Operating Leverage, Break-Even and Scenario Analyses (1/25/24)
capital rationing
The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.
hard
The situation that occurs when a business cannot raise financing for a project under any circumstances is called __________ rationing.
hard rationing
The situation that occurs when a business cannot raise financing for a project under any circumstances.
b.) be close to
To be considered good, projected cash flows should _____ actual cash flows. a.) be in opposition to b.) be close to c.) exactly match
True
True or False Ultimately, we are more interested in cash flow than accounting income.
A) Unit price
A decrease in ____________ increases accounting break-even quantity? Use straight-line depreciation. Ignore tax. A) Unit price B) Initial fixed asset cost C) Employee salary D) Fixed cost E) Unit variable labor cost
d.) beyond the break-even sales point a.) below the break-even sales point Reason: Below the break-even sales point, the firm will make negative profits (or losses). b.) at the break-even sales point Reason: At the break-even sales point, the firm will make zero accounting profit. c.) at the point at which revenues exceed total fixed costs Reason: When revenues exceed total fixed costs, variable costs must still be paid, so the firm would be operating at a loss.
A firm will start generating positive accounting profits _____. a.) below the break-even sales point b.) at the break-even sales point c.) at the point at which revenues exceed total fixed costs d.) beyond the break-even sales point
c.) 1,000,000 Reason: The NPV of the scenario originally estimated is usually used as the base case.
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. a.) 500,000 b.) 1,100,000 c.) 1,000,000 d.) 2,000,000
d.) $400,000 Reason: The NPV of the scenario originally estimated is usually used as the base case.
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. a.) $360,000 b.) $440,000 c.) $220,000 d.) $400,000
d.) to which sales can fall before a project will start losing money Reason: 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.
Corporate managers care about the break-even point because it indicates the level _____. a.) of sales they will need to make to enjoy leadership in the industry b.) of sales at which depreciation expense will be fully written off c.) of sales at which the firm can enjoy maximum tax benefits d.) to which sales can fall before a project will start losing money
marginal/incremental cost
Cost to produce one more unit, which is the same as variable cost per unit.
d.) as low as possible Reason: From a managerial perspective, highly uncertain projects can be dealt with by keeping the degree of operating leverage as low as possible. Doing so will reduce the break-even point.
From a managerial perspective, highly uncertain projects can be dealt with by keeping the degree of operating leverage _____. a.) as high as possible b.) a well-kept secret c.) fixed d.) as low as possible
c.) uncommon Reason: In a competitive market, positive NPV projects are rare because competition will have eliminated excess profits.
In a competitive market, positive NPV projects are: a.) unlimited b.) easy to find c.) uncommon
b.) repeated random drawings Reason: In a simulation, the computer draws several variables at a time randomly, then inputs those values into the model to determine the outcome.
In a simulation, the average NPV and the spread of NPVs around the average are determined by _____. a.) an educated guess b.) repeated random drawings c.) multiple forecasts d.) actual events
a.) scenario; sensitivity
In simulation analysis, a combination of _____ analysis and _____ analysis is used. a.) scenario; sensitivity b.) best-case; accelerated c.) worst-case; accelerated
sensitivity analysis
Investigation of what happens to NPV when only one variable is changed.
c.) soft a.) hard Reason: Under hard rationing, financing could not be raised for a project under any circumstances. b.) food Reason: Soft rationing occurs when units in a business are allocated a certain amount of financing for capital budgeting. d.) exceptional Reason: Soft rationing occurs when units in a business are allocated a certain amount of financing for capital budgeting.
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. a.) hard b.) food c.) soft d.) exceptional
variable
The _________ cost is equal to the quantity of output times the cost per unit of output.
financial
The _____________ break-even is the sales level that results in a zero NPV.
what
The basic approach to evaluating cash flow and NPV estimates involves asking ________-if questions.
cash break-even
The sales level that results in a zero NPV.
