Finance Exam 3

Kyle Electric has three positive net present value opportunities. Unfortunately, the firm has not been able to find financing for any of these projects. Which one of the following terms best fits the situation facing the firm?

Capital rationing

Payback period

How long does it take to recover initial cost of project Rule: accept if payback period less than present limit -Doesn't account for time value of money -Ignores cash flows after payback -Arbitrary cutoff period -Ask wrong questions

NPV

How much value is created from undertaking an investment Rule: positive= accept Negative=reject DOMINATE METHOD

Independent versus mutually exclusive projects

Independent: CF of one project are unaffected by the acceptance of the other Mutually Exclusive: the acceptance of one project precludes accepting the other

Profitability Index

Measures the benefit per unit cost, based on the time value of money. Rule: Accept if its greater than 1 -Cannot be used to rank mutually exclusive projects

Which one of the following is specifically designed to compute the rate of return on a project that has a multiple negative cash flows that are interrupted by one or more positive cash flows?

Modified internal rate of return

Valley Forge and Metal purchased a truck five years ago for local deliveries. Which one of the following costs related to this truck is the best example of a sunk cost? Assume the truck has a usable life of five years.

Money spent last month repairing a damaged front fender

Internal Rate of Return (IRR)

Most important alternative to NPV Estimated cash flows Rule: accept precut if the IRR is greater than RR Unreliable with: -non-conventional cash flows -mutually exclusive projects MIRR=better alternative

Both Projects A and B are acceptable as independent projects. However, the selection of either one of these projects eliminates the option of selecting the other project. Which one of the following terms best describes the relationship between Project A and Project B?

Mutually exclusive

Disadvantages of sensitivity and scenario analysis

Neither provides a decision rule. -No indication whether a project's expected return is sufficient to compensate for its risk. Ignores diversification. -Measures only stand-alone risk, which may not be the most relevant risk in capital budgeting.

Capital Rationing

Occurs when a firm or division has limited resources Soft rationing-self imposed, temporary(PI useful tool) Hard Rationing-Capital will never be available for projects

Which one of the following indicates that a project is expected to create value for its owners?

Positive net present value

Which one of the following indicates that a project should be rejected? Assume the cash flows are normal, i.e., the initial cash flow is negative.

Profitability index less than 1.0

Average accounting return (ARR)

Rule: accept project if AAR is greater than target rate -Not true rate of return -TVM ignored -Arbitrary benchmark -based on accounting data not CF

Reasons NPV profiles cross

Size (scale) differences. Smaller project frees up funds sooner for investment. The higher the opportunity cost, the more valuable these funds, so high discount rate favors small projects. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If discount rate is high, early CF especially good

The Corner Market has decided to expand its retail store by building on a vacant lot it currently owns. This lot was purchased four years ago at a cost of $299,000, which the firm paid in cash. To date, the firm has spent another $38,000 on land improvements, all of which was also paid in cash. Today, the lot has a market value of $329,000. What value should be included in the analysis of the expansion project for the cost of the land?

The current market value of the land

The pro forma income statements for a proposed investment should include all of the following except:

changes in net working capital.

Sensitivity analysis:

helps identify the variable within a project that presents the greatest forecasting risk.

If an investment is producing a return that is equal to the required return, the investment's net present value will be:

zero

Relevant CF

-Include only CF that will only occur if the project is accepted -Sunk costs:NO -Opp. costs:YES -Side effects/erosion:YES -NWC:YES -Financing Costs:NO -Tax Effects: YES

MIRR vs. IRR

-MIRR correctly assumes reinvestment at opportunity cost -MIRR avoids the multiple IRR problem -Managers like RR comparisons, and MIRR is better for this than IRR

Problems with scenario analysis

-Only few possible outcomes -Assumes perfectly correlated inputs -Focuses on stand-alone risk, although subjective adj. can be made

Sensitivity Analysis

-Shows how changes in an input variable affect NPV or IRR -Each variable is fixed except one Change one variable to see the effect on NPV or IRR -Answers "what if" questions

MIRR

1. Discounting approach = discount future outflows to present and add to CF0 2. Reinvestment Approach= compound all CFs except the first one forward to end 3. combination approach-discount outflows to present; compound inflows to end