Ch. 6 Capital Budgeting
What is the present value of $108 to be received at the end of one year when discounted at 8%
$100; Naturally, compounding and discounting are reciprocal operations. In one we project a present amount forward to determine its future value. In the second, we express that future amount in terms of its value to us today by discounting it.
The capital budgeting process involves qualitative and quantitative considerations. These extend to the
(1) generation of investment ideas, (2) evaluation and ranking of alternatives, (3) selection of investments and (4) continuing appraisal of post investment performance
Consider the situation in which it has been proposed to replace an outmoded piece of equipment with a new machine. What about sales demand that the old equipment was able to satisfy and that the new machine will fill as well? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(a) irrelevant; Because these sales are not incremental improvements over the status quo, they are not relevant to the cash flow analysis
Salvage value (a) is the best prediction of what an asset could be sold for at the end of the time horizon, (b) should be used to justify marginal investments, if necessary, (c) should not be used to justify marginally profitable investments, because salvage values are difficult to accurately predict, (d) A &B, (e) A & C
(e) A & C; In a cash flow forecast, salvage value is an estimate of the remaining worth of the asset at termination of the investment horizon. As you can imagine, such estimates are fraught with uncertainty, and should never be used as the basis for backing a marginal proposal
A discount factor (a) is the reverse of compounding future cash flows, (b) performs the reverse function of a compounding interest rate, (c) allows investors to quantify a figure which would make them indifferent to the returns from an investment, (d) B & C, (e) A, B & C
(e) A, B & C; All of the statements describe discount functions
benefit cost ratio
indicator of investment profitability but in isolation is of limited utility. Sum of the cash inflows/the initial investment. In the absence of the time value of money, a ratio greater than 1 suggests the investment should be pursued
If you invest $100 for one year at 8% interest, how much will your investment be worth in a year?
$108; $100 is your present value, 8% is the rate of compounding, and the future value is $108
Shortcomings of payback
(1) it disregards cash flows occurring beyond the payback period (2) it does not compensate for the timing of the cash flows within the payback period
If the hurdle rate used to discount a stream of cash flows is raised, the IRR of the cash stream will (a) always increase, (b) always decrease, (c) not change, (d) increase if the NPV is negative or decrease if the NPV is positive
(c) not change. IRR is calculated from the undiscounted cash flows. The discount rate chosen has absolutely no bearing on iRR
Jack expects tuition and fees to be $15K/yr. He is considering a stock with 8% ROI and 10% ROI. If Jack wants to minimize his current cash outlay, which stock should he buy, A or B?
B; Since B has a higher interest rate, its present value, given the same future value is less
The investment tax credit (ITC) amounts to a credit equal to a certain percentage of the cost of the investment T/F
True
qualitative considerations are as important as cash flow in investment decisions T/F
True
since a firm must outlay cash to acquire assets, their return should be evaluated with the same terms (cash) T/F
True
the useful life is the estimated economic life of the asset which is the number of years that the asset is expected to be productive T/F
True
whenever an investment's NPV is negative, its IRR will be lower than the discount rate used
Conversely, a positive NPV implies that the IRR is greater than the discount rate
suppose Jack's daughter planned to take a year of after HS to "find herself", so that he now has three years to amass the $15,000 for her tuition. Would he have to set aside more or less to achieve the future value?
Less; the longer his investment is earning money, the smaller its present value needs to be to achieve the specified future amount
Capital budgeting alternatives are evaluated on the basis of
incremental cash flows
If an investment has a negative net present value, its present value payback is
indeterminate
In order to equalize time horizons, sometimes it is necessary to estimate
residual values for the asset. In theory, the residual value is the present value of all future cash flows.
If Jack does pursue the 10% stock, how much does he need to invest so that he has precisely $15,000 in two years?
$12397; The present value of the $15K future amount when discounted at 10% for two years is: ($15,000/1.10^2) = $12397
incremental cash flow costs
(1) acquisition costs, not necessarily purchase price, (2) annual operating costs and routine maintenance, (3) depreciation lost when old asset is sold, (4) tax consequences of capital gain on sale of old asset, (5) revenue lost from sale of old asset, (6) major overhauls
Incremental cash flow benefits
(1) additional revenue made possible by investment, (2) cost savings from new asset, (3) Tax shelter from new depreciation, (4) Tax benefits such as ITC or capital losses, (5) Cash proceeds from sale of replaced asset, (6) salvage value of new asset
Rather than focusing on asset replacement, let's now consider plant expansion. What is your opinion about sales generated by the machinery at the old plant? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(a) irrelevant; Since the old plant would continue to turn out marketable products whether or not the new plant was built, sales revenue from the old plant is irrelevant
If you invested $100 in an account that would return $121 at the end of two years, and you discounted the returns from the investment at 10% annual interest, what is the present value of the investment? (a) $82.64, (b) $100, (c) $110, (d) $121
(b) $100; This illustrates a coincidental case in which the principal earns interest at exactly the same rate as the cash flows are discounted. In effect, the interest can be ignored and the present value is equal to the amount invested
Consider the situation in which it has been proposed to replace an outmoded piece of equipment with a new machine. What about direct labor charges that will no longer be necessary because of the increased speed of the new machine? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(b) an incremental benefit; Labor savings are an obvious incremental benefit from the new machