FINA 3313 - 9 and 10
Which of the following changes, if of a sufficient magnitude, could turn a negative NPV project into a positive NPV project?
A decrease in the fixed costs
According to the article, "Sunk cost fallacy: Throwing good money after bad," how can banks limit losses from bad loans?
increase bank executive turnover
What types of analyses do the BNSF strategic studies team conduct?
- discounted cash flow - sensitivity
Capital rationing may be beneficial to a firm if it:
weeds out proposals with weaker or biased NPVs.
What are advantages of payback period?
Does not require complex calculations Measures Liquidity, Easy to communicate Does not require discount rate
Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.
Mutally Exclusive
A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $100 million now, and then spend $20 million in one year. In two years it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what is the project's IRR? % terms to 2 decimal places and without the % sign.
Number of years 0, 1, 2, 3 Cash flows -100000000, -20000000, 80000000, 90000000 Present value @11% -100000000, 18018018.02, 64929794.66, 65807224.32 Therefore, Net Present value =12719000.96 or 12.72 million IRR =15.95%
Jon Stevens, BNSF Vice President and Controller describes the capital spending process primarily as
- a means to ensure regulatory compliance - a balancing act that requires careful evaluation of the costs and benefits of each project
Suppose the capital budget in the lecture example worksheet in $WIKI_REFERENCE$/pages/capital-budgeting-and-cash-flows-the-lectures?module_item_id=g9a89e790298905497957e6a4658e2a67 Video #11 was $100,000. What is the NPV of the best project(s)? Click here for the spreadsheet and open the "Capital Rationing" worksheet.
45,000
The primary purpose of capital budgeting is to:
maximize the shareholders' wealth.
NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital
False
A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $104,758,266 now, and then spend $20 million in one year. In two years it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what is the project's NPV?
CFO = -104,758,266 CO1 = -20,000,000 FO1 = 1 CO2 = 80,000,000 FO2 = 1 CO3 = 90,000,000 FO3 = 1 NPVI = 11% CPT NPV =7,960,734.96
What is the NPV of a project that costs $100,000.00 and returns $50,000.00 annually for three years if the opportunity cost of capital is 6.4%?
CFo = -100,000 CO1 = 50,000 FO1 = 3 I = 6.4 CPT NPV = 32,667.62
The disadvantages of the IRR period method is that it
Requires complex calculations Requires a lot of data (estimates of all CFs) Only works for normal cash flows
Revenues generated by a new fad product are forecast as follows: Year 1 Revenue $53,475 Year 2 Revenue $40,000 Year 3 Revenue $20,000 Year 4 Revenue $10,000 Thereafter 0 Expenses are expected to be 50% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $40,000 in plant and equipment that will be depreciated using the straight-line method over 5 years. The firm recently spent $2,000 on a study to estimate the revenues of the new product. The tax rate is 20%. What is the operating cash flow in year 1? Answer to nearest whole dollar amount.
Revenue: 53,475 Expenses: 0.5(53,475) = 26,737.50 Depreciation: 40,000/5 = 8,000 EBIT: 26,737.50 - 8,000 = 18,737.50 Tax: 0.2(18,737.50) = 3,747.50 Net Income: 18,737.50 - 3,747.50 = 14,990 OCF = 14,900 + 8,000 = 22,990 22,900
What is the equivalent annual cost for a project that requires a $50,000 investment at time-period zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10%? (Hint: Watch Video #9 - I. Capital Budgeting and Cash Flows - Annualized NPV and EAC @ $WIKI_REFERENCE$/pages/capital-budgeting-and-cash-flows-the-lectures?module_item_id=g9a89e790298905497957e6a4658e2a67
25,773.54
Grill Master Johnnys is thinking about purchasing a new, energy-efficient grill. The grill will cost $53,000.00 and will be depreciated according to the 3-year MACRS schedule. It will be sold for scrap metal after 3 years for $11,750.00. The grill will have no effect on revenues but will save Johnny's $23,500.00 per year in energy expenses. The tax rate is 40%. The 3-year MACRS schedule; Year - Depreciation 1 - 33.33 2 - 44.45 3 - 14.81 4 - 7.41 What is the total cash flow in year 3?
25,860.64
Compute the payback period for a project that requires an initial outlay of $138,098 that is expected to generate $40,000 per year for 9 years.
3.45 138098/40000
What is the amount of the operating cash flow for a firm with $399,744 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate?
399,744 (0.35) = 139,910.40 399,744 + 100,000 - 139,910.40 = 359,833.60
What is the net effect on a firm's working capital if a new project requires: $46,966 increase in inventory, $48,957 increase in accounts receivable, $35,000.00 increase in machinery, and a $46,951 increase in accounts payable? Round to nearest dollar amount.
Increase in inventory: 46,966 Increase in A/R: 48,957 Increase in A/P: 46,951 46,966 + 48,957 - 46,951 = 48,972
The "gold standard" of investment criteria refers to:
NPV
List steps of the capital budgeting process
Step 1 - Proposal Generation Step 2 - Review and Analysis Step 3 - Decision Making Step 4 - Implementation Step 5 - Follow-up
Which of the following statements is correct for a project with a negative NPV?
The cost of capital exceeds the IRR
The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0
True
The multiple IRR problem occurs when the signs of a project's cash flows change more than once.
True
What types of projects does the BNSF strategic studies team evaluate?
discretionary
Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $200 at the end of the next three years and then $1,928 per year for the three years after that. If the discount rate is 7.45% then what is the NPV?
