Week 4: Capital Budgeting Part 2

Which of the following costs would you consider when making a capital budgeting decision?

• sunk cost

• opportunity cost

• interest expense

• fixed overhead cost

Answer explanation

• sunk cost not need to be considered.
• fixed overhead cost is an example of sunk cost
• interest expense not to be considered as only consider unlevered income

Which of the following is an example of cannibalization?

• A toothpaste manufacturer adds a new line of toothpaste (that contains baking soda) to its product line.

• A grocery store begins selling T-shirts featuring the local university's mascot.

• A basketball manufacturer adds basketball hoops to its product line.

• A convenience store begins selling pre-paid cell phones.

Answer explanation

Cannibalization - new product gain sales against the existing products.

Firms should use the most accelerated depreciation scheme allowable.

• True

• False

Answer explanation

Most accelerated so depreciation will be more at the beginning of the years hence increase the tax saving and NPV.

A company spends $20 million researching whether it is possible to create a durable plastic from the process waste from feedstock preparation. The $20 million should best be considered ________.

• as a sunk cost

• as an opportunity cost

• as a fixed overhead expense

• as a capital cost

Answer explanation

Sunk cost - cost that is already incurred and cannot recoverable whether the firm going to undertake the project or not.

A consumer good company is developing a new brand of organic toothpaste. Above is the sensitivity analysis for this product. The assumptions regarding which parameter should be scrutinized most carefully in the estimation process?

• units sold

• sales price

• cost of goods

• cost of capital

Answer explanation

Cost of goods = most sensitive since any changes on its amount will cause big changes on NPV.

A consumer good company is developing a new brand of organic toothpaste. Above is the sensitivity analysis for this product. If the best-case assumptions for Net Working Capital are met, what will the net present value (NPV) of this project be?

• $0.65 million

• $1.7 million

• $2 million

• $3 million

Answer explanation

The question met best-case assumptions for net working capital. Hence use the best price for NWC which is the RHS of the optimal price (at the vertical line). the price indicates the NPV is 1.7m

A company planning to market a new model of motor scooter analyzes the effect of changes in the selling price of the motor scooter, the number of units that will be sold, the cost of making the motor scooter, the effect on Net Working Capital, and the cost of capital for the project. They predict that the break-even point for sales price for the motor scooter is $2,480. What does this mean?

• If the motor scooter is sold for $2,480, then the project will make a profit.

• If the motor scooter is sold for $2,480, then the net present value (NPV) for the product will be zero.

• The predicted selling price of the motor scooter is $2,480.

• The maximum that the motor scooter can sell for and still make the project have a positive net present value (NPV) is $2,480.

Answer explanation

Breakeven is when NPV = 0

The graph above shows the break-even analysis for the cost of making a certain good. Based on this chart, which of the following is true?

• The net present value (NPV) of the project increases with increased cost of goods sold.

• The project should not be undertaken if the predicted cost of goods sold is less than $110.

• The net present value (NPV) of the project will be positive if the cost of goods sold is greater than $110.

• If the good costs $110 to make, the net present value (NPV) of the project will be zero.

Answer explanation

Breakeven, NPV = 0 when COGS = 110

Positive NPV when COGS < 110

Negative NPV when COGS > 110

The EBIT break-even point can be calculated using which of the following formulas?

• (Units Sold × Sale Price) - (Units Sold × Cost per unit) - SG&A - Depreciation = 0

• (Units Sold × Sale Price) + (Units Sold × Cost per unit) - SG&A - Depreciation = 0

• (Units Sold × Sale Price) - (Units Sold × Cost per unit) + SG&A + Depreciation = 0

• (Units Sold × Sale Price) + (Units Sold × Cost per unit) + SG&A - Depreciation = 0

Answer explanation

Refer to the formula

The manufacturer of a brand of kitchen knives is investigating the likely effects that an increase in the cost of the raw materials required to make these knives will have on the cost of manufacturing the knives, the selling price of the knives, the number of knives that will then be sold, and the project's net present value (NPV). Which of the following best describes what type of analysis the manager is performing?

• scenario analysis

• sensitivity analysis

• break-even analysis

• EBIT-break even analysis

Answer explanation

Analysis more than 1 parameter = scenario analysis