Chapter 10 Study Notes

Chapter 10 [Old exam conceptual questions]

1- Accounting break-even is defined as the sales level that causes the project:
A) Cash flows to equal zero.
B) Discounted cash flows to equal zero.
C) Net income to equal zero.
D) Cash inflows to equal the initial cash outflows.
E) Net income to equal the initial project expenditures.

2- You have put together a set of cash flow forecasts for a project and have found, on your first
calculation, that the NPV is positive. You should:
I. Accept the project because you are certain to increase shareholder wealth.
II. Try to identify some source of value in the project.
III. Use scenario or sensitivity analysis to investigate the project in greater detail.
IV. Try to assess the degree of forecasting risk that exists with the project.
A) I and II only
B) I, II, and IV only
C) I, III, and IV only
D) II, III, and IV only
E) II and IV only

3- Economic theory suggests that ___________ the likelihood of discovering a positive NPV
project.
A) the more competitive the market, the higher
B) there is a positive relation between the competitiveness of a market and
C) the competitiveness of a market has an indirect impact on
D) the competitiveness of a market has an insignificant impact on
E) competitive markets decrease

4- If a firm's fixed costs are exactly equal to its depreciation expense, and both are greater than
zero, then at its accounting break-even point the DOL _______________.
A) is equal to one
B) is equal to two
C) is greater than two
D) is undefined since you can't divide by zero
E) cannot be determined without more information
5- If a firm's fixed costs are exactly equal to its depreciation expense, and both are greater than
zero, then at its cash break-even point the DOL ______________.
A) is equal to one
B) is equal to two
C) is greater than two
D) is undefined since you can't divide by zero
E) cannot be determined without more information

6- If a firm's fixed costs are exactly equal to its depreciation expense, and both are greater than
zero, then at its financial break-even point the DOL ____________. (The project has
conventional cash flows, no salvage value, and no net working capital investments.)
A) is less than two
B) is equal to two
C) is greater than two
D) is undefined since you can't divide by zero
E) cannot be determined without more information

7- Which one of the following statements concerning scenario analysis is correct?

A) Under the best-case scenario, total costs will be at their anticipated minimal level.
B) Under the worst-case scenario, fixed costs will be at the minimal expected level.
C) Under the base case scenario, sales will be at the highest level that is reasonably
expected.
D) Using scenario analysis, you can determine the forecast risk associated with sales.
E) Scenario analysis concentrates on the changes in net income as variables move
within reasonably expected ranges.

8- The greater the degree of sensitivity of any one variable, the:

A) Less likely that variable is to cause potential losses if the estimated values are
incorrect.
B) Higher the net present value will be with an increase in any of the variables.
C) Less slope the resulting net present value line will have when graphed against
changes in that variable.
D) More attention management should pay to the reliability of the estimates for that
variable.
E) Less important forecasting errors for that variable become.

9- The process in which a business allocates a certain amount of financing for capital spending to
each business unit is called:
A) Simulation analysis.
B) Hard rationing.
C) Soft rationing.
D) Sensitivity analysis.
E) None of the above
10- Which of the following is (are) true concerning the accounting break-even point?
I. The net income is zero.
II. The net present value is zero.
III. The operating cash flow is zero.
IV. The internal rate of return is zero.
A) I and III only
B) I and IV only
C) II only
D) III only
E) II and IV only

11- A project with IRR = -100% is operating at the __________ break-even point.
A) cash
B) accounting
C) financial
D) sales
E) marketing

12- An analysis of what happens to NPV estimates when we ask what-if questions is called:
A) Forecasting analysis.
B) Scenario analysis.
C) Sensitivity analysis.
D) Simulation analysis.
E) Break-even analysis

13- If a firm's fixed costs are exactly equal to its depreciation expense, and both are greater than
zero, then at its financial break-even point the DOL ______________.
A) is equal to one
B) is equal to two
C) is greater than two
D) is undefined since you can't divide by zero
E) cannot be determined without more information

14- A project with IRR = 0% is operating at the __________ break-even point.

A) cash
B) financial
C) accounting
D) sales
E) leveraged
15- A project with IRR = -100% is operating at __________.
A) the cash break-even point
B) the accounting break-even point
C) the financial break-even point
D) an amount less than all break-even points
E) an amount greater than all break-even points

16- The degree to which a firm or project relies on fixed production costs is called its:
A) Operating leverage.
B) Financial break-even.
C) Contribution margin.
D) Cost sensitivity.
E) None of the above.

17- __________ analysis combines _________ analysis and __________ analysis.

