TBChap 010

Chapter 10
Project Analysis
Multiple Choice Questions
1. Discounted cash-flow (DCF) analysis generally:

I) assumes that firms hold assets passively when it invests in a project;
II) considers opportunities to expand a project if the project is successful;
III) considers opportunities to abandon a project if the project is a failure
A.
B.
C.
D.
I only
II only
II and III only
I, II, and III
2. Most firms' capital investment proposals originate from:
A.
B.
C.
D.
senior management.
planning staff, corporate finance department.
the board of directors.
divisional management.
3. Generally, postaudits are conducted for large projects:
A.
B.
C.
D.
shortly after the completion of the project.

several years after the completion of the project.
shortly after the project has begun to operate.
well before the start of the project.
10-1
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4. Generally, postaudits for projects are conducted to:

I) identify problems that need fixing;
II) check the accuracy of forecasts;
III) generate questions that should have been asked before project commencement
A.
B.
C.
D.
I only
II only
I and II only
I, II, and III
5. You obtain the following data for year 1: Revenue = $43; Variable costs = $30;
Depreciation = $3; Tax rate = 30%. Calculate the operating cash flow for the project
for year 1.
A.
B.
C.
D.
$7
$10
$13
$16
6. A project has an initial investment of 100. You have come up with the following
estimates of the project's cash flows:
Suppose the cash flows are perpetuities and the cost of capital is 10%. What does a
sensitivity analysis of NPV (no taxes) show? (Answers appear in order: [Pessimistic,
Most Likely, Optimistic].)
A.
B.
C.
D.
-50, 20, +100.

-100, -50, +80.
-50, +50, +70.
+5, +11, +18.
10-2
7. You are given the following data for year 1: Revenues = 100, Fixed costs = 30; Total
variable costs = 50; Depreciation = $10; Tax rate = 30%. Calculate the after-tax cash
flow for the project for year 1.
A.
B.
C.
D.
$17
$13
$10
$7
8. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3

= 100,000. If the discount rate changes from 12% to 15%, what is the CHANGE in the
NPV of the project (approximately)?
A.
B.
C.
D.
12,750 increase
12,750 decrease
14,240 increase
14,240 decrease
9. You calculate the following estimates of project cash flows:
The revenues and costs occur in perpetuity, as opposed to the initial investment. The
cost of capital is 8%. What does a sensitivity analysis of NPV (without taxes) show?
(Answers appear in order: [Pessimistic, Most Likely, Optimistic].)
A.
B.
C.
D.
25.00, +232.50, +440.00

-100.00, +500.00, +800.00
-90.00, -55.00, -20.00
-88.33, -50.00, -18.50
10-3
10. A project requires an initial investment of $150. Your research generates the following
estimates of revenues and costs:
The cost of capital equals 10%. Assume that the cash flows occur in perpetuity. What
does a sensitivity analysis of NPV (without taxes) show? (Answers appear in order:
[Pessimistic, Most Likely, Optimistic].)
A.
B.
C.
D.
50, -100, +400

-50, +300, +500
-100, +150, +350
+100, +150, +350
11. A project requires an initial investment in equipment of $90,000 and then requires an
initial investment in working capital of $10,000 (at t = 0). You expect the project to
produce sales revenue of $120,000 per year for three years. You estimate
manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at
year-end, i.e.,t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line
depreciation over three years. At the end of the project, the firm can sell the
equipment for $10,000 and also recover the investment in net working capital. The
corporate tax rate is 30% and the cost of capital is 15%. Cash flows from the project
are:
A.
B.
C.
D.
CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600.

CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 49,600.
10-4
year-end, i.e., t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line
corporate tax rate is 30% and the cost of capital is 15%. Calculate the NPV of the
project:
A.
B.
C.
D.
$3,840.
$8,443.
$-2,735.
$7,342.
corporate tax rate is 30% and the cost of capital is 12%.
Calculate the NPV of the project:
A.
B.
C.
D.
$14,418.
$8,443.
$-2,735.
$12,873.
corporate tax rate is 30% and the cost of capital is 15%. What is the NPV of the
project if the revenues were higher by 10% and the costs were 65% of the revenues?
A.
B.
C.
D.
$8,443
$964
$5,566
$4,840
10-5
equipment for $10,000. The corporate tax rate is 30% and the cost of capital is
16.5%. Calculate the NPV of the project.
A.
B.
C.
D.
$5,648
$3,840
-$2,735
$4,848
16. The following are drawbacks of sensitivity analysis EXCEPT:
A.
it can provide ambiguous results.
B. the underlying variables are likely interrelated.
C. it can help identify the project's most important variables.
D. all of these statements are drawbacks of sensitivity analysis.
17. Which of the following statements most appropriately describes scenario analysis?
A.
B.
C.
D.
It looks at the project by changing one variable at a time.

