# Chapter 011 Project Analysis and Evaluation

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1 Multiple Choice Questions 1. Forecasting risk is defined as the: a. possibility that some proposed projects will be rejected. b. process of estimating future cash flows relative to a project. C. possibility that errors in projected cash flows will lead to incorrect decisions. d. process of ascertaining the incremental cash flows for a project. e. possibility that tax rates could change over the life of a project. SECTION: 11.1 TOPIC: FORECASTING RISK TYPE: DEFINITIONS 2. Scenario analysis is defined as: a. the determination of the most likely outcome for a project. B. analyzing the changes in NPV estimates when what-if questions are posed. c. isolating the effect that one variable has on the NPV of a project. d. comparing the NPV of a project both with and without considering the effects of erosion. e. determining the acceptability of a project based solely on the project's operating cash flows. TOPIC: SCENARIO ANALYSIS TYPE: DEFINITIONS 3. An analysis of what happens to the estimate of net present value when only one variable is changed is called analysis. a. forecasting b. scenario C. sensitivity d. simulation e. break-even TOPIC: SENSITIVITY ANALYSIS TYPE: DEFINITIONS 11-1

2 4. An analysis which combines scenario analysis with sensitivity analysis is called analysis. a. forecasting b. scenario c. sensitivity D. simulation e. break-even TOPIC: SIMULATION ANALYSIS TYPE: DEFINITIONS 5. Variable costs: A. change in direct relationship to the quantity of output produced. b. are constant in the short-run regardless of the quantity of output produced. c. reflect the change in NPV when one more unit of output is produced and sold. d. are subtracted from fixed costs to compute the contribution margin. e. are inversely related to the number of units sold. TOPIC: VARIABLE COSTS TYPE: DEFINITIONS 6. Fixed costs: a. change as the quantity of output produced changes. B. are constant over the short-run regardless of the quantity of output produced. c. reflect the change in a variable when one more unit of output is produced. d. are subtracted from sales to compute the contribution margin. e. can be ignored in scenario analysis since they are constant over the life of a project. TOPIC: FIXED COSTS TYPE: DEFINITIONS 11-2

3 7. The change in revenue that occurs when one more unit of output is sold is called the revenue. A. marginal b. average c. total d. fixed e. variable TOPIC: MARGINAL REVENUE TYPE: DEFINITIONS 8. The sales level that results in a project's net income exactly equaling zero is called the break-even. a. operational b. leveraged C. accounting d. cash e. financial TOPIC: ACCOUNTING BREAK-EVEN TYPE: DEFINITIONS 9. The sales level that results in a project's operating cash flow exactly equaling zero is called the break-even. a. operational b. leveraged c. accounting D. cash e. financial SECTION: 11.4 TOPIC: CASH BREAK-EVEN TYPE: DEFINITIONS 11-3

4 10. The sales level that results in a project's net present value exactly equaling zero is called the break-even. a. operational b. leveraged c. accounting d. cash E. financial SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN TYPE: DEFINITIONS 11. Operating leverage is the: a. dependence of a firm on variable costs. b. percentage of a sales price that is needed to cover variable costs. c. percentage of the sales price which represents the contribution margin. D. degree to which a firm relies on fixed costs. e. amount of debt used to finance a project. SECTION: 11.5 TOPIC: OPERATING LEVERAGE TYPE: DEFINITIONS 12. The percentage change in operating cash flow relative to the percentage change in quantity sold is called the: a. marginal profit. B. degree of operating leverage. c. gross profit. d. net profit. e. contribution margin. SECTION: 11.5 TOPIC: DEGREE OF OPERATING LEVERAGE TYPE: DEFINITIONS 11-4

5 13. The procedure of allocating a fixed amount of funds for capital spending to each business unit is called: a. marginal spending. b. average spending. C. soft rationing. d. hard rationing. e. marginal rationing. SECTION: 11.6 TOPIC: SOFT RATIONING TYPE: DEFINITIONS 14. Hard rationing is defined as the situation where: a. two projects have the same NPV but only one project can be financed. b. firms are forced to chose one project over another. c. divisions within a firm are granted equal amounts for capital expenditures. d. divisions within a firm request more funds for capital projects than firms have available for use. E. a firm is unable to raise the funds needed for a project from any source. SECTION: 11.6 TOPIC: HARD RATIONING TYPE: DEFINITIONS 15. Forecasting risk emphasizes the point that the correctness of any decision to accept or reject a project is highly dependent upon the: a. method of analysis used to make the decision. b. initial cash outflow. c. ability to recoup any investment in net working capital. D. accuracy of the projected cash flows. e. length of the project. SECTION: 11.1 TOPIC: FORECASTING RISK 11-5