A) Scenario; sensitivity; simulation
B) Sensitivity; simulation; scenario
C) Option; scenario; simulation
D) Simulation; scenario; sensitivity
E) Simulation; sensitivity; option

18- A project that has an IRR equal to ______ just breaks even on an accounting basis.
A) its required return
B) its AAR
C) 0 %
D) 100 %
E) -100 %

19- The analysis of the effects on a project's net present value when only one variable changes is
called ______ analysis.
A) Simulation
B) Upper and lower bound
C) Scenario
D) Sensitivity
E) Break-even
20- Which of the following describe(s) fixed costs?
I. Are constant for a given period of time
II. Are equal to zero when production is zero
III. Change with the quantity of output produced
A) I only
B) II only
C) I and II only
D) I and III only
E) II and III only

Chapter 10 [Old exam Problems]

1- Consider a three year project with the following information: initial fixed asset
investment = $420,000; straight-line depreciation to zero over the three year life; zero
salvage value; price = $26 per unit; variable cost = $18 per unit; fixed costs = $185,000;
quantity sold = 110,000 units; tax rate = 34%. What is the degree of operating leverage at
the given level of output? If the required rate of return is 12%, what is the degree of
operating leverage at the accounting, the cash and the financial break-even levels of
output? Calculate the quantity of units sold that will result in a zero NPV.
Solution:

Dep. = $420,000 / 3 = $140,000 per year

Sales 2,860,000 ($26 * 110,000)

VC -1,980,000 ($18 * 110,000)
FC -185,000
Dep. -140,000
EBIT 555,000
T (34%) -188,700
EAT 366,300
Dep. 140,000
OCF $506,300

At the given level of output:

DOL = 1 + (FC/OCF) = 1 + ($185,000 / $ 506,300) = 1.37

At the accounting break-even level of output: OCF = Dep.

DOL = 1 + (FC/OCF) = 1 + ($185,000 / $140,000) = 2.32

At the cash break-even level of output: undefined since OCF = 0

At the financial break-even level of output:

N=3
PV= 420,000
I/YR= 12
→ PMT = $174,866.57 = OCF that will make NPV = 0

DOL = 1 + (FC/OCF) = 1 + ($185,000 / $174,866.57) = 2.06

QF = [OCF + FC] / [P - v] = [174,866.57 + 185,000] / [26 -18]

= 359,866.57/8 = 44,983. 32
However, since we cannot produce 0.32 units

Therefore, QF = 44,984 units

2-Consider a three year project with the following information: initial fixed asset investment
= $360,000; straight-line depreciation to zero over the three year life; zero salvage value;
price = $23 per unit; variable cost = $15 per unit; fixed costs = $105,000; quantity sold =
110,000 units; tax rate = 31.5%. What is the degree of operating leverage at the given
level of output? If the required rate of return is 9.3%, what is the degree of operating
leverage at the financial break-even level of output? Calculate the quantity sold that will
result in a zero NPV. What is the degree of operating leverage at the accounting break-
even level of output? Calculate the quantity sold that will result in a zero NI.

Solution:
Dep. = $360,000 / 3 = $120,000 per year

Sales 2,530,000 ($23 * 110,000)

VC -1,650,000 ($15 * 110,000)
FC -105,000
Dep. -120,000
EBIT 655,000
T (31.5%) -206,325
EAT 448,675
Dep. 120,000
OCF $ 568,675

DOL at the given level of output:

DOL = 1 + (FC/OCF) = 1 + ($105,000 / $568,675) = 1.18

OCF at QF
N=3
PV= 360,000
I/YR= 9.3
→ PMT = $142,980.74 = OCF that will make NPV = 0

DOL at QF:
DOL = 1 + (FC/OCF) = 1 + ($105,000 / $142,980.74) = 1.73

QF = [OCF + FC] / [P - v] = [142,980.74+ 105,000] / [23 -15]

= 247,980.74 / 8 = 30,997.59
However, since we cannot produce 0.59 units

Therefore, QF = 30,998 units

DOL at QA: OCF = Dep.

DOL = 1 + (FC/OCF) = 1 + ($105,000 / $120,000) = 1.88
 QA = [FC + Dep] / [P - v] = [$105,000 + $120,000] / [23 -15]

= 225,000/8= 28,125 units

3- Consider a project with the following data: accounting break-even quantity = 19,000
units; cash break-even = 13,000 units; life = 5 years; fixed costs = $120,000; variable
costs = $23 per unit; required return = 16%. Assume the initial investment is depreciated
straight line to zero over the life of the project. Ignoring the effect of taxes, find the
financial break-even level of output. Calculate the degree of operating leverage at the
accounting, cash and financial break-even levels of output?

