CHAPTER 9RISK ANALYSIS, REAL OPTIONS, AND CAPITAL BUDGETINGAnswers to Concepts Review and Critical Thinking Questions1.Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product because the cash flows are probably harder to predict.2.With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.3.It is true that if average revenue is less than average cost, the firm is losing money. This much of the statement is therefore correct. At the margin, however, accepting a project with marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow.4.From the shareholder perspective, the financial break-even point is the most important. A project can exceed the accounting and cash break-even points but still be below the financial break-even point. This causes a reduction in shareholder (your) wealth.5.The project will reach the cash break-even first, the accounting break-even next and finally the financial break-even. For a project with an initial investment and sales after, this ordering will always apply. The cash break-even is achieved first since it excludes depreciation. The accounting break-even is next since it includes depreciation. Finally, the financial break-even, which includes the time value of money, is achieved.6.Traditional NPV analysis is often too conservative because it ignores profitable options such as the ability to expand the project if it is profitable, or abandon the project if it is unprofitable. The option to alter a project when it has already been accepted has a value, which increases the NPV of the project.7.The type of option most likely to affect the decision is the option to expand. If the country just liberalized its markets, there is likely the potential for growth. First entry into a market, whether an entirely new market, or with a new product, can give a company name recognition and market share. This may make it more difficult for competitors entering the market. 8.Sensitivity analysis can determine how the financial break-even point changes when some factors (such as fixed costs, variable costs, or revenue) change.9.There are two sources of value with this decision to wait. Potentially, the price of the timber can potentially increase, and the amount of timber will almost definitely increase, barring a natural catastrophe or forest fire. The option to wait for a logging company is quite valuable, and companies in the industry have models to estimate the future growth of a forest depending on its age. 10.When the additional analysis has a negative NPV. Since the additional analysis is likely to occur almost immediately, this means when the benefits of the additional analysis outweigh the costs. The benefits of the additional analysis are the reduction in the possibility of making a bad decision. Of course, the additional benefits are often difficult, if not impossible, to measure, so much of this decision is based on experience.Solutions to Questions and ProblemsNOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.Basic1.a.To calculate the accounting breakeven, we first need to find the depreciation for each year. The depreciation is:Depreciation = $896,000/8 Depreciation = $112,000 per yearAnd the accounting breakeven is:QA = ($900,000 + 112,000)/($38 25) QA = 77,846 unitsb.We will use the tax shield approach to calculate the OCF. The OCF is:OCFbase = (P v)Q FC(1 tc) + tcD OCFbase = ($38 25)(100,000) $900,000(0.65) + 0.35($112,000) OCFbase = $299,200Now we can calculate the NPV using our base-case projections. There is no salvage value or NWC, so the NPV is:NPVbase = $896,000 + $299,200(PVIFA15%,8) NPVbase = $446,606.60To calculate the sensitivity of the NPV to changes in the quantity sold, we will calculate the NPV at a different quantity. We will use sales of 105,000 units. The NPV at this sales level is: OCFnew = ($38 25)(105,000) $900,000(0.65) + 0.35($112,000) OCFnew = $341,450And the NPV is:NPVnew = $896,000 + $341,450(PVIFA15%,8) NPVnew = $636,195.93So, the change in NPV for every unit change in sales is:DNPV/DS = ($636,195.93 446,606.60)/(105,000 100,000) DNPV/DS = +$37.918If sales were to drop by 100 units, then NPV would drop by:NPV drop = $37.918(100) = $3,791.80You may wonder why we chose 105,000 units. Because it doe