6 16. Jennie is fairly cautious when considering new opportunities and therefore analyzes each project to determine the most optimistic, the most realistic, and the most pessimistic outcome that can reasonably be expected. Jennie is using: a. forecast modeling. b. sensitivity analysis. c. break-even analysis. d. soft rationing. E. scenario analysis. TOPIC: SCENARIO ANALYSIS 17. Conducting scenario analysis on a proposed project helps managers determine the: a. impact that an individual variable has on the outcome of the project. b. initial cost that will be required to implement the project. c. actual profitable life of the project. d. level of funding available for the project. E. potential range of reasonable outcomes that might be realized. TOPIC: SCENARIO ANALYSIS 18. When conducting a best case scenario analysis, you should assume that: a. the number of units sold and the variable cost per unit are at the high end of their potential ranges. B. the salvage value will be at the high end of its possible range. c. sales quantity will be at the low end of its range while the sales price is the highest price possible. d. the variable costs per unit are at the high end of potential cost range. e. fixed costs will become variable and decrease in dollar amount. TOPIC: SCENARIO ANALYSIS 11-6

7 19. The base case values used in scenario analysis are the ones considered the most: a. optimistic. b. desired by management. c. pessimistic. d. conducive to creating a positive net present value. E. likely to occur. TOPIC: SCENARIO ANALYSIS 20. Which of the following variables will be at their highest expected level under a worst case scenario? I. fixed cost II. sales price III. variable cost IV. sales quantity a. I only b. III only c. II and III only D. I and III only e. I, III, and IV only TOPIC: SCENARIO ANALYSIS 21. When you assign the highest sales price and the lowest costs to a project, you are analyzing the project under the condition known as: a. optimistic sensitivity. b. pessimistic sensitivity. C. optimistic scenario analysis. d. pessimistic scenario analysis. e. base case scenario analysis. TOPIC: SCENARIO ANALYSIS 11-7

8 22. Which one of the following statements concerning scenario analysis is correct? a. The worst case scenario determines the maximum loss, in current dollars, that a firm could incur from a given project. b. Scenario analysis reflects the entire range of results that can be realized from a proposed investment project. c. Scenario analysis provides a clear signal to management to either accept or reject a proposed project. D. Scenario analysis provides management with a glimpse of the possible range of outcomes that could be realized from a project. e. When the base case scenario results in a positive net present value, management can be assured the proposed project will meet or exceed their expectations. TOPIC: SCENARIO ANALYSIS 23. Sensitivity analysis determines the: a. range of possible outcomes given that most variables can assume a range of values. B. degree to which the net present value reacts to changes in a single variable. c. extent of the range of net present values that can be realized from a proposed project. d. degree to which a project is reliant upon the fixed costs. e. ideal ratio of variable costs to fixed costs for profit maximization. TOPIC: SENSITIVITY ANALYSIS 24. Assume you graph the changes in net present value against the changes in the value of a single variable used in a project. The steepness of the resulting function illustrates the: a. degree of operating leverage within the project. b. trade-off of variable versus fixed costs utilized by the project. c. range of total outcomes possible from accepting a proposed project. d. contribution margin of the project at various levels of output. E. degree of sensitivity of the project's outcome to changes in the single variable. TOPIC: SENSITIVITY ANALYSIS 11-8

9 25. As the degree of sensitivity of a project to a single variable rises, the: a. less important the variable to the final outcome of the project. b. less volatile the project's net present value to that variable. C. greater the importance of accurately predicting the value of that variable. d. greater the profit margin of the project. e. less volatile the project's outcome. TOPIC: SENSITIVITY ANALYSIS 26. Sensitivity analysis is based on: A. varying a single variable and measuring the resulting change in the NPV of a project. b. applying differing discount rates to a project's cash flows and measuring the effect on the NPV. c. expanding and contracting the number of years for a project to determine the optimal project length. d. the best, worst, and most expected situations. e. various states of the economy and the probability of each state occurring. TOPIC: SENSITIVITY ANALYSIS 27. To ascertain whether the accuracy of a variable cost estimate for a project will have much effect on the final outcome of that project, you should conduct analysis. a. leverage b. scenario c. break-even D. sensitivity e. cash flow TOPIC: SENSITIVITY ANALYSIS 11-9

