EFB343

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

• I only

• II only

• II and III only

• I, II, and III

Answer explanation

Traditional DCF analysis does not typically account for the active management of assets or the ability to make future decisions that might change the course of the project. It assumes that once the investment is made, the project will continue according to the original plan without considering future flexibility.

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

• $7

• $10

• $13

• $16

Answer explanation

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

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.

• $17

• $13

• $10

• $7

Answer explanation

EBT = (100 - 30 - 50 - 10) = 10;
T = 10(0.3) = 3;
CF1 = 10 - 3 + 10 = 17

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 12%. Calculate the NPV of the project

• $14,418

• $8,443

• $-2,735

• $12,873

Answer explanation

Initial investment = 90,000 + 10,000 = 100,000; CF0 = -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.
NPV = -100,000 + 42,600/(1.12) + 42,600/(1.12^2) + 59,600/(1.12^3) = 14,418

The following are drawbacks of sensitivity analysis EXCEPT:

• 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

Answer explanation

Ambiguous results arise from the definition of “optimistic” and “pessimistic”, e.g. marketing department may interpret it very differently to production department.
• Isolation of interrelated variables causes unrealistic estimation, e.g., the interrelation between market size and unit price. If market demand is high, you will not only have larger shares, but also higher unit price

The Solar Calculator Company proposes to invest $5 million in a new calculator-making 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.

• 133,000 units

• 272,000 units

• 228,000 units

• 244,000 units

Answer explanation

First, find the annual cash flow that justifies a $5 million investment using the equivalent annual cost (EAC) method. The 3-year annuity factor @ 12% equals 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.

Project analysis, beyond simply calculating NPV, includes the following procedures:

I) sensitivity analysis;
II) break-even analysis;
III) Monte Carlo simulation;
IV) scenario analysis

• I only

• I and II only

• I, II, and III only

• I, II, III, and IV

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

• +100,000,000

• +80,000,000

• +60,000,000

• +40,000,000

Answer explanation

NPV today = -500 + (1.2)(100 - 50)/0.10 = +100

perpetuity = CF/Disc.rate

Which of the following does NOT represent an option to abandon a project?

• Your friend builds a custom-made home

• You enroll in five classes, planning to drop one class before the semester ends.

• A dry cleaner purchases equipment that can be readily sold to other dry cleaners

• ou purchase a fully refundable airplane ticket

Which of the following statements is FALSE?

• One way to see why you sometimes choose not to invest in a positive-NPV project is to think about the decision of when to invest as a choice between two mutually exclusive projects: (1) invest today or (2) wait.

• You invest today only when the NPV of investing today exceeds the value of the option of waiting, which from option pricing theory we know to be always positive.

• When you do not have the option to wait, it is optimal to invest in any positive-NPV project.

• When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is positive but close to zero.

Answer explanation

When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is substantially positive