C) Degree of operating leverage
Which is relation between percentage change in OCF and quantity sold? A) Cash break-even B) Degree of sensitivity C) Degree of operating leverage D) Contribution margin
a.) OCF = (P − v) × Q − FC
Which of the following equations correctly relates OCF to sales volume? a.) OCF = (P − v) × Q − FC b.) OCF = (P − v)/(Q − FC) c.) OCF = (P − v) × Q + FC d.) OCF = (P + v) × Q − FC
d.) Research and development expense incurred in the past a.) Acquisition of new equipment to manufacture the product Reason: Acquisition of the new equipment will only be done if the project is accepted, so it is not a sunk cost. b.) Renovation of existing building to accommodate the new project Reason: Renovation of the building will only be done if the project is accepted, so it is not a sunk cost. c.) Purchase of inventory Reason: Purchase of inventory will only be done if the project is accepted, so it is not a sunk cost. Research and development expense incurred in the past
Which of the following is an example of a sunk cost? a.) Acquisition of new equipment to manufacture the product b.) Renovation of existing building to accommodate the new project c.) Purchase of inventory d.) Research and development expense incurred in the past
b.) $1,200 paid to repair a machine last year.
Which one of the following is an example of a sunk cost? a.) $4,500 reduction in current shoe sales if a store commences selling sandals. b.) $1,200 paid to repair a machine last year. c.) $1,800 increase in comic book sales if a store ceases selling puzzles. d.) $20,000 project that must be forfeited if another project is accepted. e.) $1,500 of lost sales because an item was out of stock.
scenario
________________ analysis involves estimating the best-case, worst-case, and base-case cash flows and calculating the corresponding NPVs.
variable costs
Costs that change when the quantity of output changes.
D) Fixed costs
Operating leverage is the degree of dependence a firm places on its: A) Operating cash flows B) Sales C) Variable costs D) Fixed costs E) Depreciation tax shield
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.
a.) OCF = −400 + 4*Q Reason: OCF = (P − v)*Q − FC
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: a.) OCF = −400 + 4*Q b.) OCF = 400*Q − 4 c.) OCF = 400 − 4*Q d.) OCF = 4/Q + 500
b.) what-if questions a.) for assistance from the federal government Reason: The federal government does not commonly assist in estimating cash flows. c.) random questions about the cash flow assumptions
The basic approach to evaluating cash flow and NPV estimates involves asking _____. a.) for assistance from the federal government b.) what-if questions c.) random questions about the cash flow assumptions
simulation
_________________ analysis uses a combination of scenario and sensitivity analysis.
simulation (Monte Carlo) analysis
A combination of scenario and sensitivity analysis, expanded distribution.
c.) high Reason: A firm with higher operating leverage will have high fixed costs relative to a firm with low operating leverage.
A firm with higher operating leverage will have ______ fixed costs relative to a firm with low operating leverage. a.) indeterminate b.) insufficient c.) high d.) low
d.) cannot be observed a.) is higher than its cost Reason: Positive NPV projects are not very common, so this is unlikely. b.) must be determined by the SEC Reason: The SEC does not determine market value of projects. c.) is estimated as higher than its cost Reason: Since positive NPV projects are not common, this is likely.
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 _____. a.) is higher than its cost b.) must be determined by the SEC c.) is estimated as higher than its cost d.) cannot be observed
b.) Initial investment in inventory to support the project
All of the following are related to a proposed project. Which one of these should be included in the cash flow at Time 0? a.) Net working capital recovery b.) Initial investment in inventory to support the project c.) Annual depreciation tax shield d.) Aftertax salvage value e.) Loan obtained to finance the project
c.) when the firm sells 1,000 units, profits will be equal to zero Reason: An accounting break-even point of 1,000 means that when the firm sells 1,000 units, profits will be equal to zero.
An accounting break-even point of 1,000 units means that ____. a.) the total fixed costs are equal to $1,000 b.) the maximum capacity of the plant is 1,000 units c.) when the firm sells 1,000 units, profits will be equal to zero d.) when the firm generates total revenue of $1,000, profits will be equal to zero
A) Sensitivity
Analysis of the change in a project NPV when changing a single variable is called ____________ analysis. A) Sensitivity B) Simulation C) Break-even D) Scenario E) Forecasting
a.) the necessary financing Reason: Capital rationing exists when a company has identified positive NPV projects but can't find the necessary financing.
