35. Capital Budgeting (Web + Sch. Note)

A company is considering the purchase of a copier that costs $5,000. Assume a required rate of return of 10% and the following cash flow schedule: • Year 1: $3,000. • Year 2: $2,000. • Year 3: $2,000. 1. What is the project's payback period? A. 1.5 years. B. 2.0 years. C. 2.5 years. 2. The project's discounted payback period is closest to: A. 1.4 years. B. 2.0 years. C. 2.4 years. 3. What is the project's NPV? A. -$309. B. +$883. C. +$1,523. 4. The project's IRR is closest to: A. 10%. B. 15%. C. 20%. 5. What is the project's profitability index (PI)? A. 0.72. B. 1.18. C. 1.72.

1. B 2. C 3. B 4. C 5. B PI = 1 + NPV/CF0

An analyst has gathered the following information about a project: • Cost: $10,000 • Annual cash inflow: $4,000 • Life: 4 years • Cost of capital: 12% Which of the following statements about the project is least accurate? A. The discounted payback period is 3.5 years. B. The IRR of the project is 21.9%; accept the project. C. The NPV of the project is +$2,149; accept the project.

A

One of the basic principles of capital budgeting is that: A) cash flows should be analyzed on a pre-tax basis. B) decisions are based on cash flows, not accounting income. C) opportunity costs should be excluded from the analysis of a project.

B The five key principles of the capital budgeting process are: 1. Decisions are based on cash flows, not accounting income. 2. Cash flows are based on opportunity costs. 3. The timing of cash flows is important. 4. Cash flows are analyzed on an after-tax basis. 5. Financing costs are reflected in the project's required rate of return.

An analyst has gathered the following data about two projects, each with a 12% rate of return: Project Y Project Z cost $15,000 $20,000 Life 5 years 4 years flows $5,000/year $7,500/year 1. If the projects are independent, the company should: A. accept Project Y and reject Project Z. B. reject Project Y and accept Project Z. C. accept both projects. 2 If the projects are mutually exclusive, the company should: A. reject both projects. B. accept Project Y and reject Project Z. C. reject Project Y and accept Project Z.

1. C Both have positive NPV and are independent. 2. B Project Y has higher NPV

Rosalie Woischke is an executive with ColaCo, a nationally known beverage company. Woischke is trying to determine the firm's optimal capital budget. First, Woischke is analyzing projects Sparkle and Fizz. She has determined that both Sparkle and Fizz are profitable and is planning on having ColaCo accept both projects. Woischke is particularly excited about Sparkle because if Sparkle is profitable over the next year, ColaCo will have the opportunity to decide whether or not to invest in a third project, Bubble. Which of the following terms best describes the type of projects represented by Sparkle and Fizz as well as the opportunity to invest in Bubble? Sparkle and Fizz Opportunity to invest in Bubble A) Independent projects Project sequencing B) Independent projects Add-on project C) Mutually exclusivve projects Project sequencing

A Independent projects are projects for which the cash flows are independent from one another and can be evaluated based on each project's individual profitability. Since Woischke is accepting both projects, the projects must be independent. If the projects were mutually exclusive, only one of the two projects could be accepted. The opportunity to invest in Bubble is a result of project sequencing, which means that investing in a project today creates the opportunity to decide to invest in a related project in the future.

Project sequencing is best described as: A) an investment in a project today that creates the opportunity to invest in other projects in the future. B) arranging projects in an order such that cash flows from the first project fund subsequent projects. C) prioritizing funds to achieve the maximum value for shareholders, given capital limitations.

A Projects are often sequenced through time so that investing in a project today may create the opportunity to invest in other projects in the future. Note that funding from the first project is not a requirement for project sequencing.

Which of the following statements about the discounted payback period is least accurate? The discounted payback: A) period is generally shorter than the regular payback. B) frequently ignores terminal values. C) method can give conflicting results with the NPV.

A The discounted payback period calculates the present value of the future cash flows. Because these present values will be less than the actual cash flows it will take a longer time period to recover the original investment amount.

Which of the following is the most appropriate decision rule for mutually exclusive projects? A) Accept the project with the highest net present value, subject to the condition that its net present value is greater than zero. B) Accept both projects if their internal rates of return exceed the firm's hurdle rate. C) If the net present value method and the internal rate of return method give conflicting signals, select the project with the highest internal rate of return.