It provides the break-even level of sales for the project.
It looks at different but consistent combinations of variables.
Each of these statements describes scenario analysis correctly.
18. The Financial Calculator Company proposes to invest $12 million in a new calculatormaking plant. Fixed costs are $3 million per year. A financial calculator costs $10 per
unit to manufacture and sells for $30 per unit. If the plant lasts for four years and the
cost of capital is 20%, what is the break-even level (i.e., NPV = 0) of annual sales?
(Assume that revenues and costs occur at the end of each year. Assume no taxes.)
Round to the nearest 1,000 units.
A.
B.
C.
D.
150,000 units
342,000 units
382,000 units
300,000 units
10-6
19. The Solar Calculator Company proposes to invest $5 million in a new calculatormaking plant. Fixed costs are $2 million per year. A solar calculator costs $5 per unit
to manufacture and sells for $20 per unit. If the plant lasts for three years and the
cost of capital is 12%, what is the break-even level (i.e., NPV = 0) of annual sales?
(Assume that revenues and costs occur at the end of each year. Assume no taxes.)
Round to the nearest 1,000 units.
A.
B.
C.
D.
133,000 units
272,000 units
228,000 units
244,000 units
20. Firms often calculate a project's break-even sales using book earnings. However,
break-even sales based on NPV is generally:
A.
B.
C.
D.
higher than the one calculated using book earnings.

lower than the one calculated using book earnings.
equal to the one calculated using book earnings.
not related to the one calculated using book earnings.
21. The accounting break-even point occurs when:
A.
the total revenue line cuts the fixed cost line.
B. the present value of inflows line cuts the present value of outflows line.
C.
the total revenue line cuts the total cost line.
D. total revenue is large enough to recapture depreciation expense.
22. The NPV break-even point occurs when:
A. the present value of inflows line cuts the present value of outflows line.
B.
C.
D. the present value of inflows cuts the total cost line.
10-7
23. The Financial Calculator Company proposes to invest $12 million in a new calculatormaking plant that will depreciate on a straight-line basis. Fixed costs are $3 million
per year. A financial calculator costs $10 per unit to manufacture and sells for $30
per unit. If the plant lasts for four years and the cost of capital is 20%, what is the
accounting break-even level of annual sales? (Assume no taxes.)
A.
B.
C.
D.
300,000 units
150,000 units
381,777 units
750,000 units
24. The Solar Calculator Company proposes to invest $5 million in a new calculatormaking plant that will depreciate on a straight-line basis. Fixed costs are $2 million
per year. A calculator costs $5 per unit to manufacture and sells for $20 per unit. If
the plant lasts for three years and the cost of capital is 12%, what is the accounting
break-even level of annual sales? (Assume no taxes.)
A.
B.
C.
D.
133,334 units
272,117 units
244,444 units
466,666 units
25. The Taj Mahal Tour Company proposes to invest $3 million in a new tour package
project. Fixed costs are $1 million per year. The tour package costs the company
$500 to produce and can be sold at $1500 per package to tourists. This tour package
will last for the next five years. If the cost of capital is 20%, what is the NPV breakeven number of tourists per year? (Ignore taxes. Round to the nearest 1,000.)
A.
B.
C.
D.
1,000
2,000
3,000
4,000
26. The Hammer Company proposes to invest $6 million in a new type of hammermaking equipment. The fixed costs are $0.5 million per year. The equipment will last
for five years. The manufacturing cost per hammer is $1 and each hammer sells for
$6. The cost of capital is 20%. Calculate the break-even (i.e., NPV = 0) sales volume
per year. (Ignore taxes. Round to the nearest 1,000.)
A.
B.
C.
D.
500,000 units
600,000 units
450,000 units
550,000 units
10-8
27. Hammer Company proposes to invest $6 million in a new type of hammer-making

equipment. The fixed costs are $1.0 million per year. The equipment will last for five
years. The manufacturing cost per hammer is $1 and each hammer sells for $6. The
cost of capital is 20%. Calculate the break-even (i.e., NPV = 0) sales volume per year.
(Ignore taxes. Round to the nearest 1,000.)
A.
B.
C.
D.
500,000 units
550,000 units
600,000 units
650,000 units
28. All else equal, an increase in fixed costs:

I) increases the break-even point based on NPV;
II) increases the accounting break-even point;
III) decreases the break-even point based on NPV;
IV) decreases the accounting break-even point
A.
B.
C.
D.
I and IV only
III and IV only
II and III only
I and II only
29. Project analysis, beyond simply calculating NPV, includes the following procedures:
I) sensitivity analysis;
II) break-even analysis;
III) Monte Carlo simulation;
IV) scenario analysis
A.
B.
C.
D.
I only
I and II only
I, II, and III only
I, II, III, and IV
30. One can employ simulation models to:

I) understand the project better; II) better understand forecasted cash flows; III)
assess the project risk
A.
B.
C.
D.
I only
II only
III only
I, II, and III
10-9
31. Monte Carlo simulation involves the following steps:

I) Step 1: Modeling the project;
II) Step 2: Specifying probabilities;
III) Step 3: Simulating cash flows;
IV) Step 4: Calculating present value
A.
B.
C.
D.
I and II only
I, II, and III only
II, III, and IV only
I, II, III, and IV
32. After completing a project analysis, an analyst should rely on which tool to make a
final recommendation on the project?
A.
B.
C.
D.
sensitivity analysis
break-even analysis
decision trees
NPV
33. Which of the following simulation outputs is likely to be most useful and easy to
interpret? The output shows the distribution(s) of the project's:
A.
B.
C.
D.
sales.
internal rate of return.
cash flows.
profits.
34. Generally, Monte Carlo models, for project analysis, use which device to generate
simulations?
A.
B.
C.
D.
pair of dice
roulette wheel
computer
pack of cards
35. Monte Carlo simulation is likely to be most useful:
A.
B.
C.
D.
for very complex projects.

