Principles of Finance - Chapter 11 and Smartbook

Base Case

initial set of projections

Forecasting Risk

the possibility that errors in projected cash flows will lead to incorrect decisions

In a competitive market, positive NPV projects are:

uncommon

The ___________ cost is equal to the quantity of output times the cost per unit of output.

variable

The basic approach to evaluating cash flow and NPV estimates involves asking _____.

what-if questions

An accounting break-even point of 1,000 units means that ____.

when the firm sells 1,000 units, profits will be equal to zero

The possibility that errors in projected cash flows will lead to incorrect decisions is known as _____.

forecasting risk estimation risk

The situation that occurs when a business cannot raise financing for a project under any circumstances is called _____________ rationing.

hard

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

high

A firm with higher operating leverage will have ____________ (low/high) fixed costs relative to a firm with low operating leverage.

high

For all practical purposes, it is easier to _____.

increase operating leverage than to decrease it

Corporate managers care about the break-even point because it indicates the level _____.

to which sales can fall before a project will start losing money

Total fixed costs remain constant while total variable costs ________________ (decrease/increase) if the level of output increases.

increase

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

Depreciation Fixed Costs

Which of the following are true about depreciation expense?

-It affects cash flows. -It affects the accounting profit break-even point. -It is a noncash expense.

Which of the following is a fixed cost for a tire manufacturing business?

-Building rent of $10,000/month -Manager's salary of $98,000/year

Smith Corporation has variable costs equal to $5.10 per unit, fixed costs of $11,000, and total output equal to 240 units. What is the total cost?

$12,224 ($5.1 x 240) + $11,000

Ranger Corporation is currently selling widgets for $40 at a cost of $20 per unit. Fixed costs are currently $500 and the current production is 100 widgets. What is the Operating Cash Flow at this output level?

$1500

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

Scenario Analysis

Basic form of what-if analysis. The determination of what happens to NPV estimates when we ask what-if questions.

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 upward.

Which of the following defines the contribution margin per unit? Ignore taxes.

Contribution Margin per Unit = Sales price - Variable cost per unit

The _____ is the percentage change in operating cash flow relative to the percentage change in quantity sold.

DOL

Which of the following is the correct equation for the degree of operating leverage?

DOL = 1 + FC/OCF

In the context of capital budgeting, what does sensitivity analysis do?

It examines how sensitive a particular NPV calculation is to changes in underlying assumptions.

Which of the following costs relating to a doctor's office are variable costs?

Lab reports for patients Medical supplies

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 (OCF) and sales volume (Q) can be expressed as:

OCF = −400 + 4*Q

________________ value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect.

Present

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

Present value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect.

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

Rent for the building

Which of the following is an example of a sunk cost?

Research and development expense incurred in the past

______________ analysis determines the impact on NPV of a set of events relating to a specific situation.

Scenario

_______________ analysis involves estimating the best-case, worst-case, and base-case cash flows and calculating the corresponding NPVs.

Scenario

What is scenario analysis?

Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.

The financial break-even point differs from the accounting break-even point for which of the following reasons?

The financial break-even point adjusts for time value of money.

Which one of the following will be used in the best-case analysis of a proposed project?

The lowest variable cost per unit that can reasonably be expected

Which of the following is an opportunity cost in the context of a vacant building that a firm currently owns?

The potential rental income lost by using the empty building for a project

Which of the following are true about variable costs?

The variable cost per unit may remain constant as the number of units produced increases.

What is the purpose of accounting profit break-even analysis?

To determine the level of sales at which profits are equal to zero.

What is the relationship between variable costs and output?

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

True or false: Depreciation expense on a specific asset could be a fixed dollar amount or a variable dollar amount.

True

True or false: Opportunity costs are irrelevant costs when doing capital budgeting analysis.

True

True or false: Ultimately, we are more interested in cash flow than accounting income.

True

Financial break-even is the sales level that results in _____.

an NPV of zero

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

as low as possible

To be considered good, projected cash flows should _____ actual cash flows.

be close to

A firm will start generating positive accounting profits _____.

beyond the break-even sales point

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

The sales level that results in a zero operating cash flow is called the _____________ break-even.

cash

The _________ break-even is the sales level that results in a zero NPV.

financial

The ___________ break-even is the sales level that results in a zero NPV.

financial

The ____________ break-even point adjusts for time value of money, whereas the ______________ break-even point does not.

financial; accounting

The possibility that errors in projected cash flows will lead to incorrect decisions is called _____________ , or estimation, risk.

forecasting

Sensitivity Analysis

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

An investment has a positive net present value if its _____________ ____________ exceeds its cost.

market value

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 Corporation should _____.

not expect cash flow estimates to be exactly right every time

West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.

reliability

A fixed cost is a cost that _____.

remains constant as the level of business activity changes

In a simulation, the average NPV and the spread of NPVs around the average are determined by _____.

repeated random drawings

Corporate managers care about the break-even point because it indicates the level to which _____ can fall before a project will start losing money.

sales

In simulation analysis, a combination of _____ analysis and _____ analysis is used.

scenario; sensitivity

The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting is called ____________ rationing.

soft

A 5-year project is expected to generate annual sales of 9,600 units at a price of $83 per unit and a variable cost of $54 per unit. The equipment necessary for the project will cost $373,000 and will be depreciated on a straight-line basis over the life of the project. Fixed costs are $225,000 per year and the tax rate is 21 percent. How sensitive is the operating cash flow to a $1 change in the per unit sales price?

