FIN 3403 Chapter 11 Smartbook

In a competitive market, positive NPV projects are:

Uncommon

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

*Burger King *Wendy's

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

*Forecasting risk *Estimation risk

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 NVP are positive

What are the two main benefits of performing sensitivity analysis?

*It identifies the variable that has the most effect in NVP *It reduces a false sense of security by giving a range of values for NVP instead of a single value

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 is a sunk cost?

A cost incurred in the past that is irrelevant to the capital investment decision process.

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

As low as possible

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

Opportunity costs are irrelevant costs when doing capital budgeting analysis.

False

The Alpha Division of Beta Corporation has been allocated $4 million for capital spending but has identified $4.6 million in positive NVP projects. Alpha's manager doesn't believe she can convince the company to fund the additional $0.6 million dollars because Omega is using ____ rationing because of a severe downturn in the company's overall prospects.

Hard

A firm with a higher operating leverage will have ____ 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

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

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

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

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

In a simulation, the average NVP and the spread of NVPs around the average are determined by:

Repeated random drawings

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

Research and development expense incurred in the past

The NPVs in the table below were generated using sensitivity analysis. Where should managers focus their attention? Pessimistic Expected Market Share -$1,310 $2,000 Variable Costs $1,000 $2,000 Fixed Costs $1,800 $2,000 Initial Costs $1,850 $2,000

Retaining Market Share

What is scenario analysis?

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

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

Sensitivity analysis

The Omega Division of Alpha Corporation has been allocated $4 million for capital spending but has identified $4.6 million in positive NVP 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

Capital rationing exists when a company has identified positive NVP projects but can't find:

The necessary financing

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

While performing sensitivity analysis, we recompute NVP several times by changing one input variable at a time.

True

The basic approach to evaluating cash flow and NVP estimates involves asking:

What-if questions

In a simulation, there are various possibilities. If the computer randomly picks industry sales of 10 million units, what will the price be based on the following pricing model? Price + $10 + $0.05 x Industry Sales in Millions?

$15 Unit Price + $10 + (0.05 x 10)

In a simulation, there are various possibilities. If the computer randomly picks industry sales of 10 million units and a market share of 25%, calculate total revenue based on the following two equations: Price=$100 + 0.05 x Industry Unit in millions, and Revenue - Market Share Percentage x Industry Unit Sales x Price

$262.5 million Total Revenue = {$100+(0.05x10)} x (0.25x10 million) =

Broadband, Inc. has estimated preliminary cash flows for a project and found that the NVP 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

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

*NVP considers time value of money *NVP considers all the cash flows

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