Capital rationing exists when a company has identified positive NPV projects but can't find _____. a.) the necessary financing b.) irreducible equations c.) negative cash flows d.) positive IRRs
c.) sales
Corporate managers care about the break-even point because it indicates the level to which _____ can fall before a project will start losing money. a.) depreciation b.) taxes c.) sales d.) cost of goods sold
B) Determination of changes in NPV estimates when what-if questions are posed.
Scenario analysis is defined as the: A) Isolation of the effect that a single variable has on the NPV of a project. B) Determination of changes in NPV estimates when what-if questions are posed. C) Separation of a project's sunk costs from its opportunity costs. D) Determination of the initial cash outlay required to implement a project. E) Analysis of the effects that a project's terminal cash flows has on the project's NPV.
a.) Sale price + (Book value - Sale price) × T
Three years ago, Knox Glass purchased a machine for a three-year project. The machine is being depreciated straight-line to zero over a five-year period. Today, the project ended and the machine was sold. Which one of the following correctly defines the aftertax salvage value of that machine? (T represents the relevant tax rate) a.) Sale price + (Book value - Sale price) × T b.) Sale price + (Sale price - Book value) × (1 - T) c.) Sale price + (Sale price - Book value) × T d.) Sale price × (1 - T) e.) Sale price + (Book value - Sale price) × (1 - T)
a.) sensitivity analysis b.) break-even 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). c.) simulation Reason: Simulations change multiple variables simultaneously thousands of times to find the likelihood that the NPV will be positive under numerous assumptions.
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. a.) sensitivity analysis b.) break-even analysis c.) simulation
a.) sensitivity analysis b.) simulation Reason: Simulations change multiple variables simultaneously thousands of times to find the likelihood that the NPV will be positive under numerous assumptions. c.) break-even 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).
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. a.) sensitivity analysis b.) simulation c.) break-even analysis
b.) Present value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect. Reason: Present value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect.
Which of the following statements is true in the context of comparing accounting profit and present value break-even point? a.) Both techniques are equally good. b.) Present value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect. c.) Accounting profit is superior because the financial statements report profits and not present value. d.) The superiority of a particular technique will vary from firm to firm depending on the unique circumstances of the firm.
b.) will start generating profits if it sells more than 2,000 units a.) will start generating profits if its total revenue reaches $2,000 Reason: An accounting break-even point of 2,000 means the firm will start generating profits if it sells more than 2,000 units. Total revenue depends on price per unit, as well as quantity.
An accounting break-even point of 2,000 means the firm ____. a.) will start generating profits if its total revenue reaches $2,000 b.) will start generating profits if it sells more than 2,000 units c.) will start generating losses if it sells more than 2,000 units d.) has total costs (including depreciation) of $2,000
fixed costs
Costs that do not change when the quantity of output changes during a particular time period.
d.) The new machine will generate positive operating cash flows.
Dexter Smith & Co. is replacing a machine simply because it has worn out. The new machine will not affect either sales or operating costs and will not have any salvage value at the end of its five-year life. The firm has a 34% tax rate, uses straight-line depreciation over an asset's life, and has a positive net income. Given this, which one of the following statements is correct? a.) As a project, the new machine has a net present value equal to minus one times the machine's purchase price. b.) The new machine creates erosion effects. c.) The new machine will have a zero rate of return. d.) The new machine will generate positive operating cash flows. e.) The new machine will create a cash outflow when the firm disposes of it at the end of its life.
a.) not expect cash flow estimates to be exactly right every time b.) give up estimating cash flows Reason: Estimating cash flows is useful for planning, but seldom perfectly accurate. c.) expect cash flow estimates to exactly right every time Reason: Actual cash flows are seldom equal to estimated cash flows.