10 28. Simulation analysis is based on assigning a and analyzing the results. a. narrow range of values to a single variable b. narrow range of values to multiple variables simultaneously c. wide range of values to a single variable D. wide range of values to multiple variables simultaneously e. single value to each of the variables TOPIC: SIMULATION 29. The type of analysis that is most dependent upon the use of a computer is analysis. a. scenario b. break-even c. sensitivity d. degree of operating leverage E. simulation TOPIC: SIMULATION 30. Which one of the following is most likely a fixed cost? A. office rent b. employee wages c. sales tax d. raw materials e. shipping costs TOPIC: FIXED COSTS 11-10

11 31. Which one of the following statements concerning variable costs is correct? a. Variable costs minus fixed costs equal marginal costs. b. Variable costs are equal to fixed costs when production is equal to zero. c. An increase in variable costs increases the operating cash flow. d. Variable costs are inversely related to fixed costs. E. Variable costs are inversely related to operating cash flow. TOPIC: VARIABLE COSTS 32. As the variable cost per unit increases, the: A. contribution margin decreases. b. number of units sold decreases. c. fixed cost per unit decreases. d. operating cash flow increases. e. net profit increases. TOPIC: VARIABLE COSTS 33. As additional fixed assets are purchased for a project, the project's level of fixed costs and the degree of operating leverage. A. increases; increases b. increases; decreases c. decreases; increases d. decreases; decreases e. remains constant; remains constant TOPIC: FIXED COSTS 11-11

12 34. Which one of the following is a fixed cost in the short-run? a. packaging and shipping costs b. wages for a machine operator c. the cost of raw materials d. the cost of water used in the production process E. three-year lease on a delivery truck TOPIC: FIXED COSTS 35. Management wants to offer a "Thank You" sale to its customers by offering to sell additional units of a product at the lowest price possible without affecting the firm's profits. The price management charges for these one-time sale units should be set equal to the: a. average variable cost. b. average total cost. c. average total revenue. d. marginal revenue. E. marginal cost. TOPIC: MARGINAL COST 11-12

13 36. The president of your firm would like to offer special sale prices to your best customers under the following terms: The prices will apply only to units purchased in excess of those normally purchased by the customer. The units purchased must be paid for in cash at the time of sale. The total quantity sold under these terms cannot exceed the excess capacity of the firm. The net profit of the firm should not be affected either positively or negatively. Given these conditions, the special sale price should be set equal to the: a. average variable cost. b. average total cost minus the marginal cost. c. sensitivity value of the variable cost. D. marginal cost. e. marginal cost minus the average fixed cost per unit. TOPIC: MARGINAL COST 37. The contribution margin per unit is equal to the: a. sales price per unit minus the total costs per unit. b. variable cost per unit minus the fixed cost per unit. C. sales price per unit minus the variable cost per unit. d. pre-tax profit per unit divided by the sales price. e. aftertax profit per unit divided by the sales price. TOPIC: CONTRIBUTION MARGIN 38. At the accounting breakeven point, the contribution margin must equal: a. total costs. b. fixed costs. c. the earnings before interest and taxes. D. fixed costs plus depreciation. e. depreciation. TOPIC: ACCOUNTING BREAKEVEN 11-13

14 39. Which of the following statements are correct concerning the accounting break-even point? I. The net income is equal to zero. II. The net present value is equal to zero. III. The quantity sold is equal to the total fixed costs plus depreciation divided by the contribution margin. IV. The quantity sold is equal to the total fixed costs divided by the contribution margin. A. I and III only b. I and IV only c. II and III only d. II and IV only e. I, II, and IV only TOPIC: ACCOUNTING BREAK-EVEN 40. At the accounting break-even level of sales, the operating cash flow is equal to: a. zero. B. depreciation. c. fixed costs plus depreciation. d. net income plus taxes. e. the variable costs. TOPIC: ACCOUNTING BREAK-EVEN 41. All else constant, the accounting break-even level of sales will decrease when the: a. fixed costs increase. B. depreciation expense decreases. c. contribution margin decreases. d. variable costs per unit increase. e. selling price per unit decreases. TOPIC: ACCOUNTING BREAK-EVEN 11-14

