invic

Which of the following statements about sensitivity analysis is least accurate?

A) The steeper the slope of the NPV versus the variable, the more sensitive the output variable is to a change in the input variable.

B) Sensitivity analysis starts with the best-case scenario.

C) Sensitivity analysis alters a single independent variable to determine the impact on the output variable.

---

In sensitivity analysis, you start with the “base-case” scenario. In this case, you use the company's projected cash flows as the inputs to calculate the net present value (NPV) of a project. Hopefully, supporters of a project are providing realistic information, although it may be on the optimistic side. In a “best-case” scenario, revenues would be excessively high, while expenses would be excessively low.

invic

Which of the following statements about Monte Carlo simulation is least accurate? Monte Carlo simulation:

A) is the most accurate risk analysis tool because it is based on real data.

B) can be useful for estimating the stand-alone risk of a project.

C) is capable of using probability distributions for variables as input data.

---

Monte Carlo uses computer simulated data not real data to estimate risk. It can be a very useful tool when there is a very small sample size for analysis.

invic

Which of the following statements about risk analysis techniques is least accurate?

A) Sensitivity analysis is incomplete, because it fails to consider the probability distributions of the independent variables.

B) In sensitivity analysis, the dependent variable is plotted on the y-axis and the independent variable on the x-axis. The steeper the slope on the resulting line the less sensitive the dependent variable is to changes in the independent variable.

C) Scenario analysis is a risk analysis technique that considers both the sensitivity of the dependent variable to changes in the independent variables and the range of likely values of these variables.

---

In sensitivity analysis, the dependent variable is plotted on the y-axis and the independent variable on the x-axis. The steeper the slope on the resulting line the more sensitive the dependent variable is to changes in the independent variable

invic

Which of the following statements is most accurate?

A) In a graphical depiction of sensitivity analysis, the project with the steeper line would be considered most risky, because a small error in estimating a variable, such as unit sales, will produce a large error in the net present value's prediction.

B) A company that does not adjust the discount rate for differences in project risk is likely to accept an excessive number of low risk projects.

C) The financial manager of a large corporation should view stand alone risk as most important because of its impact on debt capacity, credit worthiness, and job stability.

---

The steeper the sensitivity analysis profile, the more important it is to accurately forecast that variable’s true level. Financial managers are typically most sensitive to corporate, or within firm risk. Those companies not reducing required returns for projects with lower risk will end up accepting a higher number of high risk projects.

invic

Wanda Brunner, CFA, is working on a capital project valuation and needs to determine the appropriate discount rate. She has the following information available:

• Risk-free-rate = 8%
• Market Beta = 1.0
• Company Beta = 1.1
• Project Beta = 1.2
• Expected market return = 13%
• Trailing 12-months market return = 12%

Which of the following is closest to the most appropriate discount rate?

A) 13.5%.

B) 14.0%.

C) 13.0%.

---

Project discount rate = RF + βproject (E(RMKT) − RF )
Project discount rate = 8% + 1.2(13% − 8%)

invic

If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?

A) Both decrease.

B) Both increase.

C) One increase and one decrease.

---

An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.

invic

Spencer Charlson, Executive Vice President for PWK Design, is considering purchasing a new computer system for the firm. Charlson believes that PWK would benefit from purchasing the system now, but also is aware that Macroware, a software developer is coming out with a new operating system that will available in three months. Charlson is unsure whether or not the new operating system would help PWK and decides to wait until the new operating system comes out before making a purchase. The computer system project Charlson is evaluating would be best described as having a(n):

A) flexibility option.

B) fundamental option.

C) timing option.

---

Timing options allow a company to delay an investment with the hope of having better information in the future. Delaying an investment and basing the decision on the better information gained by waiting may improve the NPV of the overall project.

invic

Takamura Motors is evaluating a new piece of equipment that will automatically install power windows in cars coming off the production line. The equipment cost is $3.5 million, and the firm estimates that the present value of the annual cost savings from installing the equipment is $2.8 million. The production manager is also considering purchasing a module that will allow the equipment to be used for Takamura’s SUV production. The additional module represents a real option with a cost of $1.1 million dollars. The production manager estimates that adding the module would give Takamura cost savings of an additional $2.0 million.
What is the profitability of the project before and after considering the real option?

Before

After

A) $1,300,000 $200,000

B) -$700,000 $1,800,000

C) -$700,000 $200,000

---

The profitability of the project before considering the real option is the difference between the cost savings and the cost of the equipment, or 2.8 – 3.5 = -$700,000.

The profitability of the project after considering the real option = NPV (based on project alone) – cost of option + value of option. The cost of the option is $1.1 million, while the value of the option is $2.0 million. Profitability after option = -0.7 -1.1 + 2.0 = $200,000.

invic

Michael Fullen is discussing the evaluation of capital budgeting projects with his coworker, Katina Katzenmoyer. During conversation, Katzenmoyer makes the following statements regarding the determination of real option values:

Statement 1:	For independent projects, an analyst must determine a value for the real option that is separate from the project regardless of the profitability of the project.
Statement 2:	Abandonment options can be valuable, but should only be exercised when the abandonment value is greater than the discounted present value of the remaining cash flows of the project.

Are the statements made by Katzenmoyer correct?
  

A) Only one is correct.

B) Both are correct.

C) Both are incorrect.

---

Fullen should disagree with Katzenmoyer’s first statement. The value of a real option is always positive. For an independent project, if the project is already profitable, a manager can accept the project simply knowing that the real option will simply add to the profitability without determining a separate value for the option.

Fullen should agree with Katzenmoyer’s second statement. An abandonment option should be exercised when the abandonment value for a project is greater than the discounted present value of the remaining cash flows from the project.

invic

Rachel Moore, an analyst with Dawson Corporation, is discussing a potential capital project with her colleague, Phillip Cora. The project involves producing a new product that will be sold in discount retail stores. If sales for the new product are favorable, Dawson has the ability to purchase new equipment for the existing production facility that will expand production to double its current rate. However, Moore is concerned that other companies may easily replicate the product and that low barriers to entry will reduce Dawson’s profitability. If sales for the new product are disappointing after the first two years, Dawson has a potential buyer that will pay $2 million for the production facility. Moore explains these facts to Cora and asks him for help in computing an accurate net present value (NPV) for the project. Cora replies with the following statements:

Statement 1:	You cannot compute a dollar value for the project that includes both the expansion option and the abandonment option, since only one of them can actually be exercised.
Statement 2:	Since you do not have any control over what is going on at other companies, you should not factor in the creation of competing products from other companies into your analysis, and focus totally on the incremental cash flows generated from our production of the product.

How should Moore respond to Cora’s statements?

A) Agree with one only.

B) Agree with neither.

C) Agree with both

---

Moore should disagree with both of Cora’s statements. Even though both the option to double production and the option to sell the production facility cannot be exercised simultaneously, they both add value to the project and should be both be considered in any analysis. Even if it is difficult to compute an exact dollar value for each option’s contribution to the project, Moore can compute the value for the project without the options, and if the project does not already have a positive NPV, she can estimate whether the option values are enough to make the NPV positive. Cora’s second statement is also incorrect. The reaction from competitors has a definite impact on the potential profitability of the project and must be considered in the analysis