A The project that maximizes the firm's value is the one that has the highest positive NPV.

Edelman Enginenering is considering including an overhead pulley system in this year's capital budget. The cash outlay for the pully system is $22,430. The firm's cost of capital is 14%. After-tax cash flows, including depreciation are $7,500 for each of the next 5 years. Calculate the internal rate of return (IRR) and the net present value (NPV) for the project, and indicate the correct accept/reject decision. NPV IRR Accept/Reject A) $3,318 20% Accept B) $15,070 14% Accept C) $15,070 14% Reject

A Using the cash flow keys: CF0 = -22,430; CFj = 7,500; Nj = 5; Calculate IRR = 20% I/Y = 14%; Calculate NPV = 3,318 Because the NPV is positive, the firm should accept the project.

When using net present value (NPV) profiles: A) one should accept all independent projects with positive NPVs. B) the NPV profile's intersection with the vertical y-axis identifies the project's internal rate of return. C) one should accept all mutually exclusive projects with positive NPVs.

A Where the NPV intersects the vertical y-axis you have the value of the cash inflows less the cash outflows, assuming an absence of money having a time value (i.e., the discount rate is zero). Where the NPV intersects the horizontal x-axis you have the project's internal rate of return. At this cost of financing, the cash inflows and cash outflows offset each other. The NPV profile is a tool that graphically plots the project's NPV as calculated using different discount rates. Assuming an appropriate discount rate, one should accept all projects with positive net present values, if the projects are independent. If projects are mutually exclusive select the one with the higher NPV at any given level of the cost of capital.

The post-audit is used to: A. improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts. B. improve cash flow forecasts and eliminate potentially profitable but risky projects. C. stimulate management to improve operations, bring results into line with forecasts, and eliminate potentially profitable but risky projects.

A A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations.

Which of the following statements concerning the principles underlying the capital budgeting process is most accurate? A. Cash flows should be based on opportunity costs. B. Financing costs should be reflected in a project's incremental cash flows. C. The net income for a project is essential for making a correct capital budgeting decision.

A Cash flows are based on opportunity costs. Financing costs are recognized in the project's required rate of return. Accounting net income, which includes non-cash expenses, is irrelevant; incremental cash flows are essential for making correct capital budgeting decisions.

The NPV profile is a graphical representation of the change in net present value relative to a change in the: A) prime rate. B) discount rate. C) internal rate of return.

B As discount rates change the net present values change. The NPV profile is a graphic illustration of how sensitive net present values are to different discount rates. By comparison, every project has a single internal rate of return and payback period because the values are determined solely by the investment's expected cash flows.

Financing costs for a capital project are: A) subtracted from the net present value of a project. B) captured in the project's required rate of return. C) subtracted from estimates of a project's future cash flows.

B Financing costs are reflected in a project's required rate of return. Project specific financing costs should not be included as project cash flows. The firm's overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows.

Which of the following statements about NPV and IRR is least accurate? A) For independent projects if the IRR is > the cost of capital accept the project. B) For mutually exclusive projects you should use the IRR to rank and select projects. C) The NPV method assumes that all cash flows are reinvested at the cost of capital.

B For mutually exclusive projects you should use NPV to rank and select projects.

Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the basic principles of capital budgeting: Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project. Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project. Which of the following regarding Lutz's statements is most accurate? Statement 1 Statement 2 A) Correct Correct B) Correct Incorrect C) Incorrect Correct

B Lutz's first statement is correct. The timing of cash flows is important for making correct capital budgeting decisions. Capital budgeting decisions account for the time value of money. Lutz's second statement is incorrect. Capital budgeting decisions should be based on incremental after-tax cash flows, not net (accounting) income.

Which of the following types of capital budgeting projects are most likely to generate little to no revenue? A) Replacement projects to maintain the business. B) Regulatory projects. C) New product or market development.

B Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating.

Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return? A) $325,859. B) $280,913. C) $376,872.

B The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913.

If the calculated net present value (NPV) is negative, which of the following must be CORRECT. The discount rate used is: A) less than the internal rate of return (IRR). B) greater than the internal rate of return (IRR). C) equal to the internal rate of return (IRR).

B When the NPV = 0, this means the discount rate used is equal to the IRR. If a discount rate is used that is higher than the IRR, the NPV will be negative. Conversely, if a discount rate is used that is lower than the IRR, the NPV will be positive.

