PRACTICE AND CLASS Ch.11 (Capital Budgeting)

Class 9. An investment has the following cash flows. Should the project be accepted if it has been assigned a required return of 9.5 percent? Why or why not? Year Cash Flow 0 -$24,000 1 $ 8,000 2 $12,000 3 $ 9,000

CF0 -$24,000 C01 $ 8,000 F01 1 C02 $12,000 F02 1 C03 $ 9,000 F03 1 IRR CPT 9.89 percent The project should be accepted because the IRR of 9.89 percent exceeds the required return of 9.5 percent.

Class 8. What is the net present value of a project with the following cash flows and a required return of 12 percent Year Cash Flow 0 -$28,900 1 $12,450 2 $19,630 3 $ 2,750

CF0 -$28,900 C01 $12,450 F01 1 C02 $19,630 F02 1 C03 $2,750 F03 1 I = 12% NPV CPT -$177.62

Practice 4. (200,000), 90,000, 75,000, 86,000. What is the payback period for Project E?

SOLUTION: Year 1 & 2: 90,000 + 75,000 = 165,000, 2 years Year 3: (200,000 - 165,000)/86,000) = .41 of a year Final Answer: 2.41 years

Practice 2. What are the three decision-making criteria of capital budgeting?

SOLUTION: (1) examines all net cash flows, (2) considers the time value of money, and (3) considers risk using the required rate of return

Practice 3. (200,000), 100,000, 60,000, 40,000, 50,000, 60,000. What is the payback period for Project D?

SOLUTION: 100,000 + 60,000 + 40,000 = 200,000 = 3 years to pay back the initial investment of $200,000

Practice 1. What are the evaluation methods of capital budgeting?

SOLUTION: Payback period, net present value, profitability index, and internal rate of return

Practice 10. Lauren is looking into investing $70 million in a project that will expand Storm the Rack Inc.'s perfume line. The new perfume line is projected to produce cash flows of $20 million for the next 6 years. Use a discount rate of 13.65. Solve for the IRR to decide if Lauren should invest in the project?

SOLUTION: Use the equation IRR: Σ𝐶𝐹𝑡(1+𝐼𝑅𝑅)𝑡𝑛𝑡=1=𝐼𝑂 CFO: -70M CF1: 20M CF2: 20M CF3: 20M CF4: 20M CF5: 20M CF6: 20M Compute IRR = 17.97% Yes, Lauren should invest in the project because the IRR is greater than the required rate (17.97% > 13.65%)

Practice 7. Pineapple Princess Co. is considering expanding its business by investing in a slushy shack. The project will require an initial outlay of $35,560 and will have yearly cash flows of $15,360, $9,400, $16,320, $20,400, and $21,000. Assume a 9% required rate of return. What is Pineapple Princess Co.'s NPV for this project?

SOLUTION: Use the equation NPV = Σ 𝐶𝐹𝑡 (1+𝑘)𝑡 𝑛𝑡 =1 − 𝐼𝑂 CF0: -35,560 CF1: 15,360 CF2: 9,400 CF3: 16,320 CF4: 20,400 CF5: 21,000 I: 9% Compute NPV using your financial calculator = $27,146.00

Practice 6. (60,000), 23,000, 45,000, 36,000, 39,600. What is the net present value of the following stream of cash flows if the discount rate is 13%? Should you invest in the project?

SOLUTION: Use the equation NPV = Σ 𝐶𝐹𝑡 (1+𝑘)𝑡 𝑛𝑡 =1 − 𝐼𝑂 CF0: -60,000 CF1: 23,000 CF2: 45,000 CF3: 36,000 CF4: 39,600 I (the discount rate): 13% Compute NPV using your financial calculator = $44,832.81. Yes, you should invest in the project because the NPV is positive Use the following information for the next two questions:

Practice 8. What is the profitability index of Pineapple Princess Co.?

