Chapter 8

Strategy and Analysis in Using Net Present Value

Multiple Choice Questions

1. Theoretically, the NPV is the most appropriate method to determine he acceptability of a project.
A false sense of security can be overwhelm the decision-maker when the procedure is applied
properly and the positive NPV results are accepted blindly. Sensitivity and scenario analysis aid
in the process by
A) changing the underlying assumptions on which the decision is based.
B) highlights the areas where more and better data are needed.
C) providing a picture of how an event can affect the calculations.
D) All of the above.
E) None of the above.
Answer: D Difficulty: Medium Page: 213-216

2. In order to make a decision with a decision tree

A) one starts farthest out in time to make the first decision.
B) one must begin at time 0.
C) any path can be taken to get to the end.
D) any path can be taken to get back to the beginning.
E) None of the above.
Answer: A Difficulty: Medium Page: 213

3. At stage 2 of the decision tree it shows that if a project is successful, the payoff will be $53,000
with a 2/3 chance of occurrence. There is also the 1/3 chance of a $-24,000 payoff. The cost of
getting to stage 2 (1 year out) is $44,000. The cost of capital is 15%. What is the NPV of the
project at stage 1?
A) $-13,275
B) $-20,232
C) $ 2,087
D) $ 7,536
E) Can not be calculated without the exact timing of future cash flows.
Answer: B Difficulty: Hard Page: 213
Rationale:
$-44,000 + [((2/3($53,000)) + (1/3($-24,000))) / 1.15] = $-20,232

1Ross/Westerfield/Jaffe, Corporate Finance, 7/e

Use the following to answer questions 4-5:

The Quick-Start Company has the following pattern of potential cash flows with their planned investment
in a new cold weather starting system for fuel injected cars.

Cash Flow After Tax

t=0 t=1
Invest
Success $100,000,000 Years 2 – 5
$66,000,000/year
.6
Test Cost Do Not Invest
NPV = $ 0
$20,000,000 Failure
.4
NPV = $-20,000,000
Do not test

4. If the company has a discount rate of 17%, what is the value closest to time 1 net present value?
A) $ 48.6 million
B) $ 80.9 million
C) $108.2 million
D) $181.4 million
E) None of the above.
Answer: A Difficulty: Medium Page: 213
Rationale:
NPV1 = Pr[COST + CFAT*A.17,4] = NPV1 = .6[$-100,000,000+$66,000,000(2.7432)] =
$48,632,106

5. If the company has a discount rate of 17%, should they decide to invest?
A) yes, NPV = $ 2.2 million
B) yes, NPV = $ 21.6 million
C) no, NPV = $-1.9 million
D) yes, NPV = $ 8.6 million
E) No, since more than one branch is NPV = 0 or negative you must reject.
Answer: B Difficulty: Hard Page: 213
Rationale:
NPV0 = NPV1/(1+r) C0 = ($48,632,106/1.17) $20,000,000) = $21,565,903

2 Test Bank, Chapter 8

 6. In a decision tree, the NPV to make the yes/no decision is dependent on
A) only the cash flows from successful path.
B) on the path where the probabilities add up to one.
C) all cash flows and probabilities.
D) only the cash flows and probabilities of the successful path.
E) None of the above.
Answer: C Difficulty: Medium Page: 211-213

7. In a decision tree, caution should be used in analysis because

A) early stage decisions are probably riskier and should not likely use the same discount rate.
B) if a negative NPV is actually occurring, management should opt out of the project and
minimize their loss.
C) decision trees are only used for planning, not actually daily management.
D) Both A and C.
E) Both A and B.
Answer: E Difficulty: Medium Page: 212-213

8. Sensitivity analysis evaluates the NPV with respect to

A) changes in the underlying assumptions.
B) one variable changing while holding the others constant.
C) different economic conditions.
D) All of the above.
E) None of the above.
Answer: D Difficulty: Medium Page: 214-216

9. Sensitivity analysis provides information on

A) whether the NPV should be trusted, it may provide a false sense of security if all NPVs are
positive.
B) the need for additional information as it tests each variable in isolation.
C) the degree of difficulty in changing multiple variables together.
D) Both A and B.
E) Both A and C.
Answer: D Difficulty: Medium Page: 216

