Exam 13: Risk Analysis and Project Evaluations

Anderson Heating and Cooling anticipates that cash flows from home heating fuel sales next year will be $800,000 if the winter is mild, $1 000,000 if winter is average and $1 500,000 if winter is exceptionally cold.The probability of an average winter is 60%, while the probability of either a mild or an exceptionally cold winter is 20%.What is Anderson's expected cash flow from fuel sales next winter?

[blank] is the project's risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm's other projects and assets.

Mikey's Sandwich Shop expects to sell 200,000 sandwiches next year at an average price of $5.00.Variable cost of a sub is $3.00.Cash fixed costs are $85,000, depreciation $95,000 and the tax rate is 25%.If the price increases to $5.50 and all other variables remain the same, how much will free cash flow increase?

Briefly distinguish between sensitivity analysis, scenario analysis, and simulation.

The NPV of a project based on forecasted cash flows is $1 000,000.There is a 40% probability that cash flows from the project will be seriously reduced because competitors will enter the market.In this case, if the company did nothing, the NPV would be $500,000.The project can also be abandoned after two years and NPV will be $100,000.What is the expected NPV of the project when the option to abandon is considered.Should the projected be accepted?

One type of real option is to delay the beginning of a project until conditions are more favorable.

The form of risk analysis which examines the effect of various combinations of value drivers is known as [blank].

Simulation analysis is basically a form of scenario analysis in which a great many scenarios are examined to produce a probability distribution of possible outcomes.

What is the expected free cash flow for the worst case scenario?

EnVo is evaluating a proposal to move some manufacturing operations from an obsolescent plant in Mexico to a new facility in China.The new facility will cost $58 million to open and is expected to result in savings of $16 million per year for the first five years.At the end of five years, Porter will decide either to close the plant in China or to keep it indefinitely.If EnVo closes the plant, the building and equipment can be sold for $20,000,000.If the plant is kept, assume that the $16 million turns into a perpetuity.There is a 30% chance the plant will be closed and a 70% chance it will be kept.Calculate the expected NPV of the project.Use a discount rate of 12%.

Economists at Rudy Investments estimate a 20% probability of a recession next year, a 50% probability of an average economy, and a 30% probability of a rapid expansion.If there is a recession, the NPV of project O will be $20 million; if the economy is average, it will be $45 million and in case of a rapid expansion, it will be $75 million.What is the expected NPV of the project?

What is the expected net operating profit after tax (NOPAT)for the best case scenario?

What is the expected free cash flow if the most likely estimates are used?

Buttercrumbs Bakery expects to sell 1.25 million scones next year for $1.50 each.The variable cost of a scone is $0.80.Fixed costs are $150,000, depreciation $200,000 and the tax rate is 34%.If the bakery can increase the price of a scone to $1.75, sales will fall by 50,000 scone.All other things equal, operating cash flow will increase or decrease by

What is the expected NPV of the project with the option to expand if the probability of modest success is revised to 70% and great success to 30%?

The simulation approach provides us with

[blank] is the amount of risk that the project contributes to the firm as a whole.

One advantage of simulation is that it can differentiate between unsystematic and systematic risk.

Briefly explain what is meant by a real option in capital budgeting.Give two concrete examples.