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 _____. a.) not expect cash flow estimates to be exactly right every time b.) give up estimating cash flows c.) expect cash flow estimates to exactly right every time
b.) an NPV of zero
Financial break-even is the sales level that results in _____. a.) a positive IRR b.) an NPV of zero c.) an IRR that is less than the NPV d.) a positive NPV
b.) Wendy's d.) Burger King Reason: BN and A&F don't compete with McDonald's.
Select all that apply: 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? a.) Barnes and Noble b.) Wendy's c.) Abercrombie and Fitch d.) Burger King
a.) scenario analysis c.) asking what-if questions Reason: When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in scenario (or "what-if") analysis.
Select all that apply: When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in _____. a.) scenario analysis b.) fruitless endeavors c.) asking what-if questions d.) rocket science
a.) Depreciation b.) Fixed costs c.) Sunk costs Reason: Sunk costs are not included in the formula. d.) Variable costs Reason: Variable costs are not included in the numerator. They are in the denominator, which is contribution margin (sales price - variable cost per unit).
Select all that apply: Which costs are included in the numerator of the accounting profit break-even point equation? a.) Depreciation b.) Fixed costs c.) Sunk costs d.) Variable costs
a.) NPV considers time value of money. b.) NPV considers all the cash flows. c.) NPV results in only one rate of return. Reason: NPV doesn't result in a rate of return. d.) NPV properly discounts earnings. Reason: Earnings do not represent real money; in capital budgeting, only cash flows are discounted.
Select all that apply: Which of the following are reasons why NPV is considered a superior capital budgeting technique? a.) NPV considers time value of money. b.) NPV considers all the cash flows. c.) NPV results in only one rate of return. d.) NPV properly discounts earnings.
b.) Total variable costs increase as the total number of units produced increases. c.) The variable cost per unit may remain constant as the number of units produced increases. Reason: Variable costs per unit are not directly related to number of units produced. When volume discounts are reached, they can actually be inversely related.
Select all that apply: Which of the following are true about variable costs? a.) The variable cost per unit increases as the number of units produced increases. b.) Total variable costs increase as the total number of units produced increases. c.) The variable cost per unit may remain constant as the number of units produced increases.
b.) To determine the level of sales at which profits are equal to zero a.) To determine the level of sales at which variable costs are fully recovered. Reason: Accounting profit break-even analysis reveals the level of sales at which all fixed and variable costs are recovered. c.) To determine the maximum number of units that can be produced in a plant. Reason: The maximum number of units that can be produced reveals plant capacity, which is not the same as break-even. d.) To determine the level of sales at which profits generate the minimum rate of return expected by shareholders. Reason: When sales reach the break-even point, profits are zero. Shareholders expect a return greater than zero.
What is the purpose of accounting profit break-even analysis? a.) To determine the level of sales at which variable costs are fully recovered. b.) To determine the level of sales at which profits are equal to zero . c.) To determine the maximum number of units that can be produced in a plant. d.) To determine the level of sales at which profits generate the minimum rate of return expected by shareholders.
a.) Total variable costs are directly related to the level of output. Reason: Variable costs are those that increase with output, so they are directly related by definition.
What is the relationship between variable costs and output? a.) Total variable costs are directly related to the level of output. b.) Total variable costs will remain constant, regardless of the level of output. c.) Total variable costs are inversely related to the level of output.
scenario analysis
The determination of what happens to NPV estimates when we ask what-if questions. Best (high revenue, low cost) & worst (low revenue, high cost) case compared to base
degree of operating leverage (DOL)
The percentage change in operating cash flow relative to the percentage change in quantity sold.
forecasting
The possibility that errors in projected cash flows will lead to incorrect decisions is called ___________________, or estimation risk.
forecasting/estimation risk
The possibility that errors in projected cash flows will lead to incorrect decisions.
c.) reliability Reason: This may have been avoided had they assessed the reliability of the cash flow estimates
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. a.) principality b.) additivity c.) reliability d.) fungibility
c.) A cost incurred in the past that is irrelevant to the capital investment decision process. Reason: A cost incurred in the past that is irrelevant to the capital investment decision process.
