Finance 3220 Chapter 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)?
$1,260,000
Given the following, what is the project's standard deviation? 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:
$10.04
The capital budgeting director of National Products Inc. is evaluating a new 3-year project that would decrease operating costs by $30,000 per year without affecting revenues. The project's cost is $50,000. The project will be depreciated using the MACRS method over its 3-year class life. The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%. It will have a zero salvage value after 3 years. The marginal tax rate of National Products is 35%, and the project's cost of capital is 12%. What is the project's NPV?
$11,010
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
Your firm has a marginal tax rate of 40% and a cost of capital of 14%. You are performing a capital budgeting analysis on a new project that will cost $500,000. The project is expected to have a useful life of 10 years, although its MACRS class life is only 5 years. The applicable MACRS depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The project is expected to increase the firm's net income by $61,257 per year and to have a salvage value of $35,000 at the end of 10 years. What is the project's NPV?
$177,902
You are evaluating a capital budgeting project for your company that is expected to last for six years. The project begins with the purchase of a $1,200,000 investment in equipment. You are unsure what method of depreciation to use in your analysis, straight-line depreciation or the 5-year MACRS accelerated method. Straight-line depreciation results in the cost of the equipment depreciated evenly over its life. The 5-year MACRS depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. Your company's WACC is 10.5% and it has a tax rate of 35%. For purposes of this question, we are ignoring the half-year convention for the straight-line depreciation method. What is the NPV of the project given by the better depreciation method, i.e., the method that gives the higher NPV?
$20,473.06
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:
11.81
sunk cost
A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.
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 can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. A new product will generate new sales, but some of those new sales will be to customers who switch from one of the firm's current products. 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. A firm has a parcel of land that can be used for a new plant site or sold, rented, or used for agricultural purposes.
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.
replacement chain (common life) approach
A method of comparing projects with unequal lives that assumes that each project can be repeated as many times as necessary to reach a common life. The NPVs over this life are then compared, and the project with the higher common-life NPV is chosen.
Scenario analysis
A risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation.
Monte Carlo simulation
A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes.
best-case scenario
An analysis in which all of the input variables are set at their best reasonably forecasted values.
base-case scenario
An analysis in which all of the input variables are set at their most likely values.
worst-case scenario
An analysis in which all of the input variables are set at their worst reasonably forecasted values.
Incremental cash flows
Cash flows that will occur if and only if the firm takes on a project.
externalities
Effects on the firm or the environment that are not reflected in the project's cash flows.
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.
In general, the value of land currently owned by a firm is irrelevant to a capital budgeting decision because the cost of that property is a sunk cost.
False
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.
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.
Sensitivity analysis
Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant.
A company's new project evaluation should include all of the following EXCEPT:
Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
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: Which of the following statements is CORRECT?
Project X has more market risk than Project Y.
Corporate or within-firm risk
Risk considering the firm's diversification, but not stockholder diversification. It is measured by a project's effect on uncertainty about the firm's expected future returns.
Which of the following statements about sensitivity analysis and simulation analysis is CORRECT?
Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
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.
Which of the following statements is NOT CORRECT?
Sunk costs are the costs associated with "the road not taken". They represent the alternative cost of an asset if that asset were not already owned by the firm; therefore, these costs should be included in the capital budgeting analysis.
base-case NPV
The NPV when sales and other input variables are set equal to their most likely (or base-case) values.
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.
risk-adjusted cost of capital
The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital.
Which of the following is a valid assessment of the replacement chain and equivalent annual annuity methods?
The equivalent annual annuity method is easier to implement.
Crawford Mill Products' sales and profits are positively correlated with the overall economy, and the company has a beta of 1.0. Crawford Mill estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?
The proposed new project would have more stand-alone risk than the firm's typical project.
While reviewing a replacement analysis, a CEO discovers that the yearly depreciation on the old project was incorrectly listed as $50 rather than $100. Correcting the error will have which of the following effects?
The replacement will look less attractive because the differentials between the old and new cash flows will decrease.
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.
cannibalization
The situation when a new project reduces cash flows that the firm would otherwise have had.
McDonald's is planning to open a new store across from the student union. Annual revenues are expected to be $5 million. However, opening the new location will cause annual revenues to drop by $3 million at McDonald's existing stadium location. The relevant sales revenues for the capital budgeting analysis are $2 million per year.
True
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
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
Which of the following statements is CORRECT? a. Effects of a project on other parts of the firm or the environment are called externalities. b. Externalities can be either negative or positive but they should be correctly accounted for in a project's cash flows when evaluating that project. c. Positive externalities on a project are called complements. d. Cannibalization is a negative externality that reduces the cash flow in another part of the same company. e. All the statements above are correct.
e. All the statements above are correct.
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.
equivalent annual annuity
Focusing exclusively on stand-alone risk (rather than within-firm and beta risk) usually _____.
leads to good decisions because most projects' returns are positively correlated with returns on the firm's other assets and with returns on the stock market.
Calculating beta risk via a pure-play approach is rare because _____.
pure-play proxies do not exist for most projects
Managers generally evaluate within-firm and beta risk _____.
qualitatively because the relevant data do not exist for new projects
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