Shapiro_CHAPTER_5_solutions[1] - Chapter 5 Risk Analysis in...

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Chapter 5: Risk Analysis in Capital Budgeting Shapir o: CHAPTER 5 QUESTIONS 1. Comment on the following statements: a. “Because our new expansion project has the same systematic risk as the firm as a whole, we need do no further risk analysis on the project.” Answer : Investors holding the firm’s stock in their portfolios will consider the systematic risk calculation most important. \+ -However, analysis and simulation may reveal risks hidden by the systematic risk calculation. For example, if a project might drive a firm into bankruptcy, shareholders would have to bear deadweight bankruptcy losses and the costs of financial distress in general. b. “Our company should accept the new potash mine project at Moosejaw. The cost of additional loans to fund the project is 12 percent, and our simulations lead us to expect a 14 percent return from the project.” Answer : While the company expects a 14% return on assets, this calculation fails to determine the required discount rate for cash flows. Furthermore, the cost of debt is not necessarily equal to the project cost of capital. One needs to know what it would cost to finance the project on a stand-alone basis. The 12% cost of debt financing is based on the riskiness of the company’s assets that back the debt, not the riskiness of the project itself. c. “It is difficult to decide whether to spend $10 million to reopen our mine because the price of gold is so uncertain. However, if we assume the price of gold grows at an average of 5 percent a year with a standard deviation of 20 percent a year, simulation indicates the mine has an average NPV of $500,000. Therefore, we should reopen.” Answer : Expected net present value was calculated in the absence of a risk adjustment. For a risk-neutral profit maximizing firm, the decision is appropriate. Since the shareholders of most firms are not risk-neutral, a discount rate different than the risk-free rate must be used. 2. Assess the impact of the following events on a firm’s operating leverage: a. an increase in output price due to increased demand. b. a decrease in fixed cost. c. negotiation of a new contract with suppliers leading to higher commitments to purchase raw materials. d. lowered variable labor costs per unit of output. e. installation of new machine tools that lower variable production costs per unit of output. Answer : In general, factors that increase the level of fixed costs within a firm also increase its operating leverage. Therefore, event (b) reduces operating leverage while event (c) increases operating leverage. The opposite effect prevails for variable costs. Events (a) and (d) increase the contribution margin, and therefore reduce operating leverage. Event (e) affects both fixed and variable costs; the dominant effect is uncertain. 3.
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This note was uploaded on 04/03/2011 for the course FIN 202 taught by Professor Sam during the Spring '11 term at University of Texas at Dallas, Richardson.

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Shapiro_CHAPTER_5_solutions[1] - Chapter 5 Risk Analysis in...

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