Finance 326 - Chapter 11 Key Concepts and Detailed Questions

e 82. Which of the following does NOT require finding the point at which NPV=0? a. Finding the IRR b. Setting a bid price c. Finding the point at which the project pays back on a discounted basis d. Finding the financial break-even point e. Finding the EAC

e. Finding the EAC

e 49. Which of the following statements is false? a. Forecasting risk is the possibility that errors in projected cash flows lead to incorrect decisions. b. Scenario analysis asks what happens to NPV estimates if we ask what-if questions. c. Sensitivity analysis asks what happens to NPV when only one variable changes. d. Simulation analysis is a combination of scenario and sensitivity analysis. e. Fixed costs change when the quantity of output changes during a particular time period.

e. Fixed costs change when the quantity of output changes during a particular time period.

e 43. Which of the following statements is true? a. A project that just breaks even on an accounting basis will not pay back. b. A project that just breaks even on an accounting basis will have a positive rate of return. c. A project cannot earn a positive return unless its payback period is longer than the project life. d. If the net income from a project is zero, then the project will have a discounted payback that is equal to its regular payback. e. The relationship between project life and payback period alone cannot tell you whether a project has a positive or negative NPV.

e. The relationship between project life and payback period alone cannot tell you whether a project has a positive or negative NPV.

a 79. The NPV calculated using static DCF analysis is ________________ if the project gives us the opportunity to invest additional funds if things go well; that is, it includes an option to expand. a. understated b. overstated c. accurately stated even d. not conservative enough e. useless

a. understated

a 9. A project that just breaks even on a financial basis has a discounted payback equal to the project's life.

a. True

a 71. A project that is operating at its __________________ break-even point has operating cash flow equal to zero. a. cash b. accounting c. financial d. sales e. OCF

a. cash

a 75. A project that has an IRR equal to -100 percent is operating at the ______________________ break-even point. a. cash b. accounting c. financial d. income e. OCF

a. cash

a 36. Which of the following statements is true? a. A firm with high operating leverage will have higher total fixed costs than a firm with low operating leverage, all else the same. b. It is typically easier to decrease operating leverage than it is to increase it, all else the same. c. Operating leverage will rise as output increases, all else the same. d. In order to calculate DOL, all that are needed are variable costs and operating cash flows. e. The degree of operating leverage rises as price per unit is increased, all else the same.

a. A firm with high operating leverage will have higher total fixed costs than a firm with low operating leverage, all else the same.

a 56. __________________ are costs that do NOT change directly with the quantity of output. a. Fixed costs b. Variable costs c. Fixed and variable costs d. Semifixed costs e. Semivariable costs

a. Fixed costs

a 25._______________________describes the likelihood of making a bad investment decision because of errors in projected cash flows. a. Forecasting risk b. Erosion c. Scenario risk d. Incremental cash flow risk e. Operating risk

a. Forecasting risk

a 34. Which of the following is a possible reason for determining the accounting break-even point? I. It provides another type of test of accuracy of sales forecasts. II. It is relatively easy to calculate and explain. III. It identifies the contribution a project will make to a firm's cash flow. IV. Because a project that just breaks even on an accounting basis will also break even on a financial basis. a. I and II only b. II and IV only c. I, II, and IV only d. II, III, and IV only e. I, II, III, and IV

a. I and II only

a 58. Which of the following describe(s) fixed costs? I. Are constant for a given period of time II. Costs that are equal to zero when production is zero III. Costs that change with the quantity of output a. I only b. II only c. I and II only d. I and III only e. II and III only

a. I only

a 67. A project that just breaks even on _________________ basis will have a payback exactly equal to the life of the project. I. an accounting II. a cash III. a financial a. I only b. II only c. III only d. I and II only e. II and III only

a. I only

a 30. Which of the following statements about simulation analysis is correct? a. Many different variables can be allowed to take on a large number of values. b. An advantage is that the results often indicate no clear decision rule to follow. c. It is complex and costly, and likely used as a last resort in capital budgeting analysis. d. Powerful computers are making the task of simulation analysis ever more complicated. e. The probability of occurrence of different cases is most likely very difficult to assess.

a. Many different variables can be allowed to take on a large number of values.

