Business Finance CH. 12

Hobart Industries is trying to estimate its first-year operating cash flow (at t = 1) for a proposed project. The financial staff has collected the following information: The company faces a 40% tax rate. What is the project's operating cash flow for the first year (t = 1)? $ 810,000 $1,500,000 $1,080,000 $1,800,000 $1,260,000

$1,260,000

What is the project's coefficient of variation given the following? The Carlisle Corporation is considering a proposed project for its capital budget. The company estimates that the project's NPV is $5 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company's CFO, however, forecasts that there is only a 40% chance that the economy will be average. Recognizing this uncertainty, she has also performed the following scenario analysis: INFO IN ADAPTIVE TEST PREP 1.25 2.75 5.02 6.39 11.81

11.81

Franklin Corporation is considering an expansion project. The necessary equipment could be purchased for $15 million and shipping and installation costs are another $500,000. The project will also require an initial $2 million investment in net operating working capital. If the company's tax rate is 40%, what is the project's initial investment outlay (in millions)?

17.5 Purchase Price, Installation, NOWC

Of the following new product expansion situations, only one would not result in incremental cash flows so it should not be included in the capital budgeting analysis. Which situation is it?

A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected

The traditional NPV analysis may yield faulty results when a company chooses between two projects that have significantly different lives, are mutually exclusive, and _____.

Can be repeated

The _____ method of comparing projects with unequal lives calculates the NPV of each project over its stated life and then finds the constant annual cash flow that this NPV would provide over the project's initial life.

EEA

Each of the following is a valid assessment of the replacement chain and equivalent annual annuity methods EXCEPT:

Engineers prefer to use both methods in case they yield conflicting results.

Tannen Industries is considering an expansion. The necessary equipment would be purchased for $20 million, and the expansion would require an additional $1 million investment in net operating working capital. The tax rate is 40%. A.What is the initial investment outlay? Write out your answer completely. For example, 13 million should be entered as 13,000,000. Round your answer to the nearest dollar. Enter your answer as a positive value. B.The company spent and expensed $25,000 on research related to the project last year. Would this change your answer? Explain. No, last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. Yes, the cost of research is an incremental cash flow and should be included in the analysis. Yes, but only the tax effect of the research expenses should be included in the analysis. No, last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay. No, last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. C.The company plans to use a building it owns to house the project. The building could be sold for $5 million after taxes and real estate commissions. How would that fact affect your answer? The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible after-tax sale price must be charged against the project as a cost. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible before-tax sale price must be charged against the project as a cost. The potential sale of the building represents an externality and therefore should not be charged against the project. The potential sale of the building represents a real option and therefore should be charged against the project. The potential sale of the building represents a real option and therefore should not be charged against the project.

Equipment purchase ($ 20,000,000) NOWC investment (1,000,000) Initial investment outlay ($21,000,000) No, last year's $25,000 expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost.

Which of the following statements about capital budgeting is CORRECT? If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.

If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.

Global Spice Co. is considering a new project, but all methods for assessing risk indicate that the project's risk is greater than the risk of the firm's average project. In evaluating this project, it would be reasonable for Global Spice's management to do which of the following?

Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

In capital budgeting decisions, corporate risk will be of least interest to:

Institutional investors.

To assess the risk of two potential projects, X and Y, Green Plastics Inc. estimated the beta of each project versus the company's other assets. Green Plastics also estimated the beta of each project against the stock market. Together with a thorough scenario and simulation analyses, the company's research revealed the following

Project X has more market risk than Project Y

The _____ method of comparing projects with unequal lives assumes that each project can be repeated as many times as necessary to reach a common life

Replacement Chain

Which of the following statements about risk evaluation is CORRECT

Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

The CFO of Rambler Retail Concepts is considering a new project, so she plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

Which of the following is a valid assessment of the replacement chain and equivalent annual annuity methods? The equivalent annual annuity method produces better results. The equivalent annual annuity method is easier to implement. The equivalent annual annuity method is easier to explain to senior managers. The replacement chain method is easier to implement. The replacement chain method produces better results.

The equivalent annual annuity method is easier to implement.

When conducting a replacement analysis to determine whether to replace an old machine with a new one, each of the following factors should be considered EXCEPT:

The salvage value of the old machine at the end of the project.

When conducting a replacement analysis, the incremental cash flows _____.

are derived by subtracting the cash flows for the old project from the cash flows for the new project

Managers generally evaluate within-firm and beta risk _____.

qualitatively because the relevant data do not exist for new projects