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Chapter 11

All page numbers are references to Fundamentals of Corporate Finance, 12th edition by Ross, Westerfield, and Jordan (McGraw Hill, 2019)

Things to Absorb

The general topic is how to handle risk in capital budgeting. Most of the chapter is devoted to numerical analysis such as sensitivity/scenario analysis, the various types of breakeven analysis, and the computing and impact of operating leverage. Capital rationing is also a topic of which you should be aware. At some point, and the topic is not directly mentioned in Chapter 11, you will need to understand decision trees. I am placing some sample calculations below (you will see this again in Chapters 24 and 25). Be able to calculate all of the forms of break-even analysis. Know the major terms and brief definitions associated with measuring project risk sensitivity, scenario, break-even, and Monte Carlo simulation. Understand the basics of computing risk adjusted Cost of Capital.

Things to Read

Reading the Chapter should be sufficient to understand this chapter’s materials.

Things to Do

Make 100 on the Chapter Quiz. Be able to answer end-of-chapter Concepts Review 1-10 and End of Chapter Questions and Problems 1-3, 5, 7-13, 20. The calculations most likely to appear on the exam are Break-even and Operating Leverage Problems such as 1, 7, 8, and 10-12.

  1. Watch the Chapter Overview Lecture video. The video is both the Absorb, Read, Do and an extended discussion of the concepts in the chapter. The PowerPoints for all of this chapter's videos are located here.
  2. Read page 350-358.
  3. Watch the video on Investment Process, Sensitivity, Scenario, and Simulation Analysis.
  4. Read the rest of the Chapter.
  5. Watch the video on Break-even Analysis Operating Leverage, and Capital Rationing.
  6. In CourseDen, you can find both spreadsheet and written solutions to the End of Chapter Problems.
  7. Be able to the remaining suggested end of chapter questions, with a focus on 1, 7, 8, and 10-12.
  8. Review the remaining above suggested questions and problems. Be prepared for a 30-40 minute Quiz over Chapter 11
    1. If a firm's DOL is 4.0 with an operating profit of $2,000,000 and depreciation of $500,000, what are its fixed costs? | Review Audio Answer
    2. A firm with $600,000 fixed costs and $200,000 depreciation is expected to produce $225,000 in operating profits. What is its DOL? | Review Audio Answer
    3. You are the manager of a project that has a 2.07 degree of operating leverage and a required return of 14 percent. Due to the current state of the economy, you expect sales to decrease by 4.5 percent next year. What change should you expect in the operating cash flows next year given your sales prediction? | Review Audio Answer
    4. The Coffee Express has computed its fixed costs to be $.48 for every cup of coffee it sells given annual sales of 145,000 cups. The sales price is $1.29 per cup while the variable cost per cup is $.07. How many cups of coffee must it sell to breakeven on a cash basis? What is the breakeven in annual Sales? | Review Audio Answer
    5. Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the accounting break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. | Review Audio Answer
    6. Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the economic break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. | Review Audio Answer
    7. Below are a couple of audio solutions. We are evaluating a project that costs $932,000, has a 12-year life, and has no salvage value. Assume depreciation is straight-line to zero over the life of the project. Sales are projected at 75,000 units per year, the price per unit is $39, variable cost per unit is $26, and fixed costs are $778,900 per year. The tax rate is 35 percent and we require a return of 13.5 percent on this project. Suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within ±2 percent. What is the worst-case NPV? | Review Audio Answer
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