226 Part II Valuation and Capita! BudgetingQuestions and Problems Conned’ BASIC (Questions 1-10)revenue doesn’t exceed our average cost, then we will have a negative cash flow, and we will go broke!” How do you respond? 4. Break-Even Point As a shareholder of a firm that is contemplating a new proj-ect, would you be more concerned with the accounting break-even point, the cash break-even point (the point at which operating cash flow is zero), or the financial break-even point? Why? 5. Break-Even Point Assume a firm is considering a new project that requires an ini-tial investment and has equal sales and costs over its life. Will the project reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this order always apply? 6. Real Options Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project? 7. Real Options The Mango Republic has just liberalized its markets and is now per-mitting foreign investors. Tesla Manufacturing has analyzed starting a project in the country and has determined that the project has a negative NPV. Why might the company go ahead with the project? What type of option is most likely to add value to this project? 8. Sensitivity Analysis and Breakeven How does sensitivity analysis interact with break-even analysis? 9. Option to Wait An option can often have more than one source of value. Consider a logging company. The company can log the timber today or wait another year (or more) to log the timber. What advantages would waiting one year potentially have? 10. Project Analysis You are discussing a project analysis with a coworker. The project involves real options, such as expanding the project if successful, or abandoning the project if it fails. Your coworker makes the following statement: “This analysis is ridiculous. We looked at expanding or abandoning the project in two years, but there are many other options we should consider. For example, we could expand in one year, and expand further in two years. Or we could expand in one year, and abandon the project in two years. There are too many options for us to examine. Because of this, anything this analysis would give us is worthless.” How would you evaluate this statement? Considering that with any capital budgeting project there are an infi-nite number of real options, when do you stop the option analysis on an individual project? Sensitivity Analysis and Break-Even Point We arc evaluating a project that costs $724,000, has an eight-year life, and has no salvage value. Assume that deprecia-tion is straight-line to zero over the life of the project. Sales are projected at 75,000 units per year. Price per unit is $39. variable cost per unit is $23, and fixed costs are $850,000 per year. The tax rate is 35 percent, and we require a 15 percent return on this project, Calculate the accounting break-even point. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales. What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a S1 decrease in estimated variable costs. 2. Scenario Analysis In the previous problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within ±10 percent. Cal-culate the best-case and worst-case NPV figures.

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