a 65. Which of the following describes accounting break-even? In this case, v is variable cost per unit, Q is quantity sold, VC is total variable cost, D is depreciation, and FC is total fixed cost. a. Q = (FC + D)/(P - v) b. Q = (FC - D)/(P + v) c. Q = (P*v)/(FC + D) d. Q = FC + [D/(P - v)] e. Q = FC/(P - v)

a. Q = (FC + D)/(P - v)

a 60. Which of the following are variable costs over a given time period? a. Sales commissions b. Salary of the Chief Financial Officer c. Automobile lease expense d. Wages for the cleaning crew e. Insurance for the corporation's buildings

a. Sales commissions

a 52. If you see a worst case analysis for a project, the project is likely being evaluated using: a. Scenario analysis. b. Sensitivity analysis. c. Base-case analysis. d. Simulation analysis. e. Multiple-outcome analysis.

a. Scenario analysis.

a 1. Soft rationing, if it persists, is most likely bad for stockholders

a. True

a 13. Capital intensive projects have a high degree of operating leverage.

a. True

a 15. Just because the cash flows of a project are positive doesn't mean the NPV is positive.

a. True

a 16. The higher the degree of operating leverage, the greater the danger of forecasting risk.

a. True

a 17. Fixed costs do not change when the quantity of output changes during a particular time period.

a. True

a 18. Simulation analysis is a combination of scenario and sensitivity analysis.

a. True

a 20. Of the breakeven levels discussed, the financial break-even point is likely to be the most important point for a firm to identify.

a. True

a 4. DOL is equal to the percentage change in OCF divided by the percentage change in sales quantity.

a. True

a 84. If a firm's total dollar fixed costs are exactly equal to its depreciation (both are greater than zero), then at its financial break-even its DOL __________________. (The project has conventional cash flows, no salvage value, and no net working capital.) a. is less than two b. is equal to two c. is greater than two d. is undefined since you can't divided by zero e. cannot be determined without more information

a. is less than two

a 35. Any time a manager replaces a variable cost with a fixed cost, the firm's ________________ effectively increases. a. operating leverage b. managerial options c. projected cash flow d. sensitivity contribution e. total variable cost

a. operating leverage

a 22. Positive net present value projects ____________________________ a. tend to be rare in a highly competitive market b. will likely have a source of value that is difficult to determine c. tend to be rare in a highly monopolistic market d. will typically occur in international markets, but not domestic markets e. are common for firms in old, well established industries

a. tend to be rare in a highly competitive market

a 80. The NPV calculated using static DCF analysis is _______________ if the project gives us the opportunity to abandon the project if things go poorly; that is, it includes an option to abandon. a. understated b. overstated c. accurately stated even d. not conservative enough e. useless

a. understated

b 59. Which of the following is considered a fixed cost over a given time period? a. Sales commissions b. Salary of the Chief Financial Officer c. Advertising expenditures d. Shipping expense e. The cost of electricity

b. Salary of the Chief Financial Officer

c 69. A project that just breaks even on __________________ basis will have a payback shorter than the life of the project. I. an accounting II. a cash III. a financial a. I only b. II only c. III only d. I and II only e. II and III only

c. III only

b 31. ______________ analysis is a useful tool for directly examining the relationship between sales volume and profitability. a. Scenario b. Break-even c. Strategic options d. Simulation e. Contingency

b. Break-even

b 10. A project that just breaks even on an accounting basis has a discounted payback period equal to its life.

b. False

b 11. A project that just breaks even on a cash basis has a discounted payback period equal to its life.

b. False

b 12. If a project's base case NPV is positive the project should automatically be accepted.

b. False

b 14. If a division of a firm faces soft rationing and finds a worthwhile positive NPV project, it is unlikely more capital can be obtained from the firm.

b. False

b 19. If you are interested in finding out how sensitive your NPV estimate is to changes in the gross profit margin, you should use scenario analysis.

b. False

b 2. A firm that cannot raise funds in the financial markets in order to finance positive NPV projects is said to face soft capital rationing.

b. False

b 3. A firm that cannot obtain funds to finance positive NPV projects due to internal constraints is said to be facing hard capital rationing.

b. False

b 5. A firm that substitutes labor for machinery and equipment is said to be capital-intensive.

b. False

b 6. A project that just breaks even on a financial basis has a profitability index equal to zero.

b. False

b 7. A project that just breaks even on a cash basis must have a zero NPV.

b. False

b 8. A project that just breaks even on an accounting basis must have a positive NPV.

