Question

This is an old test we took and I would just like some clarification on what the answers were and why. thanks! (Also to eliminate comfusion its a study abroad course so questions are asking in euros)

14. Financial break-even analysis: a) Examines how sensitive a particular NPV calculation is to changes in underlying assumptions. b) Deals with risk that comes from the project opportunity cost of capital. c) Plots the NPV as a function of the discount rate. d) Studies the minimum number of units the company has to sell to get positive NPV. 15. Which one of the following statements is correct? a) The accounting break-even point dos not differ from the financial break-even point. b) Financial break-even analysis determines how far down sales can fall before the project is having negative profits. c) Companies that break even on an accounting basis are losing money: they are losing the opportunity cost of the initial investment d) All of the above 16. The firm does not have enough funds to finance all positive NPV projects, then: a) The firm has to invest in the highest NPV project and, if there is more the second highest NPV's project, and so on till funds are exhausted. b) If cash constrains force the firm to choose either projects 2 and 3 (NPV2= 10, NPV15) or project 1 (NPV,-20), both choices are equally good for the firm. c) The firm has to invest in the highest total NPV by combining projects, even if it does not contain the project with highest NPV. d) All of the above. money, has to invest in 17. Increasing firm's leverage: a) Results in higher financial risk. b) Results in higher required return from the company's owners. c) Results in higher cost of equity d) All of the above.

Answer 1

15. The correct answer is C, because the accounting breakeven point is the amount of sales in euros or the amount of sales in quantities required to recover the fixed cost. It is computed using the formula fixed cost/contribution. It doesn't factor in the opportunity cost of the funds invested in the project.

Option A is wrong because the accounting breakeven point breakeven point is the amount of sales in euros or the amount of sales in quantities required to recover the fixed cost whereas the financial breakeven point is the amount required to give a non negative ie 0 EPS to the shareholders, which means the amount (EBIT) necessary to meet the interest commitments. So both need not be the same

Option B is wrong because the accounting breakeven point point gives how far down the sales can fall before the project is having negative profits.

16. Option C is correct because in case of limited cash the firm has to invest in projects, after trying out various permutations and combinations, that give the highest feasible NPV.

Option A is wrong because that is always not the case. For example the company has 100 euros to invest and the projects are as follows

Investment	NPV
Project1 - 80	200
Project2 -60	130
Project3 -40	90

in the above example as the company has just 100euros he can invest in project 1, if he chooses based on the highest NPV, then he would get a return of 200. But if he chooses project 2 & 3 ie 60 +40, he would get a higher return of 220 (130+90)

Option B is wrong because choosing projects 2&3 will give a higher of 25 (10+15) rather than just choosing 1 which gives only 20. so both are not indifferent

17. Option D is correct

Beta levered = beta unlevered (1+(1-tax)debt/equity))

Option A is correct because as per the above formula with increase in debt the risk measured in terms of beta increases.

Option B & C are correct because the cost of equity and the expectation of the returns comes from the CAPM formula

Cost of Equity= Risk free rate + beta* market premium.

As beta increases the cost and expectation will also increase.