10. Fixed production costs are

A) directly related to labor costs.
B) measured as cost per unit of time.
C) measured as cost per unit of output.
D) dependent on the amount of goods or services produced.
E) None of the above.
Answer: B Difficulty: Medium Page: 214

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 11. Variable costs
A) change as the quantity of output changes.
B) are zero when production is zero.
C) are exemplified by direct labor and raw materials.
D) All of the above.
E) None of the above.
Answer: D Difficulty: Medium Page: 214

12. An investigation of the degree to which NPV depends on assumptions made about any singular
critical variable is called a(n)
A) operating analysis.
B) sensitivity analysis.
C) marginal benefit analysis.
D) decision tree analysis.
E) None of the above.
Answer: B Difficulty: Easy Page: 214

13. Scenario analysis is different than sensitivity analysis

A) as no economic forecasts are changed.
B) as several variables are changed together.
C) because scenario analysis deals with actual data versus sensitivity analysis which deals with a
forecast.
D) because it is short and simple.
E) because it is 'by the seat of the pants' technique.
Answer: B Difficulty: Medium Page: 216

14. The accounting profit break-even point occurs when

A) the total revenue curve cuts the total cost curve.
B) the total revenue curve cuts the fixed cost curve.
C) the variable cost curve cuts the total cost curve.
D) the total revenue curve cuts the variable cost curve.
E) None of the above.
Answer: A Difficulty: Easy Page: 218

15. Viewing capital budgeting decisions as a series of options is useful to strategic analysis because
A) contingent results may provide an option to bailout of a project with subsequent poor
outcomes.
B) the value of the project should be considered as the NPV plus the value of the option.
C) strong markets and subsequent expansion options should be considered at time 0.
D) All of the above.
E) None of the above.
Answer: D Difficulty: Medium Page: 223-227

4 Test Bank, Chapter 8

 16. In the present-value break-even the EAC is used to
A) determine the opportunity cost of investment.
B) allocate depreciation over the life of the project.
C) allocate the initial investment at its opportunity cost over the life of the project.
D) determine the contribution margin to fixed costs.
E) None of the above.
Answer: C Difficulty: Medium Page: 218

17. The present value break-even point is superior to the accounting break-even point because
A) present value break-even is more complicated to calculate.
B) present value break-even covers the economic opportunity costs of the investment.
C) present value break-even is the same as sensitivity analysis.
D) present value break-even covers the fixed costs of production, which the accounting break-
even does not.
E) present value break-even covers the variable costs of production, which the accounting
break-even does not.
Answer: B Difficulty: Medium Page: 219

18. The potential decision to abandon a project has option value because
A) abandonment can occur at any future point in time.
B) a project may be worth more dead than alive.
C) management is not locked into a negative outcome.
D) All of the above.
E) None of the above.
Answer: D Difficulty: Easy Page: 213

19. The Mini-Max Company has the following cost information on their new prospective project.
Calculate the accounting break-even point.

Initial investment: $700

Fixed costs: $200 per year
Variable costs: $3 per unit
Depreciation: $140 per year.
Price: $8 per unit
Discount rate: 12%
Project life: 5 years
Tax rate: 34%
A) 25 units per year
B) 68 units per year
C) 103 units per year
D) 113 units per year
E) None of the above.
Answer: B Difficulty: Medium Page: 217-218
Rationale:
Contribution Margin = ($8 - $3) (1 0.34) = $3.30
After-tax (Fixed Cost + Depreciation) = ($200 + $140) (1 0.34) = $224
Accounting BEP = $224/$3.30 = 67.88 = 68 units

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6 Test Bank, Chapter 8
 20. The Mini-Max Company has the following cost information on their new prospective project.
Calculate the present value break-even point.