Solution:

QC= FC / [P - v] = 13,000 units = 120,000 / [P - 23]

Solve for the price per unit: P = $32.23

QA= [FC + D] / [P - v] = 19,000 units = [120,000 + D] / 32.23 – 23

Solve for depreciation: D = $55,370

Initial Investment = 5 ($55,370) = $276,850

Use the financial calculator to get the OCF that makes NPV = 0

N=5; PV= 276,850, I/YR= 16 solve for PMT= $84,552.59

QF= [OCF + FC] / [P - v] = [84,552.59 + 120,000] / 9.23 = 22,161.71 or 22,162 units

 At the accounting break-even level of output: OCF = Dep.
DOL = 1 + (FC/OCF) = 1 + ($120,000/$55,370) = 3.17

At the cash break-even level of output:

DOL is undefined since OCF = 0

At the financial break-even level of output:

DOL = 1 + (FC/OCF) = 1 + ($120,000 / $84,552.59) = 2.42

4- Find the accounting break-even point given the following information: Price = $50 per unit;
variable cost = $35 per unit; fixed costs = $50,000; depreciation = $10,000.
A) 1,160 units
B) 2,298 units
C) 3,333 units
D) 3,429 units
E) 4,000 units

Solution
QA= [FC + Dep] / [P - v] = ($50,000 + $10,000) / ($50 - $35) = $60,000 / $15 per unit
QA= 4,000 units

5- Given the following information, what is the financial break-even point? Initial investment =
$390,000; variable cost = $120 per unit; fixed cost = $65,000; price = $150; life = six
years; required return = 10%; depreciation = $45,000. Ignore taxes.
A) 1,392 units
B) 2,600 units
C) 4,167 units
D) 4,463 units
E) 5,152 units

Solution:
PV = $390,000
N = 6 years
I/Yr = 10%
→ PMT = OCF = $89,546.878341
QF= [FC + OCF] / [P - v]
= ($65,000 + $89,546.878341) / ($150 - $120) = $154,546.878341 / $30 per unit = 5,151.562611
units

6- Suppose that a project has a DOL = 0.55. If the quantity being produced increases from 96
units to 100 units, what is the expected percentage change in operating cash flow?
A) 2.3%
B) 3.1%
C) 4.2%
D) 5.5%
E) 6.2%

Solution:
% Δ Q = (100 – 96) / 96 = 0.041667

DOL = (% Δ OCF) / (% Δ Q) → 0.55 = (% Δ OCF) / 0.041667

% Δ OCF = 0.55 * 0.041667 = 0.022917 = 2.2917%

7- What is the degree of operating leverage? Sales = 100,000 units; price = $50 per unit; variable
cost = $30; fixed costs = $1,250,000; depreciation = $250,000; tax rate = 34%.
A) 2.22
B) 2.37
C) 2.63
D) 3.16
E) 3.22

Solution:
Sales $5,000,000 [100,000 units * $50 per unit]
VC -3,000,000 [100,000 units * $30 per unit]
FC -1,250,000
Dep. -250,000
EBIT $500,000
T(34%) -170,000
EAT 330,000
Dep. +250,000
OCF 580,000

DOL = 1 + (FC/OCF) = 1 + ($1,250,000/$580,000) = 1 + 2.155172 = 3.155172

8- If the DOL = 1.05 and OCF rises from $10,000 to $12,500, the percentage change in sales =?
A) 18.6%
B) 19.2%
C) 22.3%
D) 23.8%
E) 26.2%

Solution:
% Δ OCF = ($12,500 - $10,000) / $10,000 = 0.25
DOL = (% Δ OCF) / (% Δ Q) = 1.05 = 0.25 / (% Δ Q)

% Δ Q = 0.25 / 1.05 = 0.238095 = 23.8095%

9- A firm has fixed costs of $30,000 per year, depreciation of $10,000 per year, a price per unit
of $50, and an accounting break-even point of 2,000 units. What is the firm's variable
cost per unit at the accounting break-even point? What are the firm's total variable costs
at the accounting break-even point?
A) $20 per unit; $40,000
B) $25 per unit; $50,000
C) $30 per unit; $60,000
D) $35 per unit; $70,000
E) $40 per unit; $80,000
Solution
QA= [FC + Dep] / [P - v] = 2,000 units = ($30,000 + $10,000) / ($50 per unit – v)
$50 per unit – v = $40,000 / 2,000 units = $20 per unit
Variable cost per unit = v = $30 per unit
VC = v*Q = $30 per unit * 2,000 units = $60,000

10- A project requires an initial investment of $10,000, straight-line depreciable to zero over four
years. The discount rate is 10%. Your tax bracket is 37% and you receive a tax credit for
negative earnings in the year in which the loss occurs. Additional information for variables with
forecast error are shown below.

