Risk Analysis, Real Options, and Capital Budgeting

A project's net present value (NPV) calculation is considered sensitive to changes in underlying assumptions. What is the analytical technique that examines how sensitive a particular NPV calculation is to these changes?

Solar Electronics Corporation's base case for its new jet engine project has an initial investment of 1,500 million and is expected to generate a cash flow of 900 million for 5 years. With a discount rate of 15 percent, what is the Net Present Value (in millions)? The 5-year annuity factor at 15 percent is 3.3522.

What is a primary drawback of sensitivity analysis that scenario analysis attempts to address?

For a project, the sales price is 2 million per engine and the variable cost is 1 million per engine. The annual fixed costs are 1,791 million and depreciation is 300 million. What is the accounting profit break-even point in terms of the number of engines sold per year?

Why is the financial (NPV) break-even point for a project generally different from its accounting break-even point?

What is the primary purpose of using Monte Carlo simulation in capital budgeting?

In the context of capital budgeting, what does the term 'real option' refer to?

An entrepreneur estimates that a single ice hotel will have an NPV of -2 million. However, there is a 50 percent chance the project will be optimistic, with an NPV of 3 million, and a 50 percent chance it will be pessimistic, with an NPV of -7 million. If the optimistic forecast occurs, the entrepreneur can expand to 10 locations. What is the true NPV of the venture, considering this option to expand?

Why does the ability to abandon a project increase its value?

Vacant urban land can have a positive market value even if a current NPV analysis of building on it yields a negative result. Which real option best explains this phenomenon?

When using a decision tree to analyze a project with multiple decision points, in what order should the decisions be analyzed?

In the Solar Electronics Corporation (SEC) decision tree example, the firm must decide whether to invest 100 million in test marketing. If the test is successful (75 percent probability), the subsequent project has an NPV of 1,517 million. If the test fails (25 percent probability), the firm will not proceed, resulting in an NPV of 0. What is the expected payoff of the project evaluated at Year 1, just after the test marketing phase?

Continuing the SEC decision tree example, the firm determines the expected payoff at Year 1 to be 1,138 million. The initial cost of test marketing at Year 0 is 100 million, and the discount rate is 15 percent. What is the NPV of the decision to conduct the test marketing?

What does a project's accounting break-even point signify?

A project requires an initial investment of 1,500 million. The annual after-tax contribution margin per unit is 0.66 million. The project's equivalent annual cost (EAC) is 447.5 million, and it pays 1,791 million in annual fixed costs and receives a depreciation tax shield of 102 million (300 million * 0.34). What is the financial break-even point in units?

In the first step of a Monte Carlo simulation for a new product, what must be specified?

Which of the following is an example of the 'option to abandon'?

What is the primary reason that traditional NPV analysis is said to underestimate the true value of a project?

A firm has a project with a pessimistic NPV of -22 million and an optimistic NPV of 18 million, each with 50 percent probability. If the pessimistic outcome occurs, the firm can abandon the project after one year, having incurred the initial investment of 12 million and one year of negative cash flows of -2 million. The discount rate is 20 percent. What is the NPV of the project considering the abandonment option?

In the Solar Electronics Corporation example, what is the key difference between the 'pessimistic' forecast for market share versus the 'pessimistic' forecast for investment?

What is the primary objective of break-even analysis in capital budgeting?

In a Monte Carlo simulation, after specifying the basic model and the probability distributions for each variable, what is the next step?

A decision tree is a tool used to analyze which of the following capital budgeting concepts?

In the Solar Electronics example, under the 'plane crash' scenario, the market size is expected to be 7,000 units (70 percent of base case) and the market share is expected to be 20 percent (2/3 of base case). With a price of 2 million per engine, what would the annual revenue be in millions?

When is it appropriate to use break-even analysis in terms of present value rather than accounting profit?

What is the primary benefit that the option to expand adds to a project's value?

A project's initial investment is 1,500 million, which is depreciated over 5 years. Annual fixed costs are 1,791 million. If the firm sells 2,091 units, at which point it breaks even on an accounting basis, what is the value of the 'Total costs per year' including fixed costs and depreciation?

In the BBI hydrogen grill example for Monte Carlo simulation, the next year's price per grill is modeled as: Price = 190 + (1 * Industrywide unit sales in millions) +/- 3. If industry sales are 11 million units, what are the two possible prices for the grill?

Which of the following statements best describes the relationship between sensitivity analysis and scenario analysis?

A firm has an initial investment of 1,500 million. At a discount rate of 15 percent, the 5-year annuity factor is 3.3522. What is the equivalent annual cost (EAC) of this investment?

Despite its theoretical superiority, why is Monte Carlo simulation not more widely used in practice for capital budgeting, according to the chapter?

What is the key insight provided by a decision tree analysis for a project with sequential decisions?

If a project's cash flows are analyzed under a 'best, optimistic, and pessimistic' (bop) framework, what type of analysis is being performed?

Which of the following is NOT one of the five basic steps of Monte Carlo simulation outlined in the chapter?

A firm is considering a project. If the project is successful, it will generate a perpetual cash flow with a present value of 20 million. If it fails, the present value of the cash flows is -5 million. There is a 60 percent chance of success. The firm has the option to abandon the project after year 1 if it fails, limiting the loss to 2 million. What is the NPV of the project with the abandonment option?

In sensitivity analysis for the Solar Electronics Corporation, which variable's pessimistic forecast caused the largest negative impact on the project's NPV?

Why might a company choose to use the simple accounting break-even analysis despite its theoretical flaws?

The chapter discusses the movie 'Speed Racer' as an example of a project that 'crashed and burned at the box office.' This outcome illustrates which key concept in capital budgeting?

If a project has an initial investment of 2,000,000, what is its equivalent annual cost (EAC) over 5 years if the discount rate is 10 percent and the 5-year annuity factor is 3.7908?

What does a decision node, typically represented by a square, signify in a decision tree?

In the Solar Electronics case, the 'base case' NPV is positive. Why is it still important to conduct further analysis like sensitivity or scenario analysis?

Which of the following scenarios best illustrates the concept of a 'timing option'?

For the Solar Electronics project, what is the annual depreciation if the initial investment is 1,500 million and it is depreciated using the straight-line method over Years 2 through 6 (a 5-year period)?

What is the key difference in how scenario analysis and sensitivity analysis handle variables?

A project is considered to have a 'false sense of security' when:

In the context of a decision tree for a new product launch, what does the term 'expected payoff' at a future node represent?

If a firm has a project with an initial investment of 500,000, a 5-year life, and a required return of 12 percent, what is the annual cost that must be covered for the project to break even in present value terms (the EAC)? The 5-year annuity factor at 12 percent is 3.6048.

Which risk analysis technique is most capable of explicitly modeling the interactions between different variables (e.g., market share and price)?

The NPV of a project is calculated to be -5 million. However, the project gives the firm the option to expand if successful, an option valued at 8 million. What is the total value of the project including the real option?

A project has fixed costs of 100,000 and depreciation of 50,000. The sales price per unit is 20 and the variable cost per unit is 15. What is the accounting break-even quantity?