage is 4.5, what percentage change in sales will result in a 3% rise in profits?

a.0.33%

b.0.67%

c.3.03%

d. 1.50%

Answer 1

1. If a 20% reduction in a project’s forecast sales would still result in a positive NPV, then sensitivity analysis would suggest:

a. that there is little point in further market research.

b. that a more detailed sales forecast is required.

c. that the initial sales forecasts were inflated.

d. that more of the company’s overhead costs can be allocated to this product.

Answer: (D) that more of the company’s overhead costs can be allocated to this product

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.

Sensitivity analysis helps a business estimate what will happen to the project if the assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to see the impact on the project's finances. In this way, it prepares the business's managers in case the project doesn't generate the expected results, so they can better analyze the project before making an investment.

Thus, if NPV is still positive after 20% reduction in project's forecaste sale, then anaysis will suggest to inrease the cost factor to understand the opposite condition.

2. A firm has a tract of timber. The future growth rate of the trees and the price of lumber are uncertain. The firm:

a. has an expansion option.

b. has an option to vary the production technology.

c. should harvest the timber immediately if NPV is positive.

d. has a timing option.

Answer: (d) has a timing option.

As firm's production & revenue is uncertain then firm can use timing option for delivery. It is an option given to the seller of an interest rate futures contract which gives the seller a choice of different delivery dates. The seller can choose from different delivery months provided that the delivery date satisfies the seller's contractual obligation to the buyer.

3. The greater the ratio of variable costs to sales, the:

a. more each additional sale contributes to the coverage of fixed costs.

b. lower the level of profitability.

c. more units that must be sold to cover fixed charges.

d. lower the benefit of conducting a sensitivity analysis.

Answer: (C) more units that must be sold to cover fixed charges.

The variable cost ratio is an expression of a company's variable production costs as a percentage of sales, calculated as variable costs divided by total revenues. It compares costs that change with levels of production to the amount of revenues generated by production. This contrasts with fixed costs that remain constant regardless of production levels. Thus, if variable cost to sale ratio is high, then sale's portion to cover fixed cost is low & so we need to sell more units to cover fixed cost.

4. The option to switch between using oil or natural gas in a power station is:

a. an option to expand.

b. an option to abandon.

c.a production flexibility option.

d. a timing option.

Answeer: (a) an option to expand.

Getting flexibility to switch between oil & natural gas increases chances to expand for the station.

6. Which one of these projects would you always reject?

a.High operating leverage, sales projected at the accounting break-even level, and no option to abandon or expand.

b.High operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand.

c.Low operating leverage, sales projected at the accounting break-even level, and an option to abandon or expand.

d.Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand

Answer: (D) Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand

With NPV break-even, its not profitable & low operating leverage also means low gross margins, thus its not profitable.

7. If project sales exceed the accounting break-even point, but the project has a negative EVA, then the project has

a.positive NPV but earns less than the discount rate.

b.negative NPV but earns more than the discount rate.

c.net loss on the income statement.

d. net profit but negative NPV.

Answer: (d) net profit but negative NPV.

Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company.
Thus, negative EVA means cost of investement will not be covered by investors.

9. If the firm's degree of operating leverage is 4.5, what percentage change in sales will result in a 3% rise in profits?

a.0.33%

b.0.67%

c.3.03%

d. 1.50%

Answer: (D) 1.5%

Degree of Operating Leverage = Contribution Margin (CM) / Net Operating Income (NOI) = (Revenue - Total Variable Cost) / Net Operating Income = Quantity x (Price - Variable Cost per Unit) / [Quantity x (Price - Variable Cost per Unit) - Fixed Operating Cost]

Operating Leverage: 4.5 & rise in profit is 3%, thus percentage change in sales is 1.5% (4.5/3)