Finance Exam 2 (Chapters 11 & 12)

11) St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings from $24,000 to $46,000 per year. The new machine will cost $80,000, and it will have an estimated life of 8 years and no salvage value. The new riveting machine is eligible for 100% bonus depreciation at the time of purchase. The applicable corporate tax rate is 25%, and the firm's WACC is 10%. The old machine has been fully depreciated and has no salvage value. Should the old riveting machine be replaced by the new one? Explain your answer.

** SEE SOLUTION SHEET **

Wild Wind Kite Co. is trying to decide which of two new projects they should take on. The NPV for Project A is $868.61. The initial cost (t=0) for Project B is $1,100 and it carries an 8% cost of capital. The positive cash flows for the next three years for Project B are $900 at year 1; $1,200 at year 2 and $200 at year 3. What is the NPV of Project B and which of the two projects should Wild Wind accept?

The NPV for Project B is $920.91; Wild Wind should accept Project B.

Poe Company is considering a project in which they would need to lease a warehouse and adapt the setup and equipment to their needs. At completion, they would need to return the warehouse to its original setup and replace the original equipment. The projected end of year cash flows are -200; 800; 200; and -500; respectively over the three-year plan. What is the NPV at a WACC of 8% and at 300%? Considering a WACC of 8%, should Poe Company accept or reject the project?

The NPV is $315.29 at 8% and $4.69 at 300%; Poe should accept the project.

3) Why is the NPV of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) more sensitive to changes in the WACC than that of a short-term project?

The NPV is obtained by discounting future cash flows, and the discounting process compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1.

3) Explain why net operating working capital is included in a capital budgeting analysis and how it is recovered at the end of a project's life.

When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net operating working capital (NOWC). Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the project's life, inventories are depleted, and receivables are collected. Thus, there is a decrease (or reduction) in NOWC, which represents an inflow in the final year of the project's life.

Even though they understand the importance of within-firm and beta risk, managers generally a. disregard both concepts when assessing the risk of diversification. b. approach these risks quantitatively rather than subjectively. c. approach these risks subjectively rather than quantitatively. d. use quantitative analysis rather than qualitative. e. minimize the impact of beta risk if historical data is available to analyze within-firm risk.

c. approach these risks subjectively rather than quantitatively.

The payback method provides good information for determining a. a project's stability. b. profitability. c. liquidity and risk. d. the crossover rate of two projects. e. the internal rate of return (IRR).

c. liquidity and risk.

incremental cash flows

cash flows that will occur if and only if the firm takes on a project

According to NPV decision rules, an independent project should be accepted if a. the NPV is less than zero. b. the NPV factor is negative. c. it aligns with the company's mission statement. d. the NPV exceeds zero. e. the NPV is equal to zero.

d) the NPV exceeds zero

Which of the following best describes a Monte Carlo simulation? a. A simplified scenario analysis that uses a project's estimated rates of return to calculate a project's deviation index b. A French founded analysis technique that determines risk by assigning probability to a best- or worst-case scenario c. An analysis method that measures the risk by examining percentage changes in NPV and input variables d. A sophisticated computer program that analyzes probable future to generate a large number of NPVs in order to measure a project's expected profitability e. An analysis technique that uses a base-case NPV and compares it to various input variables to determine separate risk factors

d. A sophisticated computer program that analyzes probable future to generate a large number of NPVs in order to measure a project's expected profitability

Chapter 12

Terms and Questions

The discount rate used to value projects is the

weighted average cost of capital

Suppose that a cafe owner is downsizing and selling some of the kitchen equipment to generate a cash flow. He sells an older oven that is rarely used due to slowing business. The book value of the oven is currently $900, and he sells it for $1,100. At a tax rate of 21%, what will the taxes be on the cash flow generated from the sale of the oven?

$42

Project L requires an initial outlay at t = 0 of $40,000, its expected cash inflows are $10,000 per year for 9 years, and its WACC is 13%. What is the project's NPV? Do not round intermediate calculations. Round your answer to the nearest cent.

NPV = $11,316.55

1) Why do we focus on cash flows as opposed to net income in capital budgeting?

Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis.

net present value profile

a graph showing the relationship between a project's NPV and the firm's cost of capital

opportunity costs

the best return that could be earned on assets the firm already owns if those assets are not used for the new project

2) What are three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain.

1) All dollars received in different years are given the same weight (time value of money is ignored) 2) Cash flows beyond the payback year are given no consideration regardless of how large they may be 3) Unlike the NPV, which tells us how much wealth a project adds, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we will recover our investment

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.

Barnett Company is trying to determine the internal rate of return (IRR) for a new project. The project has an initial investment of $1,500 and projected to have 3 years of positive cash flows: $600; $900; and $1,300; respectively. What is the estimated IRR of the project?

33.535%

REVIEW CHAPTER 12 HW QUESTIONS

6-12

Project L requires an initial outlay at t = 0 of $56,000, its expected cash inflows are $8,000 per year for 8 years, and its WACC is 13%. What is the project's payback? Round your answer to two decimal places.

7 years

sunk costs

A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected

5) If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking of mutually exclusive projects? Explain.

A high cost of capital favors a shorter-term project. If the cost of capital declined, it would lead firms to invest more in long-term projects. Regarding the last question, the answer is no; the IRR rankings are constant and independent of the firm's cost of capital.

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.

Equivalent Annual Annuity (EAA) Method

A method that calculates the annual payments that a project will provide if it is an annuity. When comparing projects with unequal lives, the one with the higher equivalent annual annuity (EAA) should be chosen.

2) Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included.

Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm undertaking this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis.

market/beta risk

Considers both firm and stockholder diversification. It is measured by the project's beta coefficient.

externality

Effects on the firm or the environment that are not reflected in the project's cash flows

Project L requires an initial outlay at t = 0 of $76,431, its expected cash inflows are $14,000 per year for 9 years, and its WACC is 14%. What is the project's IRR? Round your answer to two decimal places.

IRR = 11.37%

6) What are some differences in the analysis for a replacement project versus that for a new expansion project?

In replacement projects, the benefits are generally cost savings, although the new machinery may also permit additional output. The data for replacement analysis are generally easier to obtain than for new products, but the analysis itself is somewhat more complicated because almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers. Similarly, differences in depreciation and any other factor that affects cash flows and their tax effects must also be determined.

1) Project L requires an initial outlay at of $65,000, its expected cash inflows are $12,000 per year for 9 years, and its WACC is 9%. What is the project's NPV? IRR? Payback period?

NPV = $6,942.96 IRR = 11.57% Payback period = 5.42 years

NPV vs IRR: Which metric supersedes the other when there is a conflict in analysis?

NPV because it assumes reinvestment costs at the cost of capital and that is generally the best assumption.

7) Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method?

Payback provides information on how long funds will be tied up in a project. The shorter the payback, other things held constant, the greater the project's liquidity. This factor is often important for smaller firms that don't have ready access to the capital markets. Also, cash flows expected in the distant future are generally riskier than near-term cash flows, so the payback can be used as a risk indicator.

sensitivity analysis

Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant.

corporate (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.

9) Define (a) sensitivity analysis, (b) scenario analysis, and (c) simulation analysis. If GE were considering two projects (one for $500 million to develop a satellite communications system and the other for a new $30,000 truck), on which would the company be more likely to use a simulation analysis?

Simulation analysis involves working with continuous probability distributions, and the output of a simulation analysis is a distribution of net present values or rates of return. Scenario analysis involves picking several points on the various probability distributions and determining cash flows or rates of return for these points. Sensitivity analysis involves determining the extent to which cash flows change, given a change in one particular input variable. Simulation analysis is expensive. Therefore, it would more than likely be employed in the decision for the $500 million investment in a satellite communications system than in the decision for the $30,000 truck.

4) Why are interest charges not deducted when a project's cash flows for use in a capital budgeting analysis are calculated?

