Chapter 21 - Answer

Solutions Manual
CHAPTER 21
FINANCIAL RISK MANAGEMENT
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. Refer to page 520.
2. Refer to pages 520 through 521.
7. Refer to pages 527 though 528.
10. A decision tree is an analytical tool used in a problem in which a series
of decision has to be made at various time intervals, with each decision
influenced by the information that is available at the time it is made.
The decision branches will be drawn as broken lines emerging from
square nodes and the outcomes of a trail as solid lines emerging from
round nodes. The square nodes, from which the decision branches are
drawn, represent the points at which decision maker selects his decision.
The round nodes represent the points at which the outcome of the
decision arises. The decision maker has no control over the outcome and
can only estimate the probability of the various outcomes actually
occurring. When all of the decisions and outcomes have been represented
on the tree, each of the possible routes through tree is considered and the
monetary payoff is shown at the end of each route. Any costs incurred by
the decisions are indicated along the appropriate branches.
II. Multiple Choice Questions
21-1
Chapter 21
1.
Financial Risk Management
2.
3.
III. Problems
Problem 1
Expected Profit:
Product X =
0.20 (- P8,000) + 0.10 (- P5,000) + 0.30 (P11,000) + 0.20

(P14,000) + 0.20 (P17,000) = P7,400
Product Y =
0.15 (- P12,000) + 0.15 (- P10,000) + 0.40 (P14,000) + 0.20

(P16,000) + 0.10 (P18,000) = P7,300
Analysis:
Based on the above data, the choice will be made for Product X.
Problem 2
(a)
To break-even, the company must earn enough total contribution to cover

its fixed costs. The contribution to fixed costs and profits is P2.50 per
unit (P6 3.5 per unit).
To break-even, sales must be as follows:
Contribution required
Contribution per unit
P34,000
P2.50
13,600 units
The probability that sales will equal or exceed 13,600 units is the
probability that sales will be 14,000, 16,000 or 18,000 units, which is
(0.25 + 0.30 + 0.20) = 0.75 or 75%.
(b)
To earn profit of P10,000, the company must earn enough contribution to

cover its fixed costs (P34,000) and then make the profit, so total
contribution must be P44,000. To earn this contribution, sales must be as
follows:
P44,000
P2.50
17,600 units
The probability that sales will equal or exceed 17,600 units is the
probability of sales being 18,000 units, which is 0.20 or 20%.
21-2
Chapter 21
Problem 3
Probability
0.10
0.30
0.30
0.20
0.10
1.00
Sales Volume
(units)
Expected Sales
Volume (units)
2,000
6,000
8,000
10,000
14,000
200
1,800
2,400
2,000
1,400
7,800
EV of contribution
Less: Additional fixed overhead
EV of additional cash profit per annum
[7,800 x (12 8)]
P31,200
20,000
P11,200
(a) Calculation of expected value of NPV of project

Year
0
16
6
Expected NPV
Cash Flow
P (40,000)
11,200
3,000
DCF @ 10%
PV of Cash Flow
1.0000
4.3550
0.5645
P (40,000)
48,776
1,694
P 10,470
(b) Calculation of minimum volume of sales per annum required to justify the
project
At break-even, the NPV would be zero. Taking the cost of the equipment and
its residual value, the minimum required PV of annual cash profit would be
as under:
PV of capital outlay
PV of residual value
PV of actual cash profit required for NPV of 0
P40,000
1,694
P38,306
Discount factor of 1 per annum 6 years @ 10% is 4.355

Annual cash profit required
Annual (cash) fixed costs
(P38,306/4.355)
21-3
P 8,796
20,000
P28,796
Chapter 21
Annual contribution required for NPV = 0

Contribution per unit
= P4
Sales required to break-even:

P28,796
P4
7,199 units
Problem 4
Annual cash inflow
Less: Project cost
Net present value
(P4,500 x 2.9137)
P13,112
12,000
P 1,112
(a) Sensitivity for Project Cost

If the project cost is increased by P1,112, the NPV of the project will become
zero. Therefore, the sensitivity for project cost is:
P1,112
P12,000
100
9.27%
(b) Sensitivity for Annual Cash Inflow

If the present value of annual cash inflow is lower by P1,112, the NPV of the
project will become zero. Therefore, the sensitivity for annual cash flow is:
P1,112
P13,112
100
8.48%
(c) Sensitivity for Cost of Capital

Let x be the annuity factor which gives a zero NPV (i.e., x is the IRR)
- P12,000 + P4,500 x
P4,500 x
x
x
=
=
=
=
0
P12,000
P12,000/P4,500
2.6667
Hence, x = 2.6667 and at 18% for 4 years, the annuity factor is 2.6667.
Sensitivity %
18% 14%
14%
21-4
29%
Chapter 21
Analysis:
The cash inflow is more sensitive, since only 8.5% change in cash inflow
will make the NPV of the project zero.
Problem 5
PV of Savings
Year 1
(P60,000 x 0.9259)
Year 2
(P70,000 x 0.8573)
P 55,554
60,011
P115,565
Less: PV of Running Cost

Year 1
(P20,000 x 0.9259)
Year 2
(P25,000 x 0.8573)
Net savings
Less: Purchase cost of plant
Net present value
P18,518
21,432
39950
75,615
70,000
P 5,615
(a) Sensitivity for Plant Cost

If the purchase cost of plant increases by P5,615, the NPV of the project will
become zero. Therefore, the sensitivity for plant cost is:
P5,615
P70,000
100
8.02%
(b) Sensitivity for Running Cost

If the present value of running cost increases by P5,615, the NPV of the
project will become zero. Therefore, the sensitivity for running cost is:
P5,615
P39,950
100
14.06%
(c) Sensitivity for Savings

If the savings decrease by P5,615, the NPV becomes zero. Therefore, the
sensitivity for savings is:
P5,615
P115,565
100
Analysis:
21-5
4.86%
Chapter 21
Savings is the most sensitive.
21-6

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Solutions Manual

Financial Risk Management

0.20 (- P8,000) + 0.10 (- P5,000) + 0.30 (P11,000) + 0.20

0.15 (- P12,000) + 0.15 (- P10,000) + 0.40 (P14,000) + 0.20

To break-even, the company must earn enough total contribution to cover

To earn profit of P10,000, the company must earn enough contribution to

Financial Risk Management

[7,800 x (12 8)]

(a) Calculation of expected value of NPV of project

Discount factor of 1 per annum 6 years @ 10% is 4.355

Financial Risk Management

Annual contribution required for NPV = 0

Sales required to break-even:

(a) Sensitivity for Project Cost

(b) Sensitivity for Annual Cash Inflow

(c) Sensitivity for Cost of Capital

Financial Risk Management

Less: PV of Running Cost

(a) Sensitivity for Plant Cost

(b) Sensitivity for Running Cost

(c) Sensitivity for Savings

Financial Risk Management

Savings is the most sensitive.

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