SOLUTION: Use the equation PI = Σ 𝐶𝐹𝑡 (1+𝑘)𝑡 𝑛𝑡 =1 𝐼𝑂 CF0: 0 CF1: 15,360 CF2: 9,400 CF3: 16,320 CF4: 20,400 CF5: 21,000 I: 9% NPV= $62,706.00 Now, we take our NPV and divide it by our initial outlay: 62,706/35,560 = 1.76

Practice 5. You are an analyst in your company and have conducted a thorough analysis and have estimated the net present value of a project to be $2.6 million, the internal rate of return to be 8%, and the payback period to be 4.52 years. Given this information, should the company recommend that they capital project be accepted?

SOLUTION: Yes, because the NPV is greater than zero

Practice 9. (25,900), 19,000, 24,600, 36,000, 45,370. What is the internal rate of return for the following stream of cash flows if the discount rate is 9%?

SOULTION: Use the equation IRR: Σ𝐶𝐹𝑡(1+𝐼𝑅𝑅)𝑡𝑛𝑡=1=𝐼𝑂 CF0: -25,900 CF1: 19,000 CF2: 24,600 CF3: 36,000 CF4: 45,370 Compute IRR in your financial calculator = 88.75%

Class 10. A project has an initial cost of $1,900. The cash inflows are $0, $500, $900, and $700 over the next four years, respectively. What is the payback period?

a. 2.71 years b. 2.98 years c. 3.11 years d. 3.71 years e. never Payback period = 3.71 years

Class 3. Which one of the following statements is correct concerning the payback period a. An investment is acceptable if its calculated payback period is less than some pre-specified period of time. b. An investment should be accepted if the payback is positive and rejected if it is negative. c. An investment should be rejected if the payback is positive and accepted if it is negative. d. An investment is acceptable if its calculated payback period is greater than some pre-specified period of time. e. An investment should be accepted any time the payback period is less than the discounted payback period, given a positive discount rate

a. An investment is acceptable if its calculated payback period is less than some pre-specified period of time.

Class 6. The primary reason that company projects with positive net present values are considered acceptable is that: a. they create value for the owners of the firm. b. the project's rate of return exceeds the rate of inflation. c. they return the initial cash outlay within three years or less. d. the required cash inflows exceed the actual cash inflows. e. the investment's cost exceeds the present value of the cash inflows

a. they create value for the owners of the firm.

Class 1.The process of valuing an investment by determining the present value of its future cash flows is called (the): a. constant dividend growth model. b. discounted cash flow valuation. c. average accounting valuation. d. expected earnings model. e. Capital Asset Pricing Model.

b. discounted cash flow valuation.

Class 2. Which one of the following statements concerning net present value (NPV) is correct? a. An investment should be accepted if, and only if, the NPV is exactly equal to zero. b. An investment should be accepted only if the NPV is equal to the initial cash flow. c. An investment should be accepted if the NPV is positive and rejected if it is negative. d. An investment with greater cash inflows than cash outflows, regardless of when the cash flows occur, will always have a positive NPV and therefore should always be accepted. e. Any project that has positive cash flows for every time period after the initial investment should be accepted

c. An investment should be accepted if the NPV is positive and rejected if it is negative.

Class 7. Payback is frequently used to analyze independent projects because: a. it considers the time value of money. b. all relevant cash flows are included in the analysis. c. the cost of the analysis is less than the potential loss from a faulty decision. d. it is the most desirable of all the available analytical methods from a financial perspective. e. it produces better decisions than those made using either NPV or IRR.

c. the cost of the analysis is less than the potential loss from a faulty decision.

Class 4. An investment is acceptable if its IRR: a. is exactly equal to its net present value (NPV). b. is exactly equal to zero. c. is less than the required return. d. exceeds the required return. e. is exactly equal to 100 percent

d. exceeds the required return.

Class 5. The possibility that more than one discount rate will make the NPV of an investment equal to zero is called the _____ problem. a. net present value profiling b. operational ambiguity c. mutually exclusive investment decision d. issues of scale e. multiple rates of return

e. multiple rates of return