Which of the following statements regarding the net present value (NPV) and internal rate of return (IRR) is least accurate? A) For independent projects, the internal rate of return IRR and the NPV methods always yield the same accept/reject decisions. B) For mutually exclusive projects, you must accept the project with the highest NPV regardless of the sign of the NPV calculation. C) The NPV tells how much the value of the firm will increase if you accept the project.

B If the NPV for two mutually exclusive projects is negative, both should be rejected.

Fullen Machinery is investing $400 million in new industrial equipment. The present value of the future after-tax cash flows resulting from the equipment is $700 million. Fullen currently has 200 million shares of common stock outstanding, with a current market price of $36 per share. Assuming that this project is new information and is independent of other expectations about the company, what is the theoretical effect of the new equipment on Fullen's stock price? The stock price will: A. decrease to $33.50. B. increase to $37.50. C. increase to $39.50.

B The NPV of the new equipment is $700 million- $400 million = $300 million. The value of this project is added to Fullen's current market value. On a per-share basis, the addition is worth $300 million / 200 million shares, for a net addition to the share price of $1.50. $36.00 + $1.50 = $37.50. ---------------------------------------------------------------------- 700 - 400 = 300 200 * 36 = 7200 7200 + 300 = 7500 7500 / 200 = $37.5

A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule: Year 1: $3,000 Year 2: $2,000 Year 3: $2,000 Determine the project's payback period and discounted payback period. Payback Period Discounted Payback Period A) 2.0 years 1.6 years B) 2.0 years 2.4 years C) 2.4 years 1.6 years

B Use Calculator

Which of the following statements about NPV and IRR is least accurate? A. The IRR is the discount rate that equates the present value of the cash inflows with the present value of outflows. B. For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, the analyst should use the IRRs to select the project. C. The NPV method assumes that cash flows will be reinvested at the cost of capital, while IRR rankings implicitly assume that cash flows are reinvested at the IRR.

B NPV should always be used if NPV and IRR give conflicting decisions.

Which of the following statements is least accurate? The discounted payback period: A. frequently ignores terminal values. B. is generally shorter than the regular payback. C. is the time it takes for the present value of the project's cash inflows to equal the initial cost of the investment.

B The discounted payback is longer than the regular payback because cash flows are discounted to their present value.

Which of the following statements about the payback period method is least accurate? The payback period: A. provides a rough measure of a project's liquidity. B. considers all cash flows throughout the entire life of a project. C. is the number of years it takes to recover the original cost of the investment.

B The payback period ignores cash flows that go beyond the payback period.

Tapley Acquisition, Inc., is considering the purchase of Tangent Company. The acquisition would require an initial investment of $190,000, but Tapley's after-tax net cash flows would increase by $30,000 per year and remain at this new level forever. Assume a cost of capital of 15%. Should Tapley buy Tangent? A) No, because k > IRR. B) Yes, because the NPV = $30,000. C) Yes, because the NPV = $10,000.

C This is a perpetuity. PV = PMT / I = 30,000 / 0.15 = 200,000 200,000 ? 190,000 = 10,000 OR USE THE CALCULATOR!!!!

The Chief Financial Officer of Large Closeouts Inc. (LCI) determines that the firm must engage in capital rationing for its capital budgeting projects. Which of the following describes the most likely reason for LCI to use capital rationing? LCI: A) must choose between projects that compete with one another. B) would like to arrange projects so that investing in a project today provides the option to accept or reject certain future projects. C) has a limited amount of funds to invest.

C Capital rationing exists when a company has a fixed (maximum) amount of funds to invest. If profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize its funds to achieve the maximum value for shareholders given its capital limitations.

Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital budgeting. Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital budgeting analysis. Statement 2: Cash flows should be analyzed on an after-tax basis. Should DeWalt agree or disagree with Webb's statements? Statement 1 Statement 2 A) Agree Agree B) Disagree Disagree C) Disagree Agree

C DeWalt should disagree with Webb's first statement. Cash flows are based on opportunity costs. Any cash flows that the firm gives up because a project is undertaken should be charged to the project. DeWalt should agree with Webb's second statement. The impact of taxes must be considered when analyzing capital budgeting projects.