What is a sunk cost? a.) A cost that created a significant business loss. b.) A significant cost that will be incurred at the end of a project's life. c.) A cost incurred in the past that is irrelevant to the capital investment decision process.
d.) To determine the level of sales at which profits are equal to zero. a.) To determine the maximum number of units that can be produced in a plant. Reason: The maximum number of units that can be produced reveals plant capacity, which is not the same as break-even. b.) To determine the level of sales at which profits generate the minimum rate of return expected by shareholders. Reason: When sales reach the break-even point, profits are zero. Shareholders expect a return greater than zero. c.) To determine the level of sales at which variable costs are fully recovered. Reason: Accounting profit break-even analysis reveals the level of sales at which all fixed and variable costs are recovered.
What is the purpose of accounting profit break-even analysis? a.) To determine the maximum number of units that can be produced in a plant. b.) To determine the level of sales at which profits generate the minimum rate of return expected by shareholders. c.) To determine the level of sales at which variable costs are fully recovered. d.) To determine the level of sales at which profits are equal to zero.
marginal/incremental revenue
The change in revenue that occurs when there is a small change in output.
c.) the total number of units sold exceeds the accounting break-even point Reason: The firm will generate profits if the the total number of units sold exceeds the accounting break-even point. Total variable costs could never exceed total fixed costs, and if the contribution margin is big enough the firm would still make money.
A firm will start generating profits when ___. a.) total variable costs exceed total fixed costs b.) total revenue exceeds the initial investment required to generate that revenue c.) the total number of units sold exceeds the accounting break-even point d.) total revenue exceeds the total fixed costs
rationing
A situation in which a firm has positive NPV projects but cannot find the necessary financing is called capital _____________.
b.) Hiring additional employees to handle the increased workload should the firm accept the wreath project.
Kelley's Baskets makes handmade baskets for distribution to upscale retail outlets. The firm is currently considering making handmade wreaths also. Which is the best example of an incremental operating cash flow related to the wreath project? a.) Utilizing the basket manager to oversee wreath production. b.) Hiring additional employees to handle the increased workload should the firm accept the wreath project. c.) Researching the market to determine if wreath sales might be profitable before deciding to proceed. d.) Planning on lower interest expense by assuming proceeds of wreath sales will be used to reduce firm's currently outstanding debt. e.) Storing supplies in the same space currently used for materials storage.
a.) forecasting risk c.) estimation risk b.) managerial incompetence Reason: Errors in projecting cash flows occur even when managers are very competent. It comes from not being able to perfectly foresee the future. d.) guess and bless Reason: This is not a common name for forecasting or estimation risk.
Select all that apply: The possibility that errors in projected cash flows will lead to incorrect decisions is known as _____. a.) forecasting risk b.) managerial incompetence c.) estimation risk d.) guess and bless
c.) Tax due on the salvage value of that asset.
The current book value of a fixed asset that was purchased two years ago is used in the computation of which one of the following? a.) Depreciation tax shield. b.) MACRS depreciation for the current year. c.) Tax due on the salvage value of that asset. d.) Change in net working capital. e.) Current year's operating cash flow.
operating
The degree to which a firm or project relies on fixed costs is called the _____________ leverage
operating leverage
The degree to which a firm or project relies on fixed costs, which depends on sales
soft rationing
The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.
c.) the depreciation allowance for that period Reason: When a project breaks even on an accounting basis, the cash flow for that period will equal the depreciation allowance for that period; it is not a cash flow, but is subtracted from accounting income.
When a project breaks even on an accounting basis, the cash flow for that period will equal _____. a.) net working capital for that period b.) net income for that period c.) the depreciation allowance for that period d.) revenues for that period
d.) (Fixed costs + Depreciation)/Contribution margin
Which of the following represents the accounting profit break-even point? a.) Depreciation/Contribution margin b.) Fixed costs/Contribution margin c.) Total taxes/Contribution margin d.) (Fixed costs + Depreciation)/Contribution margin