15 42. At the accounting break-even point, the: a. payback period must equal the required payback period. b. NPV is zero. C. IRR is zero. d. contribution margin equals the fixed costs. e. contribution margin is zero. TOPIC: ACCOUNTING BREAK-EVEN 43. A project has a payback period that exactly equals the project's life. The project is operating at: a. its maximum capacity. b. the financial break-even point. c. the cash break-even point. D. the accounting break-even point. e. a zero level of output. TOPIC: ACCOUNTING BREAK-EVEN 44. Roger just completed analyzing a project. His analysis indicates that the project will have a 5-year life and require an initial cash outlay of \$225,000. Annual sales are estimated at \$685,000 and the tax rate is 35 percent. The net present value is a negative \$225,000. Based on this analysis, the project is expected to operate at the: a. maximum possible level of production. b. minimum possible level of production. c. financial break-even point. d. accounting break-even point. E. cash break-even point. SECTION: 11.4 TOPIC: CASH BREAK-EVEN 11-15

16 45. A project has a projected IRR of negative 100 percent. Which one of the following statements must also be true concerning this project? a. The discounted payback period equals the life of the project. B. The estimated sales volume is equal to the cash break-even level of sales. c. The estimated sales volume is equal to the financial break-even level of sales. d. The payback period is exactly equal to the life of the project. e. The net present value of the project is equal to zero. SECTION: 11.4 TOPIC: CASH BREAK-EVEN 46. Which of the following are characteristics of a project with sales set at the cash breakeven point? I. The project never pays back. II. The IRR equals the required rate of return. III. The NPV is negative and equal to the initial cash outlay. IV. The operating cash flow is equal to the depreciation expense. A. I and III only b. II and IV only c. I, II, and III only d. II, III, and IV only e. I, II, III, and IV SECTION: 11.4 TOPIC: CASH BREAK-EVEN 47. When the operating cash flow of a project is equal to zero, the project is operating at the: a. maximum possible level of production. b. minimum possible level of production. c. financial break-even point. d. accounting break-even point. E. cash break-even point. SECTION: 11.4 TOPIC: CASH BREAK-EVEN 11-16

17 48. The point where a project produces a rate of return equal to the required return is known as the: a. point of zero operating leverage. b. cash break-even point. c. accounting break-even point. D. financial break-even point. e. internal break-even point. SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN 49. Which of the following statements are correct concerning the financial break-even point of a project? I. The present value of the cash inflows exactly offsets the initial cash outflow. II. The payback period is equal to the life of the project. III. The NPV is zero. IV. The discounted payback period equals the life of the project. a. I and II only b. I and III only c. II and IV only d. III and IV only E. I, III, and IV only SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN 50. You would like to know the minimal level of sales that is needed for a project to be accepted based on net present value. To determine that sales level you should compute the: a. contribution margin and set that margin equal to the fixed costs. b. divided the contribution margin by (1 Tax rate). c. accounting break-even point. d. cash break-even point. E. financial break-even point. SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN 11-17

18 51. You are considering a project that you believe is quite risky. To reduce any potentially harmful results from accepting this project, you could: A. lower the degree of operating leverage. b. lower the contribution margin. c. increase the initial cash outlay. d. increase the fixed costs per unit while lowering the contribution margin. e. lower the operating cash flow of the project. SECTION: 11.5 TOPIC: OPERATING LEVERAGE 52. Which one of the following characteristics best describes a project that has a low degree of operating leverage? A. high variable costs relative to the fixed costs b. relatively high initial cash outlay c. an OCF that is highly sensitive to the sales quantity d. high level of forecasting risk e. a DOL of five or greater SECTION: 11.5 TOPIC: OPERATING LEVERAGE 53. Which one of the following will reduce the risk of a project by lowering the degree of operating leverage? a. hiring temporary workers from an employment agency rather than hiring part-time employees B. subcontracting portions of the project rather than purchasing new equipment to do all the work in-house c. leasing equipment on a long-term basis rather than buying equipment d. lowering the projected selling price per unit e. changing the proposed production method to a more capital intensive method SECTION: 11.5 TOPIC: OPERATING LEVERAGE 11-18

