FINA Exam 3

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=4I=10% CPT NPV NPV=-81,698.65 PV= -81,698.65 N=4 I=10 CPT PMT PMT=25,773.54-----ANSWER

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $486 at the end of the next three years and then $1,242 per year for the three years after that. If the discount rate is 6.48% then what is the NPV?

CFO=-5,000 CO1=486 FO1=3 CO2=1242 FO2=3 Enter NPV I= 6.48% Enter Down arrow CPT NPV=

What are advantages of payback period? Measures Liquidity, Easy to communicate Does not require complex calculations Does not require all CFs, Does not fully adjust for TVM Does not require discount rate

Does not require discount rate, does not require complex calculations, measure liquidity, easy to communicate

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 T/F

False

NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital T/F

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. T/F

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

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.

15.95

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​ $25,370,917 (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.

2600000+25370917 = 27970917

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 estimated annual sales An increase in the discount rate An increase in the initial investment A decrease in the fixed costs

A decrease in the fixed costs

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= 1400 FO2=3 NPVI=8 enter down arrow CptNPV= 183.48. PI= (183.48+5,000)/5,000 PI= 1.03669 PI=103.67%

You are considering the following three mutually exclusive projects. The required rate of return for all three projects is 14%. Year A B C 0 $ (1,000) $(5,000) $(50,000) 1 $ 300 $ 1,700 $ 0 2 $300 $ 1,700 $15,000 3 $ 600 $1,700 $ 28,500 4 $300 $1,700 $ 33,000 What is the IRR of the best project? % terms to 2 decimal places w/o % sign

For project A Cash flow in year 0 = -1000 Cash flow in year 1 = 300 Cash flow in year 2 = 300 Cash flow in year 3 = 600 Cash flow in year 4 = 300 IRR = 17.49% For project B Cash flow in year 0 = -5000 Cash flow each year from year 1 to 4 = 1700 IRR = 13.54% For project C Cash flow in year 0 = -50,000 Cash flow in year 1 = 0 Cash flow in year 2 = 15,000 Cash flow in year 3 = 28,500 Cash flow in year 4 = 33,000 IRR = 14.23% To find the IRR using a financial calculator: 1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction. 2. After inputting all the cash flows, press the IRR button and then press the compute button.

What is the net effect on a firm's working capital if a new project requires: $37,759 increase in inventory, $46,821 increase in accounts receivable, $35,000.00 increase in machinery, and a $44,664 increase in accounts payable? Round to nearest dollar amount.

Increase in Inventory: 37759 Increase in A/R: 46821 Increase in A/P: 44664 =37759+46821-44664=39916

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function. Indepedent Dependent Mutally Inclusive Mutually Exclusive

Mutually exclusive

The "gold standard" of investment criteria refers to: Profitabilty Index NPV Payback Period IRR EVA

NPV

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?

OCF = [$399,744 × (1 - .35)] + $100,000 = $359,833.60

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

Five Steps of the Capital Budgeting Process Proposal generation Review and analysis Implementation Follow-up Decision making

Proposal generation Review and analysis Decision making Implementation Follow-up

The disadvantages of the IRR period method is that it Requires complex calculations Only works for normal cash flows Adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts for risk) Requires a lot of data (estimates of all CFs) Does not require a discount rate (for calculation)

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

Revenues generated by a new fad product are forecast as follows: Year Revenues 1 $33,031 2 40,000 3 20,000 4 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: 33,031 -Expense: 16,515.50 (0.5*33,031) -Depreciation: 8,000.00 (40,000/5) =EBIT 8,515.50 -Tax 1,703.10 (0.2*8,515.50) =Net Income 6,812.40 (8,515.50-1,703.10) +Depreciation 8,000.00 =OCF 14,812.40(6,812.40+8,000) Answer: 14,812.40

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

Tax= 14.81% Initial investment:-53,000 Depreciation: YEAR 1 53,000*33.33%= $ 17,664.90 YEAR 2 53,000*44.45%= $ 23,558.50 YEAR 3 53,000*14.81%= $ 7,849.30 SV: 11,750 Saving: 23,500 R $ 23,500.00 COGS Dep $ 7,849.30 EBIT $ 15,650.70---(23,500-7,849.30) Tax $ 6,260.28---(15,650.70*.40) NI $ 9,390.42----(15,650.70-6,260.28) Dep $ 7,849.30 OCF$ 17,239.72---(9,390.42+ 7,849.30) BV= initial cost- accumulated depreciation BV=53,000-(SUM of $17,664.90+$23,558.50+$7,849.30)BV= $ 3,927.30ATSV=SV-tax*(SV-BV) ATSV=11,750-0.40*(11,750-3,927.30) ATSV= $ 8,620.92 Total Cash Flow= OCF+ATSV Total cash flow= 17,239.72+8,620.92 ANSWER= $ 25,860.64

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

True

The multiple IRR problem occurs when the signs of a project's cash flows change more than once. T/F

True

Jon Stevens, BNSF Vice President and Controller describes the capital spending process primarily as a means to ensure regulatory compliance necessary to maintain volume capacity a balancing act that requires careful evaluation of the costs and benefits of each project

a means to ensure regulatory compliance a balancing act that requires careful evaluation of the costs and benefits of each project

If a 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggest: that the initial sales forecasts were inflated. deemphasizing that variable as a critical factor. requiring a more detailed sales forecast. reallocating fixed costs to this product.

deemphasizing that variable as a critical factor

What types of analyses do the BNSF strategic studies team conduct? experimental operational discounted cash flow sensitivity

discounted cash flow sensitivity

What types of projects does the BNSF strategic studies team evaluate? mandatory critical discretionary regulated

discretionary

The dividend decision

if you can't find investments that 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? reduce provisions for non-perfomring loans make fewer loans to businesses increase bank executive turnover No answer text provided.

increase bank executive turnover

The investment decision

invest in assets that earn a return greater than the minimum acceptable hurdle rate

Identify which of these are the relevant cash flows when considering a capital budgeting project. test marketing costs fraction of CEO salary lost rent from retail facility remodeling expenses for new store increase in inventory expected salvage value of manufacturing equipment (multiple answers)

lost rent from retail facility remodeling expenses for new store increase in inventory expected salvage value of manufacturing equipment

The primary purpose of capital budgeting is to: maximize the budget. minimize the firm's costs. maximize the firm's profit. maximize the shareholders' wealth.

maximize the shareholders' wealth.

Capital rationing may be beneficial to a firm if it: increases funds to be used for other purposes weeds out proposals with weaker or biased NPVs. allows managers to select their favorite projects. reduces a firm's interest expense

weeds out proposals with weaker or biased NPVs.