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.
3. Refer to page 521.
4. Refer to pages 522 through 523.
5. Refer to pages 524 through 527.
6. Refer to page 532.
7. Refer to pages 527 though 528.
8. Refer to pages 537 through 538.
9. Refer to pages 538 through 539.
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

1. D 2. D 3. B

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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 P34,000
Contribution per unit = 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%.

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Problem 3

Sales Volume Expected Sales

Probability (units) Volume (units)
0.10 2,000 200
0.30 6,000 1,800
0.30 8,000 2,400
0.20 10,000 2,000
0.10 14,000 1,400
1.00 7,800

EV of contribution [7,800 x (12 – 8)] P31,200

Less: Additional fixed overhead 20,000
EV of additional cash profit per annum P11,200

(a) Calculation of expected value of NPV of project

Year Cash Flow DCF @ 10% PV of Cash Flow

0 P (40,000) 1.0000 P (40,000)
1–6 11,200 4.3550 48,776
6 3,000 0.5645 1,694
Expected NPV 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 P40,000

PV of residual value 1,694
PV of actual cash profit required for NPV of 0 P38,306

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

Annual cash profit required (P38,306/4.355) P 8,796

Annual (cash) fixed costs 20,000
P28,796

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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 (P4,500 x 2.9137) P13,112

Less: Project cost 12,000
Net present value 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 x 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 x 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 = 0
P4,500 x = P12,000
x = P12,000/P4,500
x = 2.6667
Hence, x = 2.6667 and at 18% for 4 years, the annuity factor is 2.6667.

18% − 14%
Sensitivity % = 14% = 29%

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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) P 55,554
Year 2 (P70,000 x 0.8573) 60,011
P115,565
Less: PV of Running Cost
Year 1 (P20,000 x 0.9259) P18,518
Year 2 (P25,000 x 0.8573) 21,432 39950
Net savings 75,615
Less: Purchase cost of plant 70,000
Net present value 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 x 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 x 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 x 100 = 4.86%

Analysis:
Savings is the most sensitive.

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