19 54. The degree of operating leverage is equal to: a. FC / OCF. b. VC / OCF. C. 1 + FC / OCF. d. 1 + VC / OCF. e. 1 FC / OCF. SECTION: 11.5 TOPIC: DEGREE OF OPERATING LEVERAGE 55. Merkel Enterprises has three divisions. As part of the planning process, the CFO requested that each division submit their capital budgeting proposals for next year. These proposals all have positive net present values and fall within the long-range plans of the firm. The requests from the divisions are \$6.2 million, \$4.8 million, and \$3.7 million, respectively. For the firm as a whole, Merkel Enterprises has a maximum of \$12 million which can be spent for new projects next year. This is an example of: a. scenario analysis. b. sensitivity analysis. c. determining operating leverage. D. soft rationing. e. hard rationing. SECTION: 11.6 TOPIC: SOFT RATIONING 56. Treynor United has received requests for capital investment funds from each of their five divisions for next year. Senior management has decided to allocate the available funds based on the profitability index of each project since the company has insufficient funds to fulfill all of the requests. Management is following a practice known as: a. scenario analysis. b. sensitivity analysis. c. leveraging. d. hard rationing. E. soft rationing. SECTION: 11.6 TOPIC: SOFT RATIONING 11-19

20 57. The CFO of Tried and True is continually receiving capital funding requests from division managers. These requests are seeking funding for positive net present value projects. The CFO continues to deny all funding requests due to the financial situation of the company. Apparently, the company is: a. operating at the accounting break-even point. b. operating at the financial break-even point. C. facing hard rationing. d. operating with zero leverage. e. operating at maximum capacity. SECTION: 11.6 TOPIC: HARD RATIONING The Franklin Co. is analyzing a proposed project. The company expects to sell 3,500 units, give or take 15 percent. The expected variable cost per unit is \$6 and the expected fixed costs are \$15,500. Cost estimates are considered accurate within a plus or minus 5 percent range. The depreciation expense is \$6,000. The sales price is estimated at \$21 a unit, give or take 3 percent. The company bases their sensitivity analysis on the base case scenario. 58. What is the sales revenue under the worst case scenario? A. \$60, b. \$62, c. \$73, d. \$84, e. \$87, Sales revenue for the worst case = 3, \$21.97 = \$60, TOPIC: SCENARIO ANALYSIS 11-20

21 59. What is the contribution margin under the base case scenario? a. \$14.55 b. \$14.82 C. \$15.00 d. \$15.45 e. \$15.63 Contribution margin for the base case = \$21 \$6 = \$15 TOPIC: SCENARIO ANALYSIS 60. What is the amount of the fixed cost per unit under the best case scenario? a. \$3.47 B. \$3.66 c. \$3.85 d. \$4.21 e. \$4.43 Fixed cost per unit for the best case = (\$15,500.95) / (3, ) = \$3.66 TOPIC: SCENARIO ANALYSIS 11-21

22 61. The company is conducting a sensitivity analysis on the sales price using a sales price estimate of \$23. What are the earnings before interest and taxes? A. \$38,000 b. \$44,000 c. \$50,000 d. \$59,500 e. \$65,000 EBIT = [(\$23 \$6) 3,500] \$15,500 \$6,000 = \$38,000 TOPIC: SENSITIVITY ANALYSIS 62. The company conducts a sensitivity analysis using a variable cost of \$10. The total cost estimate, excluding depreciation, will be: a. \$15,500 b. \$19,000 c. \$35,000 D. \$50,500 e. \$62,000 Total costs = (\$10 3,500) + \$15,500 = \$50,500 TOPIC: SENSITIVITY ANALYSIS The Quick Producers Co. is analyzing a proposed project. The company expects to sell 10,000 units, give or take 5 percent. The expected variable cost per unit is \$6 and the expected fixed cost is \$29,000. The fixed and variable cost estimates are considered accurate within a plus or minus 4 percent range. The depreciation expense is \$25,000. The tax rate is 34 percent. The sale price is estimated at \$13 a unit, give or take 6 percent

23 63. What is the earnings before interest and taxes under the base case scenario? a. \$10,560 B. \$16,000 c. \$22,440 d. \$41,000 e. \$66,000 EBIT for base case = [10,000 (\$13 \$6)] \$29,000 \$25,000 = \$16,000 TOPIC: SCENARIO ANALYSIS 64. What is the earnings before interest and taxes under the worst case scenario? a. \$840 B. \$1,650 c. \$2,810 d. \$5,090 e. \$8,530 EBIT for worst case = (10,000.95) [(\$13.94) (\$6 1.04)] (\$29, ) \$25,000 = \$1,650 TOPIC: SCENARIO ANALYSIS 11-23