Base Case Lower Bound Upper Bound

Unit Sales 3,000 2,750 3,250
Price per unit $14 $13 $16
Variable cost per unit $9 $8 $10
Fixed costs $9,000 $8,500 $10,000
What is the worst case NPV for the project?
A) -$11,594
B) -$10,967
C) -$4,423
D) -$10,563
E) +$3,677

Solution:
Worst Case Scenario: Q = 2,750 units, P = $13 per unit, v = $10 per unit, FC = $10,000

Dep. = $10,000 / 4 = $2,500 per year

Year 0
FA -10,000
CF0 -$10,000

Year 1→4
Sales $35,750 (2,750 units * $13 per unit)
VC -27,500 (2,750 units * $10 per unit)
FC -10,000
Dep. -2,500
EBIT -$4,250
T(37%) -(1,572.5)
EAT -2,677.5
Dep. +2,500
ACF1→4 -$177.5

No Terminal CF

CF0 -$10,000
CF1 -$177.5
CF2 -$177.5
CF3 -$177.5
CF4 -$177.5
I/Yr 10%
→ NPV = -$10,562.651117

11- Given the following information, what is the degree of operating leverage? Price = $40 per
unit; variable cost = $20 per unit; fixed costs = $95,000 per year; depreciation = $35,000
per year; sales = 10,000 units per year. The tax rate is 40%.
A) 0.9
B) 1.3
C) 1.5
D) 1.9
E) 2.2
Solution:
Sales $400,000
VC -200,000
FC -95,000
Dep. -35,000
EBIT $70,000
T(40%) -$28,000
EAT 42,000
Dep. +35,000
OCF $77,000

DOL = 1 + (FC/OCF) = 1 + ($95,000/$77,000) = 2.233766

12- A project has a seven-year life and an initial investment of $228,700 in equipment. The
equipment will be depreciated straight-line to zero over seven years. Fixed costs are
$124,600. Variable costs are $8.16 per unit. Sales are estimated at 54,500 units at an
average price of $11.99. The estimated ranges of each variable are: sales quantity ±15%;
sales price ± 2%; variable cost ± 10%; and fixed costs ± 4%. The tax rate is 35%. Under
the worst-case scenario, what is the operating cash flow?
A) -$54,602
B) -$21,931
C) -$12,878
D) $10,740
E) $22,549

Solution:
Worst Case Scenario:

FC = $124,600 * 1.04 = $129,584

v = $8.16 per unit * 1.1 = $8.976 per unit

Q = 54,500 units * 0.85 = 46,325 units

P = $11.99 * 0.98 = $11.7502 per unit

Dep. = $228,700 / 7 = $32,671.42857

Sales $544,328.015 (46,325 units * $11.7502 per unit)

VC -415,813.2 (46,325 units * $8.976 per unit)
FC -129,584
Dep. -32,671.42857
EBIT -$33,740.61357
T(34%) -(11,809.21475)
EAT -21,931.39882
Dep. +32,671.42857
OCF $10,740.02975

13- A project has an initial cost of $94,000 for equipment, which will be depreciated straight-line
to zero over the five-year life of the project. There is no salvage value on the equipment.
No working capital is required. Sales are estimated at 6,000 units at a selling price of
$31.40 per unit. Variable costs are $22.80 and fixed costs are $41,600. The required rate
of return is 14% and the marginal tax rate is 35%. If the sales quantity increases by 100
units, the net present value will increase by:
A) $667
B) $897
C) $1,364.
D) $1,919.
E) $2,952

Solution:
Dep. = $94,000 / 5 = $18,800, v = $22.8 per unit, P = $31.4 per unit, FC = $41,600

Q = $6,000 units then Q increases by 100 units to 6,100 units

CF0= -$46,000

CF1→5 (Q = 6,000 units) CF1→5 (Q = 6,100 units)

Sales 188,400 191,540
VC -136,800 -139,080
FC -41,600 -41,600
Dep. -18,800 -18,800
EBIT -8,800 -7,940
T (35%) -(3,080) -(2,779)
EAT -5,720 -5,161
Dep. +18,800 +18,800
ACF 13,080 13,639
I/Yr 14% 14%
NPV -$49,095.30093 -$47,176.20867

∆ NPV = -$47,176.20867 – ($49,095.30093) = -$47,176.20867 + $47,176.20867 = $1,919.09226

NPV increases by $1,919.09226