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Unformatted text preview: CHAPTER 11 PROJECT ANALYSIS AND EVALUATION Answers to Concepts Review and Critical Thinking Questions 1. 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. Accounting break-even is unaffected (taxes are zero at that point). Cash break-even is lower (assuming a tax credit). Financial break-even will be higher (because of taxes paid). 4. 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 a marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow. 5. The option to abandon reflects our ability to shut down a project if it is losing money. Since this option acts to limit losses, we will underestimate NPV if we ignore it. 6. This is a good example of the option to expand. 7. It makes wages and salaries a fixed cost, driving up operating leverage. 8. Fixed costs are relatively high because airlines are relatively capital intensive (and airplanes are expensive). Skilled employees such as pilots and mechanics mean relatively high wages which, because of union agreements, are relatively fixed. Maintenance expenses are significant and relatively fixed as well. 9. With oil, for example, we can simply stop pumping if prices drop too far, and we can do so quickly. The oil itself is not affected; it just sits in the ground until prices rise to a point where pumping is profitable. Given the volatility of natural resource prices, the option to suspend output is very valuable. 10. The implication is that they will face hard capital rationing. 11. Euro Disneys experience illustrates that profitability is everybodys concern. Finance and marketing are strongly connected because revenues are the single most important determinant of cash flow and profitability, and marketing is responsible, in large part, for revenue production. As we have seen in many places, revenue projections are a key part of many types of financial analysis; such projections are best developed in cooperation with marketing. Solutions to Questions and Problems NOTE: 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....
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This note was uploaded on 09/24/2009 for the course ECON 2298 taught by Professor Evans during the Spring '09 term at Langara.
- Spring '09