The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting cash flow analysis would "double count" the cost of debt financing.

stand-alone risk

The risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns.

cannibalization

The situation when a new project reduces cash flows that the firm would have otherwise had (when a new project takes away cash flows from an existing project of the firm)

4) The Oviedo Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine is in good working order and will last at least another 10 years. The proposed replacement machine will perform the operation so much more efficiently that Oviedo's engineers estimate that it will produce after-tax cash flows (labor savings) of $8,000 per year. The after-tax cost of the new machine is $45,000, and its economic life is estimated to be 10 years. It has zero salvage value. The firm's WACC is 10%, and its marginal tax rate is 25%. Should Oviedo buy the new machine?

With a financial calculator, input the appropriate cash flows into the cash flow register as follows: CF0 = -45000; CF1 = 8000; F01= 10 I/YR = 10; and then solve for NPV = $4,156.54. Because NPV > 0, Oviedo should purchase the new machine.

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

mutually exclusive projects

a set of projects where only one can be accepted

6) Project A has an initial cash flow of (t=0) -$25, cash flows for consecutive years thereafter are respectively, $5, $10, and $17. Project B has an initial cash flow of (t=0) -$20, cash flows for consecutive years thereafter are respectively $10, $9, and 6. a) What are the projects' NPVs assuming the WACC is 5%? 10%? 15%? b) What are the projects' IRRs at each of these WACCs? c) If the WACC was 5% and A and B were mutually exclusive, which project would you choose? What if the WACC was 10%? 15%?

a) 5%: NPV A = $3.52 | NPV B = $2.87 10%: NPV A = $0.58 | NPV B = $1.04 15%: NPV A = - $1.91 | NPV B = - $0.55 b) *when calculating IRR, we do not account for WACC IRR A = 11.10% IRR B = 13.18% c) 5% = Choose A 10% = Choose B 15% = Neither

1) Tannen Industries is considering an expansion. The necessary equipment would be purchased for $18 million and will be fully depreciated at the time of purchase, and the expansion would require an additional $2 million investment in net operating working capital. The tax rate is 25%. a) What is the initial investment outlay after bonus depreciation is considered? b) The company spent and expensed $20,000 on research related to the project last year. Would this change your answer? Explain. c) Suppose the company plans to use a building that it owns to house the project. The building could be sold for $1 million after taxes and real estate commissions. How would that fact affect your answer?

a) After-tax cost of equipment = (13.5 million) NOWC Investment = (2 million) **ANSWER: Initial Investment Outlay = ($15.5 million) b) No, last year's $20,000 expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. c) The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost.

8) You must evaluate the purchase of a proposed spectrometer for the R&D department. The purchase price of the spectrometer including modifications is $170,000, and the equipment will be fully depreciated at the time of purchase. The equipment would be sold after 3 years for $60,000. The equipment would require an $8,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $50,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 25%. a) What is the initial investment outlay for the spectrometer after bonus depreciation is considered, that is, what is the Year 0 project cash flow? b) What are the project's annual cash flows in Years 1, 2, and 3? c) If the WACC is 10%, should the spectrometer be purchased? Explain.

a) CF0 = -$135,000 After-Tax Cost = Cost (1-T) ($127,500) Change in NOWC ($8000) **ANSWER: Initial Investment Outlay = ($135,500) b & c) ** SEE SOLUTION SHEET **

Which capital budgeting method or methods is generally used by large, sophisticated firms for decision making? a. Large firms generally use all five methods for capital budgeting decisions. b. Large firms generally use only the NPV method for capital budgeting decisions. c. Large firms primarily use the payback method and sometimes use the IRR for capital budgeting decisions. d. Large firms usually just use common sense and good judgment for capital budgeting decisions.

a. Large firms generally use all five methods for capital budgeting decisions.

In which type of risk analysis is diversification totally ignored? a. Stand-alone risk b. Capital risk c. Corporate risk d. Market risk e. Beta risk

a. stand-alone risk

Which one of the following project categories for capital expenditures doesn't require a detailed analysis before approval? a. Expansion of existing products or markets b. Replacement: needed to continue current operations c. Expansion into new products or markets d. Mergers e. Replacement: cost reduction

b) replacement: needed to continue current operations

What is a reason that assuming reinvestment at the WACC is more reasonable than reinvestment at the IRR? a. The WACC is standard across all industries so it makes a better comparison for decision making. b. If a firm has reasonable access to capital markets, it can raise all the necessary capital at the going rate, which would be the WACC. c. The WACC is much easier to compute than the IRR. d. The IRR is constantly fluctuating, and the WACC is a consistent rate. e. Using the WACC doesn't result in an opportunity cost, whereas the IRR generally does.

b. If a firm has reasonable access to capital markets, it can raise all the necessary capital at the going rate, which would be the WACC.