Which of the following statements about independent projects is least accurate? A) If the internal rate of return is less than the cost of capital, reject the project. B) The net present value indicates how much the value of the firm will change if the project is accepted. C) The internal rate of return and net present value methods can yield different accept/reject decisions for independent projects.

C For independent projects the IRR and NPV give the same accept/reject decision. For mutually exclusive projects the IRR and NPV techniques can yield different accept/reject decisions.

If two projects are mutually exclusive, a company: A) must accept both projects or reject both projects. B) can accept one of the projects, both projects, or neither project. C) can accept either project, but not both projects.

C Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects.

A firm is considering a $200,000 project that will last 3 years and has the following financial data: Annual after-tax cash flows are expected to be $90,000. Target debt/equity ratio is 0.4. Cost of equity is 14%. Cost of debt is 7%. Tax rate is 34%. Determine the project's payback period and net present value (NPV). Payback Period NPV A) 2.43 years $18,716 B) 2.22 years $21,872 C) 2.22 years $18,716

C Payback Period $200,000 / $90,000 = 2.22 years NPV Method First, calculate the weights for debt and equity wd + we = 1 we = 1 ? wd wd / we = 0.40 wd = 0.40 × (1 ? wd) wd = 0.40 ? 0.40wd 1.40wd = 0.40 wd = 0.286, we = 0.714 Second, calculate WACC WACC = (wd × kd) × (1 ? t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132 + 0.100 = 0.1132 Third, calculate the PV of the project cash flows 90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716 And finally, calculate the project NPV by subtracting out the initial cash flow NPV = $218,716 ? $200,000 = $18,716

The underlying cause of ranking conflicts between the net present value (NPV) and internal rate of return (IRR) methods is the underlying assumption related to the: A) initial cost. B) cash flow timing. C) reinvestment rate.

C The IRR method assumes all future cash flows can be reinvested at the IRR. This may not be feasible because the IRR is not based on market rates. The NPV method uses the weighted average cost of capital (WACC) as the appropriate discount rate.

Which of the following statements about the internal rate of return (IRR) and net present value (NPV) is least accurate? A) The discount rate that causes the project's NPV to be equal to zero is the project's IRR. B) The IRR is the discount rate that equates the present value of the cash inflows with the present value of the outflows. C) For mutually exclusive projects, if the NPV rankings and the IRR rankings give conflicting signals, you should select the project with the higher IRR.

C The NPV method is always preferred over the IRR, because the NPV method assumes cash flows are reinvested at the cost of capital. Conversely, the IRR assumes cash flows can be reinvested at the IRR. The IRR is not an actual market rate.

Which of the following statements about NPV and IRR is NOT correct? A) The IRR can be positive even if the NPV is negative. B) When the IRR is equal to the cost of capital, the NPV equals zero. C) The NPV will be positive if the IRR is less than the cost of capital.

C This statement should read, "The NPV will be positive if the IRR is greater than the cost of capital. The other statements are correct. The IRR can be positive (>0), but less than the cost of capital, thus resulting in a negative NPV. One definition of the IRR is the rate of return for which the NPV of a project is zero.

Which of the following statements about the internal rate of return (IRR) for a project with the following cash flow pattern is CORRECT? Year 0: -$ 2,000 Year 1: $10,000 Year 2: -$ 10,000 A) No IRRs can be calculated. B) It has a single IRR of approximately 38%. C) It has two IRRs of approximately 38% and 260%.

C The number of IRRs equals the number of changes in the sign of the cash flow. In this case, from negative to positive and then back to negative. Although 38% seems appropriate, one should not automatically discount the value of 260%. Check answers by calculation: 10,000 ÷ 1.38 - 10,000 ÷ 1.382 = 1995.38 And: 10,000 ÷ 3.6 - 10,000 ÷ 3.62 = 2006.17 Both discount rates give NPVs of approximately zero and thus, are IRRs.

The NPV profiles of two projects will intersect: A. at their internal rates of return. B. if they have different discount rates. C. at the discount rate that makes their net present values equal.

C The crossover rate for the NPV profiles of two projects occurs at the discount rate that results in both projects having equal NPVs.

Which of the following statements about NPV and IRR is least accurate? A. The IRR can be positive even if the NPV is negative. B. When the IRR is equal to the cost of capital, the NPV will be zero. C. The NPV will be positive if the IRR is less than the cost of capital.

C If IRR is less than the cost of capital, the result will be a negative NPV.