FINA 3313 Exam 3 (Ch. 9-10)

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.

If a 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggest:

Deemphasizing that variable as a critical factor.

What types of projects does the BNSF strategic studies team evaluate?

Discretionary

Which of the following statements is most correct?

E. Answers a and c are correct.

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

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

Real options are most valuable when the underlying source of risk is very low.

False

When calculating the cash flows for a project, you should include interest payments.

False

The financing 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.

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 is the net effect on a firm's working capital if a new project requires: $34,867 increase in inventory, $42,427 increase in accounts receivable, $35,000.00 increase in machinery, and a $42,993 increase in accounts payable? Round to nearest dollar amount.

Increase in Inventory = 34,867 Increase in A/R = 42,427 Increase in A/P = 42,993 NWC = (34,867 + 42,427) - 42,993 = 34,301

The investment decision

Invest in assets that earn a rate greater than the minimum acceptable hurdle rate.

The primary purpose of capital budgeting is to:

Maximize the shareholders wealth

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.term-2

Mutually Exclusive

The "gold standard" of investment criteria refers to:

NPV

Capital rationing may be beneficial to a firm if it:

Weeds out proposals with weaker or biased NPVs.

The disadvantages of the IRR period method is that it

- Requires complex calculations - Only works for normal cash flows - Requires a lot of data (estimates of all CFs)

Suppose the capital budget in the lecture example worksheet in Video #11 was $100,000. What is the NPV of the best project(s)?

45,000

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 8.22%?

CF0 = -100,000 CO1 = 50,000 FO1 = 3 I/Y = 8.22% CPT NPV = 28,345.05

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.

CF0 = -100,000,000 CO1 = -20,000,000 FO1 = 1 CO2 = 80,000,000 FO2 = 1 CO3 = 90,000,000 FO3 = 1 I = 11% CPT IRR = 15.95%

List steps of the capital budgeting process

Step 1: Personal 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.

Compute the payback period for a project that requires an initial outlay of $297,771 that is expected to generate $40,000 per year for 9 years.

Time Amount Cumulative 0 (297,771) (297,771) 1 40,000 (257,771) 2 40,000 (217,771) 3 40,000 (177,771) 4 40,000 (137,771) 5 40,000 (97,771) 6 40,000 (57,771) 7 40,000 (17,771) 8 40,000 22,229 9 40,000 62,229 Look at the last number before going over the 40,000 and the year = 7 + (17,771 / 40,000) = 7.44

What types of analyses do the BNSF strategic studies team conduct?

- Discounted cash flow - Sensitivity

The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0

True

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.

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?

- Any sunk costs associated with the project. - Any opportunity costs associated with the project.

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

What are advantages of payback period?

- Measures Liquidity, Easy to communicate - Does not require complex calculations - Does not require discount rate

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 Depr % 1 33.33 2 44.45 3 14.81 4 7.41 What is the TCF in year 3?

Year 3: Initial cost = 53,000 Tax = 40% Depr % = 14.81% SV = 11,750 Saving = 23,500 Revenue = 23,500 Depreciation = (53,000*14.81%) = 7,849.30 EBIT = (23,500 - 7,849.30) = 15,650.70 Tax = (15,650.70*40%) = 6,260.28 Net Income = (15,650.70 - 6,260.28) = 9,390.42 Depreciation = 7,849.30 OCF = (9,390.42 + 7,849.30) = 17,239.72 Book Value = initial cost - accumulated depreciation BV = 53,000 - (17664.90 + 23,558.50 + 7,849.30) = 49072.70 BV = (53,000 - 49072.70) = 3,927.30 After Tax Salvage Value = Salvage Value - [Tax*(SV - BV)] ATSV = 11,750 - [40%*(11,750 - 3,927.30)] = 8,620.92 Total Cash Flow = OCF + ATSV TCF in year 3 = (17,239.72 + 8,620.92) = 25,860.64

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the demand for a new line of solar-charged motorcycles​. 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 total cash flow at​ t=10?

YEAR 0 Initial Investment = 20,000,000 - 2,600,000 = 22,600,000 NWC = (3500000 + 1500000 - 2000000) = 3,000,000 YEAR 10 Revenue = 8,000,000 Expense = (50%*8,000,000) = 4,000,000 Depreciation = (20,000,0000/10) = 2,000,000 EBIT = 2,000,000 Tax = (35%*2,000,000) = 700,000 Net Income = (2,000,000 - 700,000) = 1,300,000 Depreciation = 2,000,000 OCF = (1,300,000 + 2,000,000) = 3,300,000 ATSV = 4,500,000 - [0.35*(4,500,000 - 2,000,000)] = 3,625,000 Total Cash Flow = Operating Cash Flow + After Tax Salvage Value + Net Working Capital TCF at t=10 = (3,300,000 + 3,625,000 + 3,000,000) = 9,925,000

The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

True

Equipment with a cost of $220,000 has an estimated residual value of $30,000 and an estimated life of10 years or 19,000 hours. It is to be depreciated by the straight-line method. What is the amount of depreciation for the first full year, during which the equipment was used 2,100 hours?