b. False

b 46. The higher the degree of operating leverage, the _____________________. I. greater is the risk of forecasting error II. lower is the risk of forecasting error III. higher the break-even point, regardless of the measure IV. lower the break-even point, regardless of the measure a. I only b. I and III only c. I and IV only d. II and III only e. II and IV only

b. I and III only

b 41. Which of the following is/are true regarding soft rationing (SR) and hard rationing (HR)? I. HR is self imposed while SR is imposed by the marketplace. II. SR affects individual parts of a company while HR affects the company as a whole. III. SR can lead to HR. a. I only b. II only c. I and II only d. I and III only e. I, II, and III

b. II only

b 47. _____________________ refers to the possibility that we make a bad decision because of errors in the projected cash flows. I. Scenario risk II. Forecasting risk III. Leverage risk a. I only b. II only c. I and III only d. II and III only e. I, II, and III

b. II only

b 68. A project that just breaks even on _____________________ basis will not pay back. I. an accounting II. a cash III. a financial a. I only b. II only c. III only d. I and II only e. II and III only

b. II only

b 72. A project that has a NPV less than zero will also: I. Have a discounted payback period less than its life. II. Exceed its accounting break-even point. III. Have an IRR less than the required return. IV. Have a PI less than one. a. I and III only b. III and IV only c. II and III only d. I, III, and IV only e. I, II, III, and IV

b. III and IV only

b 45. Which of the following is generally LEAST subject to forecasting risk? a. Projected sales b. Initial investment c. Projected fixed costs d. Price per unit e. Total variable costs

b. Initial investment

b 39. Which of the following statements regarding NPV analysis is true? a. NPV calculations do not depend critically on cash flow projections. b. NPV calculations are only as good as the information that goes into their calculation. c. Negative NPV projects should be scrutinized to make sure there is a sound economic basis underlying them. d. Positive NPV projects that have relatively low levels of fixed costs should be more heavily scrutinized than projects with relatively high levels. e. NPV calculations will be correct if the wrong discount rate is used.

b. NPV calculations are only as good as the information that goes into their calculation.

b 28. Which of the following statements is false regarding scenario analysis? a. A positive NPV for a project's worst case scenario does not necessarily guarantee you a positive return from the project. b. The goal with the worst case scenario is to identify the point where NPV becomes negative. c. The base case scenario generally represents an average estimate of NPV. d. If the NPV of the best case scenario is negative then it is likely unnecessary to create base and worst case scenario. e. Scenario analysis is likely not as effective as sensitivity analysis for determining which variables have the greatest impact on projected NPVs.

b. The goal with the worst case scenario is to identify the point where NPV becomes negative.

b 26. After ten years as a general auto mechanic in a local garage, Joe decides he is tired of working for others, especially since business is typically slow and he works partially on commission. So, he decides to open his own garage. After estimating the cash flows for his new garage, he finds a large, positive NPV. Which of the following is most likely true about his analysis? a. The discount rate he used must be too high. b. Unless he can find a true source of value in his new venture, he probably made a mistake in estimating his cash flows. c. He has likely been overly optimistic about the future and has underestimated future cash flows. d. His estimates of initial outlays must be in error. e. His analysis is probably correct provided there is adequate competition in the auto repair

b. Unless he can find a true source of value in his new venture, he probably made a mistake in estimating his cash flows. business.

b 74. The sales level that results in EBIT equal to zero is called the __________________ break-even point. a. cash b. accounting c. financial d. income e. OCF

b. accounting

b 21. Projected cash flow is typically defined to be a. the best case expected cash flow b. an average of the possible cash flows from the various scenarios c. the largest possible cash flow d. the cash flow that results in the lowest NPV but still allows the project to be accepted e. the least likely cash flow

b. an average of the possible cash flows from the various scenarios

b 38. A golf course/property developer buys twice as much land as needed to build an 18-hole golf course and housing development so that, if things go very well, a second 18-hole golf course and housing project can be added later without acquiring more land. The developer is prepared to exercise the option to _____________________. a. quit b. expand c. abandon d. wait e. rebuild

b. expand

b 61. Costs that result from a small change in output are called __________________ costs. a. fixed costs b. marginal costs c. average costs d. special costs e. product costs

b. marginal costs

b 51. You want to determine how changes in the price of a product affect a project's NPV and IRR. To determine the impact, you should use ______________ analysis. a. scenario b. sensitivity c. base-case d. simulation e. multiple-outcome

b. sensitivity

b 23. Which of the following does NOT correctly complete this sentence: Conventional capital budgeting analysis will tend to understate the true NPV of a project unless _________________ is considered. a. a contingency plan option b. the option to default c. the option to expand d. the option to abandon e. the option to wait

b. the option to default

c 76. A project that has an IRR equal to _____________________ just breaks even on an accounting basis. a. its required return b. its AAR c. 0 percent d. 100 percent e. -100 percent

c. 0 percent

c 70. A project with conventional cash flows that just breaks even on an accounting basis: a. Pays back on a discounted basis. b. Pays back on a conventional basis prior to the end of the life of the project. c. Has an IRR that is equal to zero. d. Has a positive NPV. e. Has a PI that is greater than one.