-434.19 CF0 = -5000 CO1 = 200 FO1 = 3 CO2 = 1928 FO2 = 3 I = 7.45 CPT NPV = -434.19
What is the profitability index for Project A with a cost of capital of 8%? Year - 0 1 2 3 4 5 Project A - ($42,000) $14000 $14000 $14000 $14000 $14000 Project B - ($45,000) $28,000 $12,000 $10,000 $10,000 $10,000
1.33 Value of cash inflows at the present - =(14000/1.08) + (14000/(1.08)^2) + (14000/(1.08)^3) + (14000/(1.08)^4) + (14000/(1.08)^5) = (12962.96 + 12002.74 + 11113.65 + 10290.41 + 9528.16) = 55898 Profitability index = Present value of future inflows/initial outflows = 55898/42000 = 1.33
Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. If the discount rate is 8% then what is the PI? Answer in % format
103.67% (900/1.08) + (900/(1.08)^2) + (900/(1.08)^3) + (1400/(1.08)^4) + (1400/(1.08)^5) + (1400/(1.08)^6) = (833.33 + 771.60 + 714.45 + 1029.04 + 952.82 + 882.24) = 5183.48 5183.48 / 5000 = 1.036696 = 103.67%
You are considering the following three mutually exclusive projects. The required rate of return for all three projects is 14%. Year - 0 1 2 3 4 Project A - ($1000) $300 $300 $600 $300 Project B - ($5000) $1700 $1700 $1700 $1700 Project C - ($50000) $0 $15000 $28500 $33000 What is the IRR of the best project? % terms to 2 decimal places w/o % sign
14.23 Project A - NPV: 500 IRR: 17.49 Project B - NPV: 1800 IRR: 13.54 Project C - NPV: 26500 IRR: 14.23
Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet demand for a new line of solar charged motorcycles (who wants to ride on a cloudy day anyway?) The proposed project has the following features; • The firm just spent $300,000 for marketing study to determine consumer demand (@ t=0). • Aero Motorcycles purchased the land the factory will be built on 5 years ago for $2,000,000 and owns it outright (that is, it does not have a mortgage). The land has a current market value of $2,600,000. • The project has an initial cost of $21,038,407 (excluding land, hint: land is not subject to depreciation). • If the project is undertaken, the company will realize an additional $8,000,000 in sales over each of the next ten years. (i.e. sales in each year are $8,000,000) • The company's operating cost (not including depreciation) will equal 50% of sales. • The company's tax rate is 35 percent. • Use a 10-year straight-line depreciation schedule. • At t = 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $4,500,000 (assume land has a book value equal to the original purchase price). • The project's WACC = 10 percent • Assume the firm is profitable and able to use any tax credits (i.e. negative taxes) .0 What is the project's outflow at t=0? Answer to the nearest whole dollar value.
=2,600,000+ 21,038,407 = 23,638,407
A corporation is contemplating an expansion project. The CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the corporation's cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows? Group of answer choices
Any opportunity costs associated with the project.
It should not usually be clear whether we are describing independent or mutually exclusive projects in the following chapters because when we only describe one project then it can be assumed to be independent
False
Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.
False
Sunk cost
Refer to any cash flows that have already been incurred or that will still be incurred even if a project is rejected
Match those following concepts for first principle The investment decision The finance decision The dividend decision
The investment decision - invest in assets that earn a return greater than the minimum acceptable hurdle rate The finance decision - find the right kind of debt for your firm and the right mix of debt and equity to fund your operations The dividend decision - if you can't find investments that make your minimum acceptable rate, return the cash to owners of your business
If a 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggest: Group of answer choices
deemphasizing that variable as a critical factor.
Identify which of these are the relevant cash flows when considering a capital budgeting project.
lost rent from retail facility remodeling expenses for new store increase in inventory expected salvage value of manufacturing equipment
Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the demand for a new line of solar-charged motorcycles (who wants to ride on a cloudy day anyway?) The proposed project has the following features; • The firm just spent $300,000 for a marketing study to determine consumer demand (@ t=0). • Aero Motorcycles purchased the land the factory will be built on 5 years ago for $2,000,000 and owns it outright (that is, it does not have a mortgage). The land has a current market value of $2,600,000. • The project has an initial cost of $20,000,000 (excluding land, hint: the land is not subject to depreciation). • If the project is undertaken, at t = 0 the company will need to increase its inventories by $3,500,000, accounts receivable by $1,500,000, and its accounts payable by $2,000,000. This net operating working capital will be recovered at the end of the project's life (t = 10). • If the project is undertaken, the company will realize an additional $8,000,000 in sales over each of the next ten years. (i.e. sales in each year are $8,000,000) • The company's operating cost (not including depreciation) will equal 50% of sales. • The company's tax rate is 35 percent. • Use a 10-year straight-line depreciation schedule. • At t = 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $4,500,000 (assume land has a book value equal to the original purchase price). • The project's WACC = 10 percent • Assume the firm is profitable and able to use any tax credits (i.e. negative taxes). What is the operating cash flow @ t=1? Round to nearest whole dollar value. What is the operating cash flow @ t=2? Round to nearest whole dollar value. What are the after tax proceeds from the sale of the factory (i.e., ATSV)? Round to nearest whole dollar value. What is the total cash flow at t=10? Round to nearest whole dollar value. What is the project's NPV? Round to nearest whole dollar value.
operating cash flow @ t=1? 3,212,500 operating cash flow @ t=2? 3,212,500 What are the after tax proceeds from the sale of the factory (i.e., ATSV)? 4,500,000 What is the total cash flow at t=10? 10,712,500 What is the project's NPV? (3,066,994.50)