for projects of moderate complexity.
for very simple projects.
regardless of the project's complexity.
10-10
36. Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of a
deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction
costs are $50/bbl. PI expects prices and costs to remain constant. The rig will produce
an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per year,
which is also the cost of capital. (Ignore taxes). Calculate the NPV to invest today.
A.
B.
C.
D.
+100,000,000
+80,000,000
+60,000,000
+40,000,000
37. Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of a
costs are $50/bbl. PI expects costs to remain constant. The rig will produce an
estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per year, which is
also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are
equally likely to be $120/bbl. or $80/bbl. next year. Calculate today's NPV of the
project (i.e., NPV @ t = 0) if it were postponed by one year.
A.
B.
C.
D.
+$100 million
+$154 million
+$170 million
+$187 million
38. The following are real options EXCEPT:
A.
B.
C.
D.
stock options.
timing options.
options to expand.
options to abandon.
39. Petroleum Inc. (PI) controls off-shore oil leases. It is considering the construction of a
costs are $50/bbl. PI expects costs to remain constant. The rig will produce an
estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per year, which is
also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are
equally likely to be $120/bbl. or $80/bbl. next year.
Suppose that PI has the option to postpone the project by one year. Calculate the
value of the real option to postpone the project for one year.
A.
B.
C.
D.
+$30 million
+$50 million
+$54 million
+$70 million
10-11
40. Which of the following does NOT represent an option to expand a project?
A. A firm leases more office space than it forecasts it will need.

B. A company engages in test marketing for a new product.
C. Your university builds an administrators' parking garage having more parking
spaces than administrators.
D. A dry cleaner purchases equipment that can be readily sold to other dry cleaners.
41. Which of the following does NOT represent an option to abandon a project?
A.
Your friend builds a custom-made home.
B. You enroll in five classes, planning to drop one class before the semester ends.
C. A dry cleaner purchases equipment that can be readily sold to other dry cleaners.
D. You purchase a fully refundable airplane ticket.
42. You are planning to produce a new action figure called "Hillary". However, you are
very uncertain about the demand for the product. If it is a hit, you will have net cash
flows of $50 million per year for three years (starting next year, i.e., at t = 1). If it
fails, you will only have net cash flows of $10 million per year for two years (also
starting next year). There is an equal chance that it will be a hit or failure (probability
= 50%). You will not know whether it is a hit or a failure until after the first year's
cash flows are in, i.e., at t = 1. You have to spend $80 million immediately for
equipment and the rights to produce the figure. If the discount rate is 10%, calculate
Hillary's NPV.
A.
B.
C.
D.
-9.15
+13.99
+5.15
-14.4
10-12
= 50%). You will not know whether it is a hit or a failure until the first year's cash
flows are in, i.e., at t = 1. You have to spend $80 million immediately for equipment
and the rights to produce the figure. If you can sell your equipment for $60 million
immediately after the first year's cash flows are received, calculate Hillary's NPV with
this abandonment option. (The discount rate is 10%. The equipment can only be
resold at the end of the first year.)
A.
B.
C.
D.
-9.1
+9.1
+13.99
-14.4
= 50%). You will not know whether it is a hit or a failure until the first year's cash
flows are in, i.e., at t = 1. You have to spend $80 million immediately for equipment
and the rights to produce the figure. If you can sell your equipment for $60 million
once the first year's cash flows are received, calculate the value of the abandonment
option. (The discount rate is 10%.)
A.
B.
C.
D.
-9.15
+13.99
+23.14
0
45. The following options associated with a project increase managerial flexibility:
I) option to expand; II) option to abandon; III) production options; IV) timing options
A.
B.
C.
D.
I only
II only
I, II, III, and IV
IV only
10-13
46. You are given the following net future values for harvesting trees from a plot of
forestland. (This is a one-time harvest.)
If the cost of capital is 15%, calculate the optimal year to harvest:
A.
B.
C.
D.
year 1
year 2
year 3
year 4
47. The Consumer-Mart Company is going to introduce a new consumer product. If

brought to market without research about consumer tastes the firm believes that
there is a 60% chance that the product will be successful. If successful, the project
has a NPV = $500,000. If the product is a failure (40%) and withdrawn from the
market, then NPV = -$100,000. A consumer survey will cost $60,000 and delay the
introduction by one year. With a survey, there is an 80% chance of consumer
acceptance, in which case the NPV = $500,000. If, on the other hand the product is a
failure (20%) and withdrawn from the market, then NPV = -$100,000. The discount
rate is 10%. By how much does the marketing survey change the expected net
present value of the project?
A.
B.
C.
D.
increases the NPV by $25,455

decreases the NPV by $5950
increases the NPV by $8955
decreases the NPV by $25,455
48. KMW Inc. sells finance textbooks for $150 each. The variable cost per book is $30 and
the fixed cost per year is $30,000. The process of creating a textbook costs $150,000
and the average book has a life span of three years. What is the economic or NPV
break-even number of books that must be sold each year given a discount rate of
12%?
A.
B.
C.
D.
156
191
235
771
True / False Questions
10-14
49. Expansion options generally show as an asset on a corporation's balance sheet.

True
False
50. Postaudits are conducted before the start of projects.

True
False
51. Most firms keep track of the progress of projects by conducting postaudits shortly
after the projects have begun to operate.
True
False
52. Projects with higher fixed costs have lower break-even points.
True
False
53. The break-even point in terms of NPV is usually lower than the break-even point on
an accounting basis.
True
False
54. Firms that operate at break-even on an accounting basis are really losing the
opportunity cost of capital on their investments.
True
False
55. Monte Carlo simulation is a tool intended to consider all possible combinations of
variables.
True
False
56. In constructing a Monte Carlo simulation model of an investment project, one

typically ignores possible interdependencies between variables.
True
False
57. Monte Carlo simulation should be used to get the distribution of NPV values for a
project.
True
False
58. Tangible assets usually have higher abandonment values than intangible ones.
True
False
59. The option to wait is a type of abandonment option.