Annual Depreciation = (Cost - Residual Value) / Useful Life Annual Depr = (220,000 - 30,000) / 10 = $19,000

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the demand for a new line of solar-charged motorcycles. 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 $ 1500000 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 • Assume the firm is profitable and able to use any tax credits (i.e. negative taxes). What are the after tax proceeds from the sale of the factory (i.e..ATSV)?

Book Value = Initial cost - accumulated depreciation BV = 20,000,000 - 18,000,000 (9 years * 2,000,000 for depreciation each year) BV = 2,000,000 After Tax Salvage Value = Salvage Value - [Tax*(Salvage Value - Book Value)] SV = 4,500,000 (9th bullet) Tax = 35% (7th bullet) BV = 2,000,000 ATSV = (4,500,000 - [35%*(4,500,000 - 2,000,000)] = 3,625,000

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

CF0 = -5,000 C01 = 900 FO1 = 3 CO2 = 1,400 FO2 = 3 I = 8% CPT NPV = 183.48 PI = (183.48 + 5,000) / 5,000 = 1.03669 = 103.67%

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%?

CF0 = -50,000 CO1 = -10,000 FO1 = 4 I = 10% CPT NPV = -81,698.65 PV = -81,698.65 N = 4 I = 10% CPT PMT = 25,773.54

A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $84,391,290 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 NPV?

CF0 = -84,391,290 CO1 = -20,000,000 FO1 = 1 CO2 = 80,000,000 FO2 = 1 CO3 = 90,000,000 FO3 = 1 I = 11% CPT NPV = 28,327,710.96

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $223 at the end of the next three years and then $1,383 per year for the three years after that. If the discount rate is 7.98% then what is the NPV?

CFO = -5,000 CO1 = 223 FO1 = 3 CO2 = 1,383 FO2 = 3 I = 7.98% CPT NPV = -1,593.19

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 $22,973,784 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. (ie, 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%. • 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 (ie.negative taxes).0 What is the project's outflow at t=0?

Current market value = 2,600,000 Initial cost = 22,973,784 Outflow at t=0 = (22,973,784 + 2,600,000) = 25,573,784

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the demand for a new line of solar-charged motorcycles. 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 $2,748,044. • 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 (ie negative taxes). What is the project's NPV?

Current market value of​ = 2,748,044 Year 0: Initial Investment = 20,000,000 + 2,748,044 = 22,748,044.00 NWC = (3500000 + 1500000 - 2000000) = 3,000,000 CF0 = (22,748,044 + 3,000,000) = 25,748,044 Year 1-9: Revenues = 8,000,000 (5th bullet) Expense = (50%*8,000,000) = 4,000,000 (6th bullet) Depreciation = (20,000,000 / 10) = 2,000,000 (3rd & 8th bullet) EBIT = (8,000,000 - 4,000,000 - 2,000,000) = 2,000,000 Tax = (35%*2,000,000) = 700,000 Net Income = (2,000,000 - 700,000) = 1,300,000 Depreciation = 2,000,000 CO1 = (1,300,000 + 2,000,000) = 3,300,000 FO1 = 9 Year 10: Total Cash Flow = Operating Cash Flow + After Tax Salvage Value + Net Working Capital CO2 = (3,300,000 + 3,625,000 + 3,000,000) = 9,925,000 FO2 = 1 CF0 = (25,748,044) CO1 = 3,300,000 FO1 = 9 CO2 = 9,925,000 FO2 = 1 I = 10% (10th bullet) CPT NPV = -2,916,748.26

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

What is the amount of the operating cash flow for a firm with $378,585 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate?

OCF = EBIT - tax + Depreciation EBIT = 378,585 tax = 132,504.75 (35%*EBIT) Depreciation = 100,000 OCF = 378,585 - 132,504.75 + 100,000 = 346,080.25

What is the internal rate of return for a project with an initial outlay of $10,000 that is expected to generate cash flows of $2,000 per year for 6 years?

PV = -10,000 FV = 0 PMT = 2,000 N = 6 CPT I/Y = 5.47

Revenues generated by a new fad product are forecast as follows: Year: 1 Revenues: 44,359 Year:2 Revenues: 40,000 Year: 3 Revenues: 20,000 Year: 4 Revenues: 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?

Revenue = 44,359.00 Expense = (50%*44,359) = 22,179.50 Depreciation = (40,000/5) = 8,000.00 EBIT = (44,359 - 22,179.50 - 8,000) = 14,179.50 Tax = (20%*14,179.50) = 2,835.90 Net Income = (14,179.50 - 2,835.90) = 11,343.60 Depreciation = 8,000.00 OCF in year 1 = (11,343.60 + 8,000) = 19,343.60

Aero Motorcycles is considering opening a new manufacturing Fort Worth to meet the demand for a new line of solar-charged facility in motorcycles. 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 lie. negative taxes). What is the operating cash flow @t=1?

Revenues = 8,000,000 (5th bullet) Expense = (50%*8,000,000) = 4,000,000 (6th bullet) Depreciation = (20,000,000 / 10) = 2,000,000 (3rd & 8th bullet) EBIT = (8,000,000 - 4,000,000 - 2,000,000) = 2,000,000 Tax = (35%*2,000,000) = 700,000 Net Income = (2,000,000 - 700,000) = 1,300,000 Depreciation = 2,000,000 OCF at t=1 = (1,300,000 + 2,000,000) = 3,300,000

The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

True