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Free CMA Exam Braindumps (page: 52)

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Sensitivity analysis is used in capital budgeting to

  1. Estimate a project's internal rate of return.
  2. Determine the amount that a variable can change without generating unacceptable results.
  3. Simulate probabilistic customer reactions to a new product.
  4. Identify the required market share to make a new product viable and produce acceptable results.

Answer(s): B

Explanation:

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 of the estimates used. For example, forecasts of many calculated NPVs under various assumptions may be 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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When determining net present value in an inflationary environment, adjustments should be made to

  1. Increase the discount rate, only.
  2. Increase the estimated cash inflows and increase the discount rate.
  3. Increase the estimated cash inflows but not the discount rate.
  4. Decrease the estimated cash inflows and increase the discount rate.

Answer(s): B

Explanation:

In an inflationary environment, nominal future cash flows should increase to reflect the decrease in the value of the unit of measure. Also, the investor should increase the discount rate to reflect the increased inflation premium arising from the additional uncertainty. Lenders will require a higher interest rate in an inflationary environment.



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When evaluating a capital budgeting project, a company's treasurer wants to know how changes in operating income and the number of years in the project's useful life will affect its breakeven internal rate of return. The treasurer is most likely to use

  1. Scenario analysis.
  2. Sensitivity analysis.
  3. Monte Carlo simulation.
  4. Learning curve analysis.

Answer(s): B

Explanation:

Forecasts of many calculated NPVs under various assumptions are compared to see how sensitive NPV is to changing conditions. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV). Thus, the asset may appear to be much riskier than was originally predicted. In summary, sensitivity analysis is simply an iterative process of recalculated returns based on changing assumptions.



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A company is evaluating the possible introduction of a new version of an existing product that will have a 2-year life cycle. At the end of 2 years, this version will be obsolete, with no additional cash flows or salvage value. The initial and sole outlay for the modified product is $6 million, and the company's desired rate of return is 10%. Following are the potential cash flows (assumed to occur at the end of each year) and their probabilities if the product is marketed:


The following interest factors for the present value of $1 at 10% are relevant:
Period 1 .909
2 .826
The project's net present value is

  1. $878,050
  2. $3,242,050
  3. $3,636,000
  4. $6,000,000

Answer(s): A

Explanation:

The expected value of the cash flows at the end of Year 1 is $4 million [(.3 x $2 million)+ (.4x $4 million) + (.3 x $6 million)], and the present value of this amount is $3,636,000 (.909 x $4 million). The expected I value of the cash flows at the end of Year 2 is $3,925,000 [(.3 x .5 x $0) + (.3 x .5 x $4 million) + (.4x .25 x $6.4 million) + (.4x .75 x $3.2 million) + (.3 x Ax $6.875 million) + (.3 x .6 x $5 million)], and the present value of this amount is $3,242,050 (.826 x $3,925,000). Hence, the NPV is $878,050 [($3,636,000 + $3,242,050) -- $6 million initial outlay].






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