Initial investment: $700

Fixed costs are $ 200 per year
Variable costs: $ 3 per unit
Depreciation: $ 140 per year
Price: $8 per unit
Discount rate: 12%
Project life: 3 years
Tax rate: 34%
A) 68 units per year
B) 75 units per year
C) 84 units per year
D) 114 units per year
E) None of the above.
Answer: D Difficulty: Medium Page: 218-219
Rationale:
EAC = $700/A.12,3 = $700/2.4018 = $291.45
PV BEP = [EAC + FC(1-Tc)-Dep(Tc)]/(CM(1-Tc))
= [$291.45 + $200(.66)-$140(.34)]/5(.66) = 113.89 units = 114 units

21. From the information below, calculate the accounting break-even point.

Initial investment: $2,000

Fixed costs are $2,000 per year
Variable costs: $6 per unit
Depreciation: $250 per year
Price: $20 per unit
Discount rate: 10%
Project life: 4 years
Tax rate: 34%
A) 88 units per year
B) 100 units per year
C) 143 units per year
D) 161 units per year
E) None of the above.
Answer: D Difficulty: Medium Page: 218-219
Rationale:
Contribution Margin = ($20 - $6) (1 0.34) = $9.24
After tax (Fixed Cost + Depreciation) = ($2,000 + $250) (1 0.34) = $1,485
Accounting BEP = $1,485/$9.24 = 160.71 units = 161 units

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 22. Given the following information, calculate the present value break-even point.

Initial investment: $2,000

Fixed costs: $2,000 per year
Variable costs: $6 per unit
Depreciation: $ 250 per year
Price: $20 per unit
Discount rate: 10%
Project life: 4 years
Tax rate: 34%
A) 100 units per year
B) 143 units per year
C) 202 units per year
D) 286 units per year
E) None of the above.
Answer: C Difficulty: Medium Page: 218-219
Rationale:
EAC = $2,000/(PVIFA.10,4) = $2,000/3.1699 = $630.93
PV BEP = [EAC + FC(1-Tc)-Dep(Tc)]/(CM(1-Tc))
= [$630.93+$2,000(1-0.34)-$250(.34)]/[($20 - $6)(1-0.34)] = 201.94 = 202 units

23. Which of the following are types of break-even analysis?

A) present value break-even
B) accounting profit break-even
C) market value break-even
D) Both A and B.
E) Both A and C.
Answer: D Difficulty: Easy Page: 216

24. The approach that further attempts to model real word uncertainty by analyzing projects the way
one might analyze gambling strategies is called
A) gamblers approach.
B) blackjack approach.
C) Monte Carlo simulation.
D) scenario analysis.
E) sensitivity analysis.
Answer: C Difficulty: Easy Page: 219

25. Monte Carlo simulation is

A) the most widely used by executives.
B) a very simple formula.
C) provides a more complete analysis that sensitivity or scenario.
D) the oldest capital budgeting technique.
E) None of the above.
Answer: C Difficulty: Easy Page: 223

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9Ross/Westerfield/Jaffe, Corporate Finance, 7/e
 26. Which of the following are hidden options in capital budgeting?
A) option to expand.
B) timing option.
C) option to abandon.
D) All of the above.
E) None of the above.
Answer: D Difficulty: Easy Page: 223-226

Essay Questions

27. A project has sales of $100 per year forever. Costs will be $54 the first year and will increase by
8% every year. Ignoring taxes, what is the NPV at 10%? (Hint: consider the option to abandon
in your answer).
Difficulty: Hard Page: 224-225
Answer:
Find where increasing Cost would equal sales.
Calculate t: $100 = $54(1.08)t
1.85185 = 1.08t t = 8.0065 = 8 years.
NPV = ($100-$54)/1.1 + ($100-$54(1.08))/(1.12) + ($100-$54(1.08)2)/(1.13) +
($100-$54(1.08)3)/(1.14) + ($100-$54(1.08)4)/(1.15) + ($100-$54(1.08)5)/(1.16) + ($100-
$54(1.08)6)/(1.17) + ($100-$54(1.08)7)/(1.18) + ($100-$54(1.08)8)/1.19 = $164.87

28. The Marx Brewing Company recently installed a new bottling machine. The machine's initial
cost is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years. The
machine's per year fixed cost is $1,800, and its variable cost is $0.50 per unit. The selling price
per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. Calculate the
accounting break-even point on the new machine, as well as the present value break-even point
on the new machine.
Difficulty: Medium Page: 216- 219
Answer:
Accounting break-even is:
$1,800 + ($400)(1 – 0.34) / ($1.50 - $0.5)(1-.34) = 2,200 units
Present value break-even is:
EAC = $2,000/(PVIFA.16,5) = $2,000/3.2743 = $610.81
PV BEP = [EAC + FC(1-Tc)-Dep(Tc)]/(CM(1-Tc))
= [$610.81 + $1,800(1-.34) - $400(.34)] / ($1.50 - $0.50)(1-.34) = 2,519 units

