McCann Company can manufacture one of two special orders with their existing capacity. Special Order A is for 100,000 units and Special Order B is for 200,000 units.Cost and revenue data per unit are as follows:Based on the above information, which one of the following statements correctly identifies the effect on pretax profit if the optimal decision is made?
Answer(s): B
The effect on pretax profit of producing the two special orders can be calculated as follows:
For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management
Answer(s): D
Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to use a hurdle rate (desired rate of return) higher than the firm's cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected.
A company uses portfolio theory to develop its investment portfolio. If the company wishes to obtain optimal risk reduction through the portfolio effect, it should make its next investment in an investment that
Answer(s): A
A common general definition is that risk is an investment with an unknown outcome but a known probability distribution of returns (a known mean and standard deviation). An increase in the standard deviation (variability) of returns is synonymous with an increase in the riskiness of a project. Risk is also increased when the project's returns are positively (directly) correlated with other investments in the company's portfolio; that is, risk increases when returns on all projects rise or fall together. Consequently, the overall risk is decreased when projects have low variability and are negatively correlated (the diversification effect).
Mega, Inc., a large conglomerate with operating divisions in many industries, uses risk- adjusted discount rates in evaluating capital investment decisions. Consider the following statements concerning Mega's use of risk-adjusted discount rates.I). Mega may accept some investments with internal rates of return less than Mega's overall average cost of capital.II). Discount rates vary depending on the type of investment.Ill). Mega may reject some investments with internal rates of return greater than the cost of capital.IV). Discount rates may vary depending on the division.Which of the above statements are correct?
Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways1 one of which is to use a hurdle rate higher than the firm's cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected. Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may exceed the cost of capital when the risk-adjusted rate is higher than the IRR. Conversely, the IRR for an accepted investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR. In this case, the investment presumably has very little risk. Furthermore, risk-adjusted rates may also reflect the differing degrees of risk, not only among investments, but by the same investments undertaken by different organizational subunits.
Sensitivity analysis, if used with capital projects,
Answer(s): C
After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity ofthe estimates used. For example, forecasts of many calculated NPVs under various assumptions maybe compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive.
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