True
False
10-15
60. Firms with higher fixed costs tend to have higher degrees of operating leverage.
True
False
61. Adding a fudge factor to the cost of capital will penalize longer-term projects more
due to compounding.
True
False
62. In most cases the present value break-even quantity is higher than the accounting
break-even quantity.
True
False
63. Monte Carlo simulation is mostly an advanced version of scenario analysis.

True
False
Short Answer Questions
64. Indicate some of the problems associated with the capital investment process.
65. Discuss the importance of conducting postaudits.
10-16
66. Briefly describe sensitivity analysis as used for project analysis.
67. How do managers supplement the NPV analysis of a project to gain a better
understanding of a project?
68. Briefly discuss break-even analysis.
10-17
69. Briefly discuss the usefulness of Monte Carlo simulation in project analysis.
70. Briefly explain the term real options.
71. Briefly discuss various real options associated with capital budgeting projects.
72. Define the term abandonment value.
10-18
73. Briefly explain timing options.
74. Explain the usefulness of decision trees in project analysis.
75. Why is sensitivity analysis less realistic than Monte Carlo simulation?
10-19
Chapter 10 Project Analysis Answer Key
Multiple Choice Questions
1.
Discounted cash-flow (DCF) analysis generally:

I) assumes that firms hold assets passively when it invests in a project;
II) considers opportunities to expand a project if the project is successful;
III) considers opportunities to abandon a project if the project is a failure
A.
B.
C.
D.
I only
II only
II and III only
I, II, and III
Type: Medium
2.
Most firms' capital investment proposals originate from:
A.
B.
C.
D.
senior management.
planning staff, corporate finance department.
the board of directors.
divisional management.
Type: Easy
3.
Generally, postaudits are conducted for large projects:
A.
B.
C.
D.
shortly after the completion of the project.

several years after the completion of the project.
shortly after the project has begun to operate.
well before the start of the project.
Type: Medium
10-20
4.
Generally, postaudits for projects are conducted to:

I) identify problems that need fixing;
II) check the accuracy of forecasts;
III) generate questions that should have been asked before project
commencement
A.
B.
C.
D.
I only
II only
I and II only
I, II, and III
Type: Difficult
5.
You obtain the following data for year 1: Revenue = $43; Variable costs = $30;
Depreciation = $3; Tax rate = 30%. Calculate the operating cash flow for the
project for year 1.
A.
B.
C.
D.
$7
$10
$13
$16
Pretax income = (43 - 30 - 3) = 10; Tax = 10(0.3) = 3; Net profit = 10 - 3 = 7;

Operating cash flow = 7 + 3 = 10.
Type: Difficult
10-21
6.
A project has an initial investment of 100. You have come up with the following
estimates of the project's cash flows:
Suppose the cash flows are perpetuities and the cost of capital is 10%. What does
a sensitivity analysis of NPV (no taxes) show? (Answers appear in order:
[Pessimistic, Most Likely, Optimistic].)
A.
B.
C.
D.
-50, 20, +100.

-100, -50, +80.
-50, +50, +70.
+5, +11, +18.
Pessimistic NPV = [(15 - 10)/0.10] - 100 = -50;

Most Likely NPV = [(20 - 8)/0.10] - 100 = +20;
Optimistic NPV = [(25 - 5)/0.10] - 100 = +100.
Type: Medium
7.
You are given the following data for year 1: Revenues = 100, Fixed costs = 30;
Total variable costs = 50; Depreciation = $10; Tax rate = 30%. Calculate the aftertax cash flow for the project for year 1.
A.
B.
C.
D.
$17
$13
$10
$7
EBT = (100 - 30 - 50 - 10) = 10;

T = 10(0.3) = 3;
CF1 = 10 - 3 + 10 = 17.
Type: Difficult
10-22
8.
A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000;

C3 = 100,000. If the discount rate changes from 12% to 15%, what is the CHANGE
in the NPV of the project (approximately)?
A.
B.
C.
D.
12,750 increase
12,750 decrease
14,240 increase
14,240 decrease
NPV at 12% = 135,400, NPV at 15% = 122,650.

Change = 122,650 - 135, 410 = -12,750.
Type: Difficult
9.
You calculate the following estimates of project cash flows:
The revenues and costs occur in perpetuity, as opposed to the initial investment.
The cost of capital is 8%. What does a sensitivity analysis of NPV (without taxes)
show? (Answers appear in order: [Pessimistic, Most Likely, Optimistic].)
A.
B.
C.
D.
25.00, +232.50, +440.00

-100.00, +500.00, +800.00
-90.00, -55.00, -20.00
-88.33, -50.00, -18.50
Pessimistic NPV = [(30 - 20)/0.08] - 100 = +25.00;

Most likely NPV = [(40 - 15)/0.08] - 80 = +232.50;
Optimistic NPV = [(50 - 10)/0.08] - 60 = +440.00.
Type: Medium
10-23
10.
A project requires an initial investment of $150. Your research generates the

following estimates of revenues and costs:
The cost of capital equals 10%. Assume that the cash flows occur in perpetuity.
What does a sensitivity analysis of NPV (without taxes) show? (Answers appear in
order: [Pessimistic, Most Likely, Optimistic].)
A.
B.
C.
D.
50, -100, +400

-50, +300, +500
-100, +150, +350
+100, +150, +350
Pessimistic NPV = [(30 - 25)/0.10] - 150 = -100;

Expected NPV = [(50 - 20)/0.10] - 150 = +150;
Optimistic NPV = [(65 - 15)/0.10] - 150 = +350.
Type: Difficult
10-24
11.
A project requires an initial investment in equipment of $90,000 and then requires

an initial investment in working capital of $10,000 (at t = 0). You expect the
project to produce sales revenue of $120,000 per year for three years. You
estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs
occur at year-end, i.e.,t = 1, t = 2, and t = 3.) The equipment depreciates using
straight-line depreciation over three years. At the end of the project, the firm can
sell the equipment for $10,000 and also recover the investment in net working
capital. The corporate tax rate is 30% and the cost of capital is 15%. Cash flows
from the project are:
A.
B.
C.
D.
CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600.

CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 49,600.
Initial Investment = 90,000 + 10,000 = 100,000; CF 0 = -100,000;

CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600;
CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 =
59,600.
In year 3, note that the equipment is sold for $10,000 but generates a taxable
capital gain. Meanwhile, working capital of $10,000 is recouped in year 3.
Type: Difficult
10-25
12.

occur at year-end, i.e., t = 1, t = 2, and t = 3.) The equipment depreciates using
capital. The corporate tax rate is 30% and the cost of capital is 15%. Calculate the
NPV of the project:
A.
B.
C.
D.
$3,840.
$8,443.
$-2,735.
$7,342.
Initial investment = 90,000 + 10,000 = 100,000; CF 0 = -100,000;

CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600;
CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 =
59,600.
Feedback: NPV = -100,000 + 42,600/(1.15) + 42,600/(1.15^2) + 59,600/(1.15^3)
= 8,443.
Type: Difficult
10-26
13.

capital. The corporate tax rate is 30% and the cost of capital is 12%.
Calculate the NPV of the project:
A.
B.
C.
D.
$14,418.
$8,443.
$-2,735.
$12,873.

CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600;
CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 =
59,600.
NPV = -100,000 + 42,600/(1.12) + 42,600/(1.12^2) + 59,600/(1.12^3) = 14,418.
Type: Difficult
10-27
14.

capital. The corporate tax rate is 30% and the cost of capital is 15%. What is the
NPV of the project if the revenues were higher by 10% and the costs were 65% of
the revenues?
A.
B.
C.
D.
$8,443
$964
$5,566
$4,840

CF1 and CF2: (132,000 - 85,800 - 30,000)(1 - 0.3) + 30,000 = 41,340;
CF3: (132,000 - 85,800 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 =
58,340.
In year 3, note that the equipment is sold for $10,000 but is taxable.
NPV = -100,000 + 41,340/(1.15) + 41,340/(1.15^2) + 58,340/(1.15^3) = 5,566.
Type: Difficult
10-28
15.

sell the equipment for $10,000. The corporate tax rate is 30% and the cost of
capital is 16.5%. Calculate the NPV of the project.
A.
B.
C.
D.
$5,648
$3,840
-$2,735
$4,848

CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600;
CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 =
59,600.
In year 3, note that the equipment is sold for $10,000 but is taxable. Meanwhile,
working capital of $10,000 is recouped in year 3.
NPV at 16.5% = -100,000 + (42,600/1.165) + (42,600/(1.165^2)) + (59,600/
(1.165^3)) = $564.8.
Type: Difficult
16.
The following are drawbacks of sensitivity analysis EXCEPT:
A.
B.
C.
D.
it can provide ambiguous results.

the underlying variables are likely interrelated.
it can help identify the project's most important variables.
all of these statements are drawbacks of sensitivity analysis.
Type: Medium
17.
Which of the following statements most appropriately describes scenario analysis?
A.
B.
C.
D.
It looks at the project by changing one variable at a time.

It provides the break-even level of sales for the project.
It looks at different but consistent combinations of variables.
Each of these statements describes scenario analysis correctly.
Type: Easy
10-29
18.
The Financial Calculator Company proposes to invest $12 million in a new

calculator-making plant. Fixed costs are $3 million per year. A financial calculator
costs $10 per unit to manufacture and sells for $30 per unit. If the plant lasts for
four years and the cost of capital is 20%, what is the break-even level (i.e., NPV =
0) of annual sales? (Assume that revenues and costs occur at the end of each year.
Assume no taxes.) Round to the nearest 1,000 units.
A.
B.
C.
D.
150,000
342,000
382,000
300,000
units
units
units
units
First, find the annual cash flow that justifies a $12 million investment using the
equivalent annual cost (EAC) method. The 4-year annuity factor @ 20% equals
2.5887346.
EAC = 12/2.5887346 = $4,635,469 million. The plant must net this amount of cash
flow each year. Given $3M of annual fixed costs, let X = the annual sales rate:
X (30 - 10) -3,000,000 = 4,635,469;
X = 7,635,469/20 = 381,773.45 or approximately 382,000 units.
Type: Difficult
19.
The Solar Calculator Company proposes to invest $5 million in a new calculatormaking plant. Fixed costs are $2 million per year. A solar calculator costs $5 per
unit to manufacture and sells for $20 per unit. If the plant lasts for three years and
the cost of capital is 12%, what is the break-even level (i.e., NPV = 0) of annual
sales? (Assume that revenues and costs occur at the end of each year. Assume no
taxes.) Round to the nearest 1,000 units.
A.
B.
C.
D.
133,000
272,000
228,000
244,000
units
units
units
units
2.40183127.
EAC = 5,000,000/2.40183127 = 2,081,745 million. The plant must net this amount
of cash flow each year. Given $2M of annual fixed costs, let X = the annual sales
rate:
(X) (20 - 5) - 2,000,000 = 2,081,745;
X = (4,081,745/15) = 272,117 units or about 272,000 units.
Type: Difficult
10-30
20.
Firms often calculate a project's break-even sales using book earnings. However,
break-even sales based on NPV is generally:
A.
B.
C.
D.
higher than the one calculated using book earnings.