10 Test Bank, Chapter 8

 29. The Marx Brewing Company recently installed a new bottling machine. The machine's initial
cost is $2,000, and can be depreciated on a straight line basis to a zero salvage in 5 years. The
machine's per year fixed cost is $1,800, and its variable cost is $0.50 per unit. The selling price
per unit is $1.50. Marx's tax rate is 34%, and it uses a 16% discount rate. If Marx sells 2,500
units what is the accounting profit and contribution margin for Marx Brewing?
Difficulty: Medium Page: 217-218
Answer:
Rev $3,750 CM = P - VC = $1.50-$0.50 = $1.00
-FC 1,800
-VC 1,250
-Dep $400
$300
-Tax 102
NI $198

30. From the information below, calculate the impact of discount rate changes on the present-value
break-even point. Specifically, if the discount rate were to move from 10% to either 5% or 15%,
show what would happen to the present-value break-even points? How sensitive is the break-
even to the discount rate change? Show all work.

Initial investment: $2,000

Fixed costs: $2,500 per year
Variable costs: $8 per unit
Depreciation: $500 per year
Price: $ 25 per unit
Initial discount rate: 10%
Project life: 4 years
Tax rate: 34%

If the discount rate were 15% and 5% what would be the present-value break-even points. How
sensitive is the break-even to the discount rate change? Show all work.
Difficulty: Hard Page: 218-219
Answer:
 PV Break-even (10%) = $630.94 + ($2,500(.66) - $500(.34))/($25 - $8)(.66) = 188.14

(EAC @ 10% = 630.94)

 PV Break-even (15%) =$ 700.53 + ($2,500(.66) - $500(.34))/($25 - $8)(.66) = 194.34
 PV Break-even (5%) = $564.02 + ($2,500(.66) - $500(.34))/($25 - $8)(.66) = 182.17
Not very sensitive; a 50% increase or decrease in the discount rate causes only a 3.3% increase
or decrease in break-even units.

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11
 31. Your company has a new project to be considered. You are given the following information on
the best guess of related outcomes for the project. The cost of developing and market testing the
product over the next year is $225 million. If the test is successful, which is expected to be 65%,
the company will spend another $800 million to put the productive capabilities in place. The
expected cash flows after tax for a successful project are $225 million each year for the next six
years with a probability of .8; there is a 20% chance of a zero NPV. If the tests were to fail, the
cash flows associated with continuing in years 2 - 7 would be $125 million per year after tax.
The company uses a 12% discount rate for these types of projects. Determine the net present
value if the tests are a success. Draw a decision tree and calculate the net present value of the
project.
Difficulty: Hard Page: 212
Answer:
NPV1 = Pr[Cost + CFAT*A.12,6] = .65{[$-800+($225)4.1114].8+.2(0)} = .65($100.52)=$65.34
NPV0 =$ -225 + $65.34/1.12 = $-166.66; Do not invest.

32. Discuss two shortcomings in the standard decision tree analysis that a financial manager should
be cognizant of?
Difficulty: Medium Page: 212-213
Answer:
First, there is differential risk at various stages of the tree should imply the use of different
discount rates. Second, the firm has different options than following a negative NPV path and
may alter the total outcome under poor future stages.

33. Sensitivity analysis is a method which allows for evaluation of the NPV given a series of changes
to the underlying assumptions. Discuss why and how scenario analysis is used in addition to
sensitivity analysis.
Difficulty: Medium Page: 213-216
Answer:
Sensitivity analysis:
measures input of changing one input at a time.
variables may change simultaneously in reality.
estimates may be overly optimistic or pessimistic.
Scenario analysis:
a variant of sensitivity analysis.
allows for multiple factor influences.
examines a number of different scenarios.
minimizes the false sense of security that may come from sensitivity analysis.

34. The market value of an investment project should be viewed as the sum of the standard NPV and
the value of managerial options. Explain three different real or managerial options that
management may have, what they are, and how they would influence market value.
Difficulty: Easy Page: 223-227
Answer:
To expand project -- favorable market reaction
Contract business -- under conditions of poor demand, etc.
Abandonment, equipment replacement, opening and closing facilities.

12 Test Bank, Chapter 8