24 65. What is the net income under the best case scenario? a. \$5, b. \$10, c. \$15, D. \$20, e. \$24, Net income for best case = {[10, ] [(\$ ) (\$6.96)] (\$29,000.96) \$25,000} {1.34} = \$20, TOPIC: SCENARIO ANALYSIS 66. What is the operating cash flow for a sensitivity analysis using total fixed costs of \$26,000? a. \$19,000 b. \$22,960 c. \$29,040 d. \$31,460 E. \$37,540 EBIT = [(10,000 (\$13 \$6)] \$26,000 \$25,000 = \$19,000 Tax = \$19, = \$6,460 OCF = \$19,000 + \$25,000 \$6,460 = \$37,540 TOPIC: SENSITIVITY ANALYSIS 11-24

25 67. What is the contribution margin for a sensitivity analysis using a variable cost per unit of \$9? a. \$3 B. \$4 c. \$7 d. \$9 e. \$13 Contribution margin = \$13 - \$9 = \$4 TOPIC: SENSITIVITY ANALYSIS 68. Your company is reviewing a project with labor cost of \$11.60 per unit, raw materials cost of \$24.58 a unit, and fixed costs of \$12,000 a month. Sales are projected at 10,000 units over the four-month life of the project. What are the total variable costs of the project? a. \$116,000 b. \$129,800 c. \$141,800 D. \$361,800 e. \$373,800 Total variable costs = (\$ \$24.58) 10,000 = \$361,800 TOPIC: VARIABLE COST 11-25

26 69. A project has earnings before interest and taxes of \$6,500, fixed costs of \$40,000, a selling price of \$12 a unit, and a sales quantity of 10,000 units. Depreciation is \$8,500. What is the variable cost per unit? a. \$6.25 B. \$6.50 c. \$6.75 d. \$7.00 e. \$7.25 [10,000 (\$12.00 v)] \$40,000 \$8,500 = \$6,500; v = \$6.50 TOPIC: VARIABLE COST 70. At a production level of 6,500 units, a project has total costs of \$95,000. The variable cost per unit is \$ What is the amount of the total fixed costs if the production level is increased to 7,000 units without increasing the total fixed assets? a. \$19,400 b. \$21,600 C. \$24,800 d. \$28,000 e. \$30,200 Total fixed cost = \$95,000 (6,500 \$10.80) = \$24,800 TOPIC: FIXED COST 11-26

27 71. A company is considering a project with a cash break-even point of 14,500 units. The selling price is \$14 a unit and the variable cost per unit is \$8. What is the projected amount of fixed costs? A. \$87,000 b. \$94,000 c. \$109,000 d. \$116,000 e. \$203,000 FC at the cash break-even point = 14,500 (\$14 \$8) = \$87,000 TOPIC: FIXED COST 72. Highland's Hats currently produces 1,500 ski hats at a total cost of \$11,520. If the firm produces 1,501 ski hats, the total costs increase to \$11, What is the minimal price Highland's Hats can charge for the 1,501 st ski hat without affecting the firm's profits? a. \$7.65 B. \$7.66 c. \$7.67 d. \$7.68 e. \$7.69 Marginal cost of 1,501 st unit = \$11, \$11,520 = \$7.66 TOPIC: MARGINAL COST 11-27

28 73. Choice Coffee has computed their fixed costs to be \$.20 for every cup of coffee they sell given an average daily sales level of 600 cups. They charge \$1.65 per cup of coffee. The variable cost per cup is \$.45. What is the contribution margin per cup of coffee sold? a. \$.65 b. \$.90 c. \$1.00 D. \$1.20 e. \$1.65 Contribution margin = \$1.65 \$.45 = \$1.20 TOPIC: CONTRIBUTION MARGIN 74. Madeline's Specialty Goods is considering a project with total sales of \$19,000, total variable costs of \$10,400, total fixed costs of \$4,500, and estimated production of 500 units. The depreciation expense is \$2,600 a year. What is the contribution margin per unit? a. \$12.00 B. \$17.20 c. \$23.80 d. \$29.00 e. \$34.00 Contribution margin = (\$19,000 \$10,400) / 500 = \$17.20 TOPIC: CONTRIBUTION MARGIN 11-28