What is one of the interesting trends revealed in a summary of the surveys on manager use of criterion methods between 1960 and 1999? a. The discounted payback method was commonly used prior to 1980, but rarely used after 1999. b. The NPV was scarcely used before 1980 but was close to the top in usage by 1999. c. The IRR is the all-time least favorite method among managers. d. The NPV was the primary method used prior to 1980 but has since declined greatly in use. e. The payback method has always been among the most popular, but in recent years has become almost obsolete.

b. The NPV was scarcely used before 1980 but was close to the top in usage by 1999.

Which of the following would be a factor in a replacement analysis that would indicate a company should reject the replacement of current equipment? a. The depreciation must be taken at a straight-line rate rather than immediately with bonus depreciation. b. The new equipment is projected to lower capacity and increase production costs. c. The old equipment has no salvage value. d. The new equipment is projected to increase capacity and lower production costs. e. The new equipment has a higher NPV than the old equipment

b. The new equipment is projected to lower capacity and increase production costs.

Suppose that Gaylin's Gyros has two cafes in the same town. Gaylin decides to open a food truck in addition to the two cafes and finds an available spot just a few blocks away from one of the restaurants. The new food truck is doing really well and always busy, but business at the nearby cafe has slowed significantly and Gaylin is considering laying off some of the cafe staff. Gaylin's situation is an example of a. an opportunity cost. b. cannibalization. c. a sunk cost. d. an externality. e. an incremental cash flow.

b. cannibalization.

Measuring the change in an NPV percentage resulting from the percentage change of an input variable is the basis of a a. base-case analysis. b. sensitivity analysis. c. Monte Carlo simulation. d. scenario analysis. e. diversification analysis.

b. sensitivity analysis.

Which of the following is CORRECT regarding the analysis of an expansion project? a. It is not necessary for opportunity costs to be considered in an expansion project. b. A sunk cost is an essential factor for the cost analysis of an expansion project. c. Taking immediate (bonus) depreciation versus straight line depreciation will result in a higher NPV for the project. d. The effects of cannibalization should not be included in the analysis until the project is completed. e. The assumption of imminent changes to tax law has no bearing on the analysis of an expansion project.

c. Taking immediate (bonus) depreciation versus straight line depreciation will result in a higher NPV for the project.

Which of the following statements is true about the internal rate of return (IRR) on a project? a. The trial-and-error method to find the internal rate of return (IRR) is the most commonly used. b. The internal rate of return (IRR) essentially calculates the rate that will equate the project investment to the NPV. c. The internal rate of return (IRR) in capital budgeting is similar to the yield to maturity (YTM) on a bond. d. The Excel method to find the internal rate of return (IRR) is complex and time consuming in comparison to using calculator functions. e. The internal rate of return (IRR) is calculated the exact opposite way as finding the NPV.

c. The internal rate of return (IRR) in capital budgeting is similar to the yield to maturity (YTM) on a bond.

What is one of the advantages that MIRR has over the regular IRR? a. MIRR assumes that the lowest IRR is the reinvestment rate, making calculation simple. b. MIRR relies more heavily on common sense and good judgment for decision making. c. There can never be more than one MIRR, eliminating the multiple IRR problem. d. The MIRR is a much more reliable predictor of liquidity than the IRR. e. The MIRR is the average of the IRRs, making it a more concise method of criterion.

c. There can never be more than one MIRR, eliminating the multiple IRR problem.

Which of the following statements is true about the criterion methods used for capital budgeting decisions in current times? a. The payback method is generally used as a primary source and reinforced with the MIRR. b. With modern technology to calculate the criterion, common sense and good judgment is no longer necessary for making sound decisions. c. The NPV and IRR are used, but the other methods are too complex to calculate and are becoming obsolete. d. All of the methods are easy to calculate and provide useful information. e. The return and profitability index is the most commonly used criterion method today.

d. All of the methods are easy to calculate and provide useful information.