c. Has an IRR that is equal to zero.

c 85. Which of the following is/are true about a project that just breaks even on an accounting basis? I. The project has an IRR = 0% II. The project has an IRR = -100% III. The project has a negative NPV IV. The project has an NPV of zero V. The project has an IRR equal to the firm's required return a. II only b. III only c. I and III only d. I and IV only e. II and IV only

c. I and III only

c 24.________________analysis allows a firm to ask what-if type questions in capital budgeting. I. Scenario II. Sensitivity III. Simulation IV. Break-even a. I and II only b. II and III only c. I, II, and III only d. I, II, and IV only e. I, II, III, and IV

c. I, II, and III only

c 87. Which of the following is/are true about a project that breaks even on a financial basis? I. The project has an IRR = 0% II. The project has an IRR = -100% III. The project has a negative NPV IV. The project has an NPV of zero V. The project has an IRR equal to the firm's required return a. I only b. III only c. IV and V only d. I and III only e. II and IV only

c. IV and V only

c 78. A firm that faces capital rationing must select a subset of capital projects based on some ranking criterion. The capital budgeting technique best suited for this is the ________________. a. NPV b. IRR c. PI d. AAR e. payback

c. PI

c 33. A farmer in the Midwest hires a grain harvesting crew from Oklahoma to harvest his wheat at the end of each summer. Because the crop yield varies from year to year, the crew charges the farmer according to the number of bushels actually harvested. For capital budgeting purposes, the harvesting charges should be classified as a: a. Fixed cost since they must be paid each year. b. Fixed cost since the crew will be paid regardless of whether or not the crop is harvested. c. Variable cost since, if the crop yield is zero bushels, the crew receives no payment. d. Combination of fixed and variable cost, the variable portion of which is based on forecasted bushels harvested. e. Variable cost only if the crop yield is poor in a given year.

c. Variable cost since, if the crop yield is zero bushels, the crew receives no payment.

c 50. In previous chapters, we calculated NPV based on a project's average or expected forecasted cash flows. When doing what-if analysis, this initial estimate is called the __________________. a. initial analysis b. first go-around c. base case d. initial projection e. best case scenario

c. base case

c 42. Your company's scientists have developed an exciting new product that is unlike anything presently available to consumers. The NPV of bringing the product to market is positive yet you are uncertain about the sales projections. The best way for you to test the validity of the sales projections is to use ______________________ analysis. a. sensitivity and payback b. payback and break-even c. break-even and sensitivity d. operating leverage e. IRR

c. break-even and sensitivity

c 37. The process of identifying managerial options implicit in a project is known as _______________ analysis. a. scenario b. sensitivity c. contingency d. break-even e. discretionary

c. contingency

c 73. A project that is operating at its ___________________ break-even point will have an NPV equal to zero. a. cash b. accounting c. financial d. NPV e. OCF

c. financial

c 77. A project that has an IRR equal to _________________ just breaks even on a financial basis. a. 0 percent b. its AAR c. its required return d. 100 percent e. -100 percent

c. its required return

c 32. A financial manager reviewing a project is concerned about the level of forecasting risk in the project's forecasted cash flows. The manager should use ______________ analysis to identify the variable that presents the highest degree of forecasting risk. a. scenario b. simulation c. sensitivity d. break-even e. strategic options

c. sensitivity

c 54. A project has a required return of 10%. At the accounting break-even, _______________________________. a. NPV is positive b. net income is positive c. the project OCF is equal to depreciation d. a project's cash flow is equal to zero each year e. price per unit and variable cost per unit are equal to one another

c. the project OCF is equal to depreciation

d 27. The purpose of scenario analysis is to: a. Evaluate all possible cash flow forecasts. b. Evaluate all possible contingencies and prepare for the occurrence of each. c. Analyze highly negative NPV projects more closely. d. Assess the reasonableness of the cash flows that form the basis for an NPV calculation. e. Gauge the effectiveness of a capital budgeting project after it is already operating.

d. Assess the reasonableness of the cash flows that form the basis for an NPV calculation.

d 81. All else the same, if you decrease the level of fixed costs, which of the following will also fall? I. Operating leverage II. Accounting break-even III. Operating cash flow IV. Cash break-even a. I and II only b. II and IV only c. I, II, and III only d. I, II, and IV only e. I, II, III, and IV

d. I, II, and IV only a. I and II only

d 57. Which of the following describe(s) variable costs? I. Costs that can be forecasted with a high degree of accuracy II. Costs that are equal to zero when production is zero III. Costs that change with the quantity of output a. II only b. I and II only c. I and III only d. II and III only e. I, II, and III only

d. II and III only

d 86. Which of the following is/are true about a project that breaks even on a cash basis? I. The project has an IRR = 0% II. The project has an IRR = -100% III. The project has a negative NPV IV. The project has an NPV of zero V. The project has an IRR equal to the firm's required return a. I only b. II only c. III only d. II and III only e. II, III, and V only

d. II and III only

d 40. You have put together a set of cash flow forecasts for a project and have found, on your first calculation, that the NPV is positive. You should: I. Accept the project because you are certain to increase shareholder wealth. II. Try to identify some source of value in the project. III. Use scenario or sensitivity analysis to investigate the project further. IV. Try to assess the degree of forecasting risk there is in the project. a. I and II only b. I, II, and IV only c. I, III, and IV only d. II, III, and IV only e. II and IV only

d. II, III, and IV only

d 63. Which of the following statements is false regarding break-even? a. Accounting break-even is the sales level that results in zero project net income. b. The cash break-even is the sales level that results in $0.00 OCF. c. The financial break-even is the sales level that results in a zero NPV. d. If there is depreciation the cash break-even will exceed accounting break-even. e. Of the three break-evens, the financial break-even level of sales is typically the highest.

d. If there is depreciation the cash break-even will exceed accounting break-even.

d 44. The accounting break-even: a. Indicates when NPV turns positive. b. Excludes depreciation in its computation. c. Is the same as the internal rate of return. d. Indicates the point at which operating cash flow is equal to depreciation. e. Describes the point below which the sales level results in a positive net income.

d. Indicates the point at which operating cash flow is equal to depreciation.

d 53. Which of the following would likely lead to the largest number of NPV calculations? a. Scenario analysis b. Sensitivity analysis c. Base-case analysis d. Simulation analysis e. Contingency analysis

d. Simulation analysis

d 55. __________________ analysis combines __________________ analysis and __________________ analysis. a. Scenario; sensitivity; simulation b. Sensitivity; simulation; scenario c. Option; scenario; simulation d. Simulation; scenario; sensitivity e. Simulation; sensitivity; option

d. Simulation; scenario; sensitivity

d 62. Which of the following describes total cost? In this case, v is variable cost per unit, Q is quantity sold, VC is total variable cost, and FC is total fixed cost. a. TC = v*Q b. TC = v + FC*Q c. TC = VC - FC d. TC = v*Q + FC e. TC = v*Q + FC*Q

d. TC = v*Q + FC

d 83. If a firm's total dollar fixed costs are exactly equal to its depreciation (both are greater than zero), then at its cash break-even its DOL __________________. a. is equal to one b. is equal to two c. is greater than two d. is undefined since you can't divide by zero e. cannot be determined without more information

d. is undefined since you can't divide by zero

d 64. The _________________________ is also known as the contribution margin per unit. a. unit fixed cost - selling price b. unit selling price - unit fixed cost c. unit variable cost - unit fixed cost d. unit selling price - unit variable cost e. unit variable cost - unit selling price

d. unit selling price - unit variable cost

d 66. Which of the following does NOT correctly complete this sentence: A project that just breaks even on an accounting basis _____________________________. a. will lose money in a financial sense b. will result in zero taxes paid c. will not affect total net income for a firm d. will have either positive or negative EBIT e. will have operating cash flows equal to depreciation

d. will have either positive or negative EBIT

e 48. Economic theory suggests that _________________ the likelihood of discovering a positive NPV project. a. the more competitive the market, the higher b. there is a positive relationship between the competitiveness of a market and c. the competitiveness of a market has an indirect impact on d. the competitiveness of a market has an insignificant impact on e. competitive markets decrease

e. competitive markets decrease

e 29. In _______________ analysis we investigate the impact on NPV of allowing one variable to change while holding all other variables constant. a. scenario b. break-even c. strategic options d. simulation e. sensitivity

e. sensitivity