29 75. Your company is considering a new project with estimated depreciation of \$630, fixed costs of \$5,000, and total sales of \$10,050. The variable cost per unit are estimated at \$3.75. What is the accounting break-even level of production? a. 1,100 units B. 1,179 units c. 1,216units d. 1,298 units e. 1,347 units Accounting break-even Q = (\$5,000 + \$630) / [(\$10,050 / Q) \$3.75]; Q = 1, = 1,179 TOPIC: ACCOUNTING BREAK-EVEN 76. The accounting break-even production quantity for a project is 5,850 units. The fixed costs are \$27,400 and the contribution margin is \$7. What is the projected depreciation expense? a. \$0 b. \$12,836 c. \$12,914 d. \$13,224 E. \$13,550 Depreciation at the accounting break-even = (5,850 \$7) \$27,400 = \$13,550 TOPIC: ACCOUNTING BREAK-EVEN 11-29

30 77. A project has an accounting break-even point of 1,600 units. The fixed costs are \$3,200 and the depreciation expense is \$200. The projected variable cost per unit is \$ What is the projected sales price? a. \$9.65 b. \$14.75 c. \$18.35 d. \$20.50 E. \$22.63 Accounting break-even Q = 1,600 = (\$3,200 + \$200) / (P \$20.50); P = \$22.63 TOPIC: ACCOUNTING BREAK-EVEN 78. A proposed project has fixed costs of \$3,700, depreciation expense of \$1,400, and a sales quantity of 1,500 units. What is the contribution margin if the projected level of sales is the accounting break-even point? a. \$2.47 b. \$2.64 c. \$3.10 D. \$3.40 e. \$3.71 Contribution margin = (\$3,700 + \$1,400) / 1,500 = \$3.40 TOPIC: ACCOUNTING BREAK-EVEN 11-30

31 79. The Baltimore Co. would like to add a new product to complete their lineup. They want to know how many units they must sell to limit their potential loss to their initial investment. What is this quantity if their fixed costs are \$14,000, the depreciation expense is \$2,800, and the contribution margin is \$1.25? a. 2,240 units b. 6,880 units c. 8,960 units D. 11,200 units e. 13,440 units Cash break-even point = \$14,000 / \$1.25 = 11,200 SECTION: 11.4 TOPIC: CASH BREAK-EVEN 80. The Handelcreek Co. is considering expanding their operations. Fixed costs are estimated at \$86,000 a year. The variable cost per unit is estimated at \$ The estimated sales price is \$34.00 per unit. What is the cash break-even point of this project? a. 2,529 units b. 4,649 units C. 5,548 units d. 7,114 units e. 9,740 units Cash break-even point = \$86,000 / (\$34.00 \$18.50) = 5, = 5,548 SECTION: 11.4 TOPIC: CASH BREAK-EVEN 11-31

32 81. A project has a contribution margin of \$6, projected fixed costs of \$14,000, projected variable cost per unit of \$14, and a projected financial break-even point of 6,000 units. What is the operating cash flow at this level of output? A. \$22,000 b. \$34,000 c. \$46,000 d. \$62,000 e. \$70,000 Operating cash flow at the financial break-even point = (6,000 \$6) \$14,000 = \$22,000 SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN 82. The Colby Brothers have been busy analyzing a new product. They have determined that an operating cash flow of \$18,200 will result in a zero net present value, which is a company requirement for project acceptance. The fixed costs are \$11,650 and the contribution margin is \$7.40. The company feels that they can realistically capture five percent of the 75,000 unit market for this product. Should the company develop the new product? Why or why not? a. Yes; The project has an expected internal rate of return of 100 percent. b. Yes; The expected level of sales exceeds the required number of units. c. Yes; The project is expected to sell 324 units more than the required number of units. D. No; The expected level of sales is less than the required level of 4,034 units. e. No; The annual sales would need to exceed 4,521 units to be acceptable. Financial break-even point = (\$11,650 + \$18,200) / \$7.40 = 4, = 4,034 units. Expected sales = 75, = 3,750 units. The project should not be accepted because the expected level of sales is less than the financial break-even point. SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN 11-32

33 83. ABC, Inc. is considering a project with a discounted payback just equal to the project's life. The projections include a sales price of \$13, variable cost per unit of \$10.50, and fixed costs of \$5,000. The operating cash flow is \$6,300. What is the break-even quantity? a. 3,869 units b. 3,913 units c. 4,340 units D. 4,520 units e. 4,610 units Financial break-even point = (\$5,000 + \$6,300) / (\$13 \$10.50) = 4,520 units SECTION: 11.4 TOPIC: FINANCIAL BREAK-EVEN 84. A coworker is in charge of a project that has a degree of operating leverage of 2.0. What will happen to the operating cash flows if your coworker decreases the number of units sold by 10 percent? a. 10 percent decrease B. 20 percent decrease c. 5 percent increase d. 10 percent increase e. 20 percent increase Percentage change in OCF = 2.0 (.10) =.20 = 20 percent decrease SECTION: 11.5 TOPIC: OPERATING LEVERAGE 11-33