Which of the following is an example of a project that would likely have multiple IRRs? a. A beverage company is considering investing in a new product label to boost sales appeal. b. A construction company considers building a new housing development. c. A technology company is producing a new design of GPS. d. An oil company invests in a project with a guarantee to erase its environmental impact at completion. e. A hydropower company invests in new turbines to increase power generation.

d. An oil company invests in a project with a guarantee to erase its environmental impact at completion.

Suppose that Project A has a life of 6 years and Project B has a life of 4 years. How many times (after the initial project life) would each project need to be repeated in order to conduct an analysis with the replacement change approach? a. Project A would need to be repeated 5 times and Project B would need to be repeated 3 times b. Project A would need to be repeated 3 times and Project B would need to be repeated 5 times. c. Project A would need to be repeated twice and Project B would need to be repeated twice. d. Project A would need to be repeated once and Project B would need to be repeated twice. e. Project A would need to be repeated once and Project B would need to be repeated once

d. Project A would need to be repeated once and Project B would need to be repeated twice. ** so both will be at 12 years Project A 6 years, repeat = 12 years Project B 4 years, repeat x2 = 12 years

Which of the following is correct about the assumptions of reinvestment rates? a. The NPV and IRR both assume the IRR as the rate of reinvestment. b. The WACC is always used as the assumed rate of reinvestment. c. The NPV and IRR both assume the WACC as the rate of reinvestment. d. The NPV assumes reinvestment at the WACC, whereas the IRR assumes reinvestment at the IRR. e. The NPV assumes reinvestment at the IRR, whereas the IRR assumes reinvestment at the WACC.

d. The NPV assumes reinvestment at the WACC, whereas the IRR assumes reinvestment at the IRR.

Which of the following would be irrelevant to analyzing a new product that a manufacturing company wants to start producing and selling? a. Estimated production output b. Depreciation rates of new equipment required for the project c. Sales projections d. Administrative salaries e. Opportunity costs

d. administrative salaries

When plotting values on a graph for a NPV profile, the NPV at a zero cost of capital is a. equal to the terminal value of the project. b. plotted at point 0,0 on the graph. c. equal to the cash flow t=0. d. equal to the net total of the undiscounted cash flows. e. the sum of all discounted cash flows.

d. equal to the net total of the undiscounted cash flows.

The key information to use when conducting a replacement analysis is the a. projected sales revenue. b. NPV of the present equipment. c. salvage value of the old equipment. d. incremental cash flows. e. cost of the working operating capital.

d. incremental cash flows.

Which one of the following is a basic condition that can cause NPV profiles to cross and lead to conflicts? a. Differences in initial investment costs b. The WACC is assumed as the reinvestment rate c. A change in company leadership d. The cost of capital is greater than the crossover rate e. Differences in project scale or size

e. Differences in project scale or size

Which type of risk is theoretically the most relevant in risk analysis? a. Corporate risk b. Stand-alone risk c. Diversification risk d. Capital risk e. Market risk

e. Market risk

Which of the criterion methods provides indications of a project's liquidity and risk? a. The IRR and MIRR methods provide indications of a project's liquidity and risk. b. The NPV method provides indications of a project's liquidity and risk. c. The MIRR method provides indications of a project's liquidity and risk d. The NPV and MIRR methods provide indications of a project's liquidity and risk e. The payback and discounted payback methods provide indications of a project's liquidity and risk.

e. The payback and discounted payback methods provide indications of a project's liquidity and risk.

A problem with measuring the effects of diversification on a new project is that a. it is hard to project sales output. b. most managers lack good judgement. c. returns don't align with the market. d. beta scores provide little in the means of relevant data. e. historical data is not available.

e. historical data is not available.

Future cash flow drives a project's

present value

independent projects

projects with cash flows that are not affected by the acceptance or non-acceptance of other projects

crossover rate

the cost of capital at which the NPV profiles of two projects cross and, thus, at which the project's NPVs are equal