lower than the one calculated using book earnings.
equal to the one calculated using book earnings.
not related to the one calculated using book earnings.
Type: Difficult
21.
The accounting break-even point occurs when:
A.
B. the present value of inflows line cuts the present value of outflows line.
C.
D. total revenue is large enough to recapture depreciation expense.
Type: Medium
22.
The NPV break-even point occurs when:
A. the present value of inflows line cuts the present value of outflows line.
B.
C.
D.
the present value of inflows cuts the total cost line.
Type: Medium
23.
The Financial Calculator Company proposes to invest $12 million in a new

calculator-making plant that will depreciate on a straight-line basis. Fixed costs are
$3 million per year. A financial calculator costs $10 per unit to manufacture and
sells for $30 per unit. If the plant lasts for four years and the cost of capital is 20%,
what is the accounting break-even level of annual sales? (Assume no taxes.)
A.
B.
C.
D.
300,000
150,000
381,777
750,000
units
units
units
units
Fixed costs and depreciation both equal $3M per year. Let X = the annual sales
rate. Let p equal the price and v equal the variable cost. X = (FC + D)/(p - v) =
(3,000,000 + 3,000,000)/(30 - 10) = 300,000.
Type: Difficult
10-31
24.
The Solar Calculator Company proposes to invest $5 million in a new calculatormaking plant that will depreciate on a straight-line basis. Fixed costs are $2 million
per year. A calculator costs $5 per unit to manufacture and sells for $20 per unit. If
the plant lasts for three years and the cost of capital is 12%, what is the
accounting break-even level of annual sales? (Assume no taxes.)
A.
B.
C.
D.
133,334
272,117
244,444
466,666
units
units
units
units
Fixed costs and depreciation equal $2M and $1.67M per year, respectively. Let X =
the annual sales rate. Given a price of $20 and variable cost of $5,
X = (2,000,000 + 1,666,667)/(20 - 5) = 244,444 units.
Type: Difficult
25.
The Taj Mahal Tour Company proposes to invest $3 million in a new tour package
project. Fixed costs are $1 million per year. The tour package costs the company
$500 to produce and can be sold at $1500 per package to tourists. This tour
package will last for the next five years. If the cost of capital is 20%, what is the
NPV break-even number of tourists per year? (Ignore taxes. Round to the nearest
1,000.)
A.
B.
C.
D.
1,000
2,000
3,000
4,000
2.9906.
EAC = $3 million/2.9906 = $1.00 million. The tour must net this amount of cash
flow each year. Given $1M of annual fixed costs, let X = the annual sales rate: (X)
(1500 - 500) - 1,000,000 = 1,000,000.
X (1000) = 2,000,000;
X = 2,000,000/1000 = 2000.
Type: Difficult
10-32
26.
The Hammer Company proposes to invest $6 million in a new type of hammermaking equipment. The fixed costs are $0.5 million per year. The equipment will
last for five years. The manufacturing cost per hammer is $1 and each hammer
sells for $6. The cost of capital is 20%. Calculate the break-even (i.e., NPV = 0)
sales volume per year. (Ignore taxes. Round to the nearest 1,000.)
A.
B.
C.
D.
500,000
600,000
450,000
550,000
units
units
units
units
2.9906.
EAC = 6/2.9906 = 2 million.
The equipment must net this amount of cash flow each year. Given $0.5M of
annual fixed costs, let X = the annual sales rate:
X (6 - 1) - 500,000 = 2,000,000;
X = 2,500,000/5 = 500,000 units.
Type: Difficult
27.
Hammer Company proposes to invest $6 million in a new type of hammer-making

equipment. The fixed costs are $1.0 million per year. The equipment will last for
five years. The manufacturing cost per hammer is $1 and each hammer sells for
$6. The cost of capital is 20%. Calculate the break-even (i.e., NPV = 0) sales
volume per year. (Ignore taxes. Round to the nearest 1,000.)
A.
B.
C.
D.
500,000
550,000
600,000
650,000
units
units
units
units
2.9906.
EAC = 6/2.9906 = 2 million. The equipment must net this amount of cash flow
each year. Given $1.0M of annual fixed costs, let X = the annual sales rate:
X (6 - 1) - 1,000,000 = 2,000,000;
X = 3,000,000/5 = 600,000 units.
Type: Difficult
10-33
28.
All else equal, an increase in fixed costs:

I) increases the break-even point based on NPV;
II) increases the accounting break-even point;
III) decreases the break-even point based on NPV;
IV) decreases the accounting break-even point
A.
B.
C.
D.
I and IV only
III and IV only
II and III only
I and II only
Type: Medium
29.
Project analysis, beyond simply calculating NPV, includes the following procedures:
I) sensitivity analysis;
II) break-even analysis;
III) Monte Carlo simulation;
IV) scenario analysis
A.
B.
C.
D.
I only
I and II only
I, II, and III only
I, II, III, and IV
Type: Easy
30.
One can employ simulation models to:

I) understand the project better; II) better understand forecasted cash flows; III)
assess the project risk
A.
B.
C.
D.
I only
II only
III only
I, II, and III
Type: Easy
10-34
31.
Monte Carlo simulation involves the following steps:

I) Step 1: Modeling the project;
II) Step 2: Specifying probabilities;
III) Step 3: Simulating cash flows;
IV) Step 4: Calculating present value
A.
B.
C.
D.
I and II only
I, II, and III only
II, III, and IV only
I, II, III, and IV
Type: Medium
32.
After completing a project analysis, an analyst should rely on which tool to make a
final recommendation on the project?
A.
B.
C.
D.
sensitivity analysis
break-even analysis
decision trees
NPV
Type: Difficult
33.
Which of the following simulation outputs is likely to be most useful and easy to
interpret? The output shows the distribution(s) of the project's:
A.
B.
C.
D.
sales.
internal rate of return.
cash flows.
profits.
Type: Medium
34.
Generally, Monte Carlo models, for project analysis, use which device to generate
simulations?
A.
B.
C.
D.
pair of dice
roulette wheel
computer
pack of cards
Type: Easy
10-35
35.
Monte Carlo simulation is likely to be most useful:
A.
B.
C.
D.
for very complex projects.

for projects of moderate complexity.
for very simple projects.
regardless of the project's complexity.
Type: Easy
36.
Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of
a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and
extraction costs are $50/bbl. PI expects prices and costs to remain constant. The
rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is
10% per year, which is also the cost of capital. (Ignore taxes). Calculate the NPV to
invest today.
A.
B.
C.
D.
+100,000,000
+80,000,000
+60,000,000
+40,000,000
Easiest to do computations in $M.

NPV today = -500 + (1.2)(100 - 50)/0.10 = +100.
Type: Difficult
10-36
37.
Petroleum Inc. (PI) controls offshore oil leases. It is considering the construction of
extraction costs are $50/bbl. PI expects costs to remain constant. The rig will
produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per
year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are
uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Calculate
today's NPV of the project (i.e., NPV @ t = 0) if it were postponed by one year.
A.
B.
C.
D.
+$100
+$154
+$170
+$187
million
million
million
million

NPV(at t = 1, oil price = $120/bbl.) = -500 + (1.2)(120 - 50)/0.10 = +340;
NPV(at t = 1, oil price = $80/bbl.) = -500 + (1.2)(80 - 50)/0.10 = -140 (reject so
NPV = 0);
Expected NPV(at t = 0) = ((0.5)(0) + (0.5)(340))/1.10 = 154.5.
Type: Difficult
39.
Petroleum Inc. (PI) controls off-shore oil leases. It is considering the construction of
extraction costs are $50/bbl. PI expects costs to remain constant. The rig will
produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per
year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are
uncertain and are equally likely to be $120/bbl. or $80/bbl. next year.
Suppose that PI has the option to postpone the project by one year. Calculate the
value of the real option to postpone the project for one year.
A.
B.
C.
D.
+$30
+$50
+$54
+$70
million
million
million
million

NPV today = -500 + (1.2) ((0.5 120 + 0.5 80) - 50)/0.10 = +100;
NPV(at t = 1, oil price = $120/bbl.) = -500 + (1.2)(120 - 50)/0.10 = +340;
NPV(at t = 1, oil price = $80/bbl.) = -500 + (1.2)(80 - 50)/0.10 = -140 (reject so
NPV = 0);
NPV(at t = 1, oil price = $80/bbl.) = 0;
Expected NPV(at t = 0) = ((0.5)(0) + (0.5)(340))/1.10 = 154.5;
Value of the option to wait = 154 - 100 = $54 million.
Type: Difficult
10-37
40.
Which of the following does NOT represent an option to expand a project?
A. A firm leases more office space than it forecasts it will need.

B. A company engages in test marketing for a new product.
C. Your university builds an administrators' parking garage having more parking
spaces than administrators.
D. A dry cleaner purchases equipment that can be readily sold to other dry
cleaners.
Type: Medium
41.
Which of the following does NOT represent an option to abandon a project?
A.
Your friend builds a custom-made home.
B. You enroll in five classes, planning to drop one class before the semester ends.
C. A dry cleaner purchases equipment that can be readily sold to other dry
cleaners.
D.
You purchase a fully refundable airplane ticket.
Type: Medium
42.
You are planning to produce a new action figure called "Hillary". However, you are
very uncertain about the demand for the product. If it is a hit, you will have net
cash flows of $50 million per year for three years (starting next year, i.e., at t = 1).
If it fails, you will only have net cash flows of $10 million per year for two years
(also starting next year). There is an equal chance that it will be a hit or failure
(probability = 50%). You will not know whether it is a hit or a failure until after the
first year's cash flows are in, i.e., at t = 1. You have to spend $80 million
immediately for equipment and the rights to produce the figure. If the discount
rate is 10%, calculate Hillary's NPV.
A.
B.
C.
D.
-9.15
+13.99
+5.15
-14.4
Calculate the PV of cash inflows. The 3-year annuity factor at 10% equals 2.48685.
The 2-year annuity factor at 10% equals 1.73554.
PV(Success) = 50 (2.48685) = 124.3426;
PV(Failure) = 10 (1.73554) = 17.3554;
NPV = -80 + (124.3426)(0.5) + (17.3554)(0.5) = -9.15.
Type: Difficult
10-38
43.
(probability = 50%). You will not know whether it is a hit or a failure until the first
year's cash flows are in, i.e., at t = 1. You have to spend $80 million immediately
for equipment and the rights to produce the figure. If you can sell your equipment
for $60 million immediately after the first year's cash flows are received, calculate
Hillary's NPV with this abandonment option. (The discount rate is 10%. The
equipment can only be resold at the end of the first year.)
A.
B.
C.
D.
-9.1
+9.1
+13.99
-14.4
NPV with abandonment option:
PV(success) = 50(2.48685) = 124.3426;
PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 (assuming that the equipment will be sold
if the action figure is a failure);
NPV = -80 + (124.3426)(0.5) + (63.6364)(0.5) = +13.99.
Type: Difficult
10-39
44.
(probability = 50%). You will not know whether it is a hit or a failure until the first
year's cash flows are in, i.e., at t = 1. You have to spend $80 million immediately
for equipment and the rights to produce the figure. If you can sell your equipment
for $60 million once the first year's cash flows are received, calculate the value of
the abandonment option. (The discount rate is 10%.)
A.
B.
C.
D.
-9.15
+13.99
+23.14
0
1) Calculate the NPV of the project without an abandonment option.