$7,584

Which of the following represents the accounting profit break-even point?

(Fixed costs + Depreciation)/Contribution margin

If the proposal under consideration involves a new product, then we might ask questions such as the following:

-Are we certain that our new product is significantly better than that of the competition? -Can we truly manufacture at lower cost, or distribute more effectively, or identify undeveloped market niches, or gain control of a market?

Which of the following statements are true regarding fixed and variable costs?

-Fixed costs per unit will decrease while variable costs per unit will stay constant if the level of output increases. -Total fixed costs remain constant while total variable costs increase if the level of output increases.

Which of the following are examples of fixed costs for a car repair shop performing oil changes and other repairs?

-Insurance for the shop -Monthly rent for the shop -Salary for the shop manager

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

-NPV considers all the cash flows. -NPV considers time value of money.

Which of the following are examples of variable costs for a car manufacturer?

Labor costs The cost of steel Freight costs

You are evaluating a project and are concerned about the reliability of the cash flow forecasts. To reduce any potentially harmful results from accepting this project, you should consider:

Lowering the degree of operating leverage

Which of the following equations correctly relates OCF to sales volume?

OCF = (P − v) × Q − FC

What is the difference between scenario analysis and sensitivity analysis?

Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at at time.

______________________ analysis is the investigation of what happens to NPV when only one variable is changed.

Sensitivity

_________________-- analysis uses a combination of scenario and sensitivity analysis.

Simulation

Total Variable Cost (TVC) formula

TVC = Total quantity of input x Cost per unit of output (TVC = Q x v)

Capital rationing exists when a company has identified positive NPV projects but can't find _____.

The necessary financing

True or false: When a business does hard rationing, the firm's DCF analysis breaks down.

True

In a graph with output on the x-axis and 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

When McDonald's decides to build a new restaurant at a particular location, which of the following competitors might also be tempted to locate new facilities in the same area?

Wendy's and Burger King

Simulation Analysis

a combination of scenario and sensitivity analysis

A legitimately positive NPV may be due to all of the following except _____.

a poll showing your customers prefer your product, when actual data shows that is not the case

A situation in which a firm has positive NPV projects but cannot find the necessary financing is called capital _______________.

rationing

When using _______________ all of the variables except one are frozen in order to determine how sensitive the NPV estimate is to changes in that particular variable.

sensitivity analysis Reason: Break-even analysis finds the quantity sold that will result in an NPV of zero (or accounting profits of zero, depending on the type of break-even analysis). Also, simulations change multiple variables simultaneously thousands of times to find the likelihood that the NPV will be positive under numerous assumptions.

The Omega Division of Alpha Corporation has been allocated $4 million for capital spending but has identified $4.6 million in positive NPV projects. Omega's manager thinks he can convince the company to fund the additional $0.6 million dollars because Omega uses _______ rationing to control overall spending.

soft

What are the two main benefits of performing sensitivity analysis?

-It identifies the variable that has the most effect on NPV. -It gives a range of values for NPV instead of a single value, so it gives a more realistic picture.

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

-Palmer has a better product than its competition. -Palmer has a better distribution channel than its competition. -Palmer can produce the product more cheaply 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

What is the total number of inputs that change while doing sensitivity analysis?

1

Broadband, Inc. has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $1,000,000. 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.

1,000,000

N Corp has a variable cost per unit of $1.20, and the lease payment on the production facility runs $4,200 per month. N Corp sells the units at $4.60 and has depreciation equal to $225. What is the amount of units that N Corp needs in order to break-even?

1,301 Break Even Level = (FC+D)/(P-V)

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

inaccurate

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

inaccurate or wrong

Total fixed costs remain constant while total variable costs __________________ (decrease/increase) if the level of output increases.

increase

What are the two main drawbacks of sensitivity analysis?

-It does not consider interaction among variables. -It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.

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

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

The contribution margin per unit will increase if ____.

the sales price per unit increases while the variable cost per unit decreases

The cash break-even is the sales level that results in a ______ operating cash flows.

zero

A project with a life of 6 years is expected to provide annual sales of $340,000 and costs of $237,000. The project will require an investment in equipment of $610,000, which will be depreciated on a straight-line method over the life of the project. You feel that both sales and costs are accurate to +/−15 percent. The tax rate is 21 percent. What is the annual operating cash flow for the best-case scenario?

$171,095

As a practical matter, it is easier to _________________ (decrease/increase) operating leverage than it is to __________________ (decrease/increase) it.

increase; decrease