34 85. The department manager has noted that every time the sales quantity increases by 6 percent for a particular project, the operating cash flow for the project increases by 9 percent. What is the degree of operating leverage for this project if the contribution margin is \$2? a..67 B c d e Degree of operating leverage =.09 /.06 = 1.50 SECTION: 11.5 TOPIC: OPERATING LEVERAGE 86. The fixed costs of a project are \$6,000. The depreciation expense is \$4,500 and the operating cash flow is \$18,000. What is the degree of operating leverage for this project? A b c d e Degree of operating leverage = 1 + (\$6,000 / \$18,000) = 1.33 SECTION: 11.5 TOPIC: OPERATING LEVERAGE 11-34

35 87. Donald and Sons manage a product with a 3.0 degree of operating leverage. Sales of the product are expected to increase by 10 percent next year. What is the expected change in the operating cash flow for this product for next year? a. 3.3 percent increase b. 10 percent increase C. 30 percent increase d. 10 percent decrease e. 30 percent decrease Percentage change in OCF = =.30 = 30 percent increase SECTION: 11.5 TOPIC: OPERATING LEVERAGE Essay Questions 88. What is operating leverage and why is it important in the analysis of capital expenditure projects? The textbook defines operating leverage as "the degree to which a firm or project relies on fixed costs". The more capital intensive a firm becomes, the higher the firm's degree of operating leverage. The degree of operating leverage determines the percentage change in a firm's operating cash flow relative to the percentage change in sales quantity. Thus, capital intensive firms are more susceptible to forecasting risk. AACSB TOPIC: REFLECTIVE THINKING SECTION: 11.5 TOPIC: OPERATING LEVERAGE 11-35

36 89. What is forecasting risk and why is it important to the analysis of capital expenditure projects? Forecasting risk, as defined by the textbook, is "the possibility that errors in projected cash flows will lead to incorrect decisions". For example, cash flows that are overly optimistic might result in a projected positive NPV and lead to project acceptance, when in reality, the project should have been rejected. AACSB TOPIC: REFLECTIVE THINKING SECTION: 11.1 AND 11.2 TOPIC: FORECASTING RISK 90. How do the accounting, cash, and financial break-even points differ from one another? The accounting break-even point is the level of sales required for a firm to just cover its fixed operating costs and depreciation expense resulting in a zero net income. The cash break-even point is the level of sales at which the firm covers its cash fixed operating costs causing the operating cash flow to equal zero. The financial break-even point is the level of sales which causes the NPV of a project to equal zero which indicates that the project has no wealth implications for the firm. AACSB TOPIC: REFLECTIVE THINKING AND 11.4 TOPIC: BREAK-EVEN ANALYSIS 91. What is the benefit of scenario analysis if it does not always produce a clear accept or reject decision for a proposed project? Sometimes scenario analysis provides a fairly clear indicator that a project should be either accepted or rejected. Frequently however, no clear cut accept or reject decision is indicated. However, scenario analysis does provide managers with a general feel for the volatility and potential range of outcomes that might be realized if a project is accepted. This understanding helps managers decide whether or not a project is acceptable to their firm at a particular point in time. AACSB TOPIC: REFLECTIVE THINKING TOPIC: SCENARIO ANALYSIS 11-36

37 92. Consider the following statement by a project analyst: "I analyzed a project using best case, worst case, and most expected case scenario analysis. I computed break-evens and degrees of operating leverage. I conducted sensitivity analysis and simulation analysis. I computed NPV, IRR, payback, AAR, and PI. In the end, I have over a hundred different estimates and am more confused than ever. I would have been better off just sticking with my first estimate and going with my gut feel." Critique this statement. Project analysis, in all of its various forms, is designed to help project analysts ask the right questions and gain information regarding the potential range of outcomes, the volatility of those outcomes, and the pros and cons of a project. By conducting this analysis, the analyst gains a better understanding of the situation by asking the right questions. However, the final results of the analysis are subject to error especially if the cash flow forecasts are questionable. AACSB TOPIC: REFLECTIVE THINKING SECTION: 11.7 TOPIC: EVALUATION 11-37

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