The 2-year annuity factor at 10% equals 1.73554.
PV(Success) = 50 (2.48685) = 124.3426;
PV(Failure) = 10 (1.73554) = 17.3554;
NPV = -80 + (124.3426)(0.5) + (17.3554)(0.5) = -9.15.
2) Calculate the NPV of the project with an abandonment option.
NPV with abandonment option:
PV(success) = 50(2.48685) = 124.3426;
PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 (assuming that the equipment will be sold
if the action figure is a failure);
NPV = -80 + (124.3426)(0.5) + (63.6364)(0.5) = +13.99.
3) Value of the abandonment option = NPV (with the option) - NPV (without the
option) = 13.99 - (-9.15) = 23.14.
Type: Difficult
45.
The following options associated with a project increase managerial flexibility:

I) option to expand; II) option to abandon; III) production options; IV) timing
options
A.
B.
C.
D.
I only
II only
I, II, III, and IV
IV only
Type: Easy
10-40
46.
You are given the following net future values for harvesting trees from a plot of
forestland. (This is a one-time harvest.)
If the cost of capital is 15%, calculate the optimal year to harvest:
A.
B.
C.
D.
year
year
year
year
1
2
3
4
Type: Difficult
47.
The Consumer-Mart Company is going to introduce a new consumer product. If

brought to market without research about consumer tastes the firm believes that
there is a 60% chance that the product will be successful. If successful, the project
has a NPV = $500,000. If the product is a failure (40%) and withdrawn from the
market, then NPV = -$100,000. A consumer survey will cost $60,000 and delay the
introduction by one year. With a survey, there is an 80% chance of consumer
acceptance, in which case the NPV = $500,000. If, on the other hand the product
is a failure (20%) and withdrawn from the market, then NPV = -$100,000. The
discount rate is 10%. By how much does the marketing survey change the
expected net present value of the project?
A.
B.
C.
D.
increases the NPV by $25,455

decreases the NPV by $5950
increases the NPV by $8955
decreases the NPV by $25,455
No survey: Expected NPV = 500,000 (0.6) - 100,000 (0.4) = +260,000.

With the survey: Expected NPV = -60,000 + [(500,000)(0.8) - (100,000)(0.2)]/
(1.10)
12/18/2012 = +285,455.
Increase in NPV by the survey = 285,455 - 260,000 = 25,455.
Type: Difficult
10-41
Type: Difficult
10-42

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Chapter 10

Multiple Choice Questions

1. Discounted cash-flow (DCF) analysis generally:

2. Most firms' capital investment proposals originate from:

3. Generally, postaudits are conducted for large projects:

shortly after the completion of the project.

4. Generally, postaudits for projects are conducted to:

-50, 20, +100.

8. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3

9. You calculate the following estimates of project cash flows:

25.00, +232.50, +440.00

50, -100, +400

CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600.

16. The following are drawbacks of sensitivity analysis EXCEPT:

It looks at the project by changing one variable at a time.

higher than the one calculated using book earnings.

21. The accounting break-even point occurs when:

27. Hammer Company proposes to invest $6 million in a new type of hammer-making

28. All else equal, an increase in fixed costs:

30. One can employ simulation models to:

31. Monte Carlo simulation involves the following steps:

35. Monte Carlo simulation is likely to be most useful:

for very complex projects.

38. The following are real options EXCEPT:

A. A firm leases more office space than it forecasts it will need.

If the cost of capital is 15%, calculate the optimal year to harvest:

47. The Consumer-Mart Company is going to introduce a new consumer product. If

increases the NPV by $25,455

True / False Questions

49. Expansion options generally show as an asset on a corporation's balance sheet.

50. Postaudits are conducted before the start of projects.

56. In constructing a Monte Carlo simulation model of an investment project, one

59. The option to wait is a type of abandonment option.

63. Monte Carlo simulation is mostly an advanced version of scenario analysis.

Short Answer Questions

65. Discuss the importance of conducting postaudits.

66. Briefly describe sensitivity analysis as used for project analysis.

68. Briefly discuss break-even analysis.

70. Briefly explain the term real options.

72. Define the term abandonment value.

73. Briefly explain timing options.

74. Explain the usefulness of decision trees in project analysis.

Chapter 10 Project Analysis Answer Key

Multiple Choice Questions

Discounted cash-flow (DCF) analysis generally:

Most firms' capital investment proposals originate from:

Generally, postaudits are conducted for large projects:

shortly after the completion of the project.

Generally, postaudits for projects are conducted to:

Pretax income = (43 - 30 - 3) = 10; Tax = 10(0.3) = 3; Net profit = 10 - 3 = 7;

-50, 20, +100.

Pessimistic NPV = [(15 - 10)/0.10] - 100 = -50;

EBT = (100 - 30 - 50 - 10) = 10;

A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000;

NPV at 12% = 135,400, NPV at 15% = 122,650.

You calculate the following estimates of project cash flows:

25.00, +232.50, +440.00

Pessimistic NPV = [(30 - 20)/0.08] - 100 = +25.00;

A project requires an initial investment of $150. Your research generates the

50, -100, +400

Pessimistic NPV = [(30 - 25)/0.10] - 150 = -100;

A project requires an initial investment in equipment of $90,000 and then requires

CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600.