Chapter 11: Project Analysis and Evaluation

what will the shapes of total revenue and total costs be on a graph that depicts number of units on the x-axis and dollar amount (revenues and cost) on the y-axis?

Both the total revenue and total cost curves will slope upwards

If Kellog's introduces a new brand of cereal, it will most likely lead to ____ in its sales of existing cereals.

Erosion, i.e., a decrease

T/F: Opportunity costs are irrelevant costs when doing capital budgeting analysis.

False

Sensitivity analysis

investigation of what happens to NPV when only one variable is changed

A firm will start generating positive accounting profits

beyond the break-even sales point.

From a managerial perspective, highly uncertain projects can be dealt with by keeping the degree of operating leverage:

as low as possible

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:

cannot be observed

Variable costs

costs that vary directly with the level of production

A contribution margin of $35 means that _____.

each sale of an additional unit will contribute $35 toward paying fixed costs.

A firm with higher operating leverage will have ____ fixed costs relative to a firm with low operating leverage.

high

A potential problem with DCF analysis is that a project may appear to have a positive NPV because the estimated cash flows are ___.

inaccurate

Fixed Costs

costs that remain constant as output changes

Compute net acct profit based on the following info: Revenues = 4,000; VC = 1,600; FC = 700; Dep = 300; Tax rate = 21%

$1,106 4000 - 1600 - 700 - 300 = 1400 1400 * .21 = 294 1400 - 294 = 1106

A real estate agent has leased 10 rooms in a resort area for $100,000 for the summer season. She hopes to rent these rooms and generate profit for her business. What will the fixed costs be for the real estate agent if only 6 rooms are occupied because of excessive rains?

$100,000 she is paying this no matter what

You are in the business of manufacturing watches. The parts for each of these watches costs an average of $25. Your costs for the month are $3,000. What will be the monthly total variable costs if you manufacture 100 watches?

$2500 ($25 per watch x 100 watches)

Broadband, Inc. has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of _____ as the base case.

$400,000

What is the contribution margin if the sales price per unit is $15,000, variable cost per unit is $10,000 and fixed costs are $2,000? Ignore taxes.

$5,000

The possibility that error in projected cash flows will lead to incorrect decisions is known as:

*Forecasting risk *Estimation risk

Which of the following is a legitimate reason for a project to have a positive NVP for Palmer Corporation?

*Palmer can produce the product more cheaply than it competition *Palmer has a better distribution channel than its competition *Palmer has a better product than its competition

When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in:

- scenario analysis - asking what-if questions

Project net income

= EBIT - taxes or = (Sales - Variable costs - Fixed costs - Depreciation) * (1 - taxes)

Evans Corporation estimated that the cash flows last year from a particular project would be $40,000, but the actual cash flow turned out to be $37,500. Evans Corporations should:

Not expect cash flow estimates to be exactly right every time

Suppose price per unit is $6, variable cost per unit is $2, fixed costs are $400 and the depreciation allowance per year is $500. The relationship between operating cash flow and sales volume (Q) can be expressed as:

OCF = -400 + 4*Q

Which of the following statements is true in the context of comparing accounting profit and present value break even point?

PV is superior to acct profit because it adjusts for time value and considers the depreciation tax shield effect

Degree of Operating Leverage (DOL)

Percentage change in OCF = DOL × Percentage change in Quantity sold or DOL = 1 + FC/OCF

Break-even level equation

Q = (FC + D) / (P - v) or Total units sold = (Fixed costs + Depreciation) / (Selling price per unit - Variable cost per unit)

Which if the following is a fixed cost for a garment manufacturing business?

Rent for the building

Contribution margin per unit

Sales price per unit - Variable Costs per unit

Total Costs TC equation

TC = Total costs + Fixed costs

Total Variable cost TVC equation

TVC = Total quantity of output * Cost per unit of output or VC = Q * v

Base-case NPV

The NPV when sales and other input variables are set equal to their most likely (or base-case) values.

Forecasting risk

The possibility that errors in projected cash flows will lead to incorrect decisions. Also known as estimation risk.

What is the relationship between variable costs and output?

Total variable costs are directly related to the level of output.

in a graph with output on the x-axis and the dollar amount (for costs and revenues) on the y-axis, what will be the shapes of variable and fixed costs?

Variable costs will be upward sloping while fixed costs will be parallel to the x-axis.

An accounting break-even point of 2,000 means the firm ____________.

Will start generating profits if it sells more than 2,000 units

Operating leverage

the degree to which a firm or project relies on fixed costs

when a project breaks even on an accounting basis, the cash flow for that period will equal:

the depreciation allowance for that period

Scenario analysis

the determination of what happens to NPV estimates when we ask what-if questions

Financial break-even

the sales level that results in a zero NPV

Accounting break-even

the sales level that results in zero project net income

Capital rationing

the situation that exists if a firm has positive NPV projects but cannot find the necessary financing

Hard rationing

the situation that occurs when a business cannot raise financing for a project under any circumstances

Soft rationing

the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting

In a competitive market, positive NPV projects are:

uncommon

Compute the NPV of a project that has the following end-of-year cash flow projections: Year 1 = $40,000; Year 2 = $50,000; Year 3 =-$22,000. the project requires an initial investment of $75,000 and has a discount rate of 10%.

-$13,843 (40000/1.1 + 50000/1.1^2 + (-22000)/1.1^3) - 75000

Which of the following are true about depreciation expense?

1) it affects the accounting profit break even point 2) it affects cash flows 3) it is a non cash expense

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

1. it considers the riskiness of the project. 2. it considers time value of money. 3. it considers all the cash flows. 4. it properly chooses among mutually exclusive projects (helps rank).

If fixed costs are $3,500 and the operating cash flow is $4,500, then the degree of operating leverage (DOL) is:

1.78 DOL = 1FC/OCF = 1 3500/4500 = 1.78

What costs are included in the numerator of the accounting profit break-even point equation?

Depreciation and fixed costs

mac company requires a 15 return on its investments. it is considering launching a new ergonomic chair that will sell for $500 and cost $200 per unit to make. Fixed costs will be $1 million per year, and the initial investment for the new product will be $4 million. The company expects the project to last for 10 years, after which there will be innovations that will cause the product to be obsolete. Calculate the financial break-even point for the new product. The ten year annuity factor at 15 percent is 5.0188.

5990 OCF necessary to recover initial investment is: 4,000,000 / 5.0188 = 797,003.37 Q = (FC * OCF)/(P-v) = (1,000,000 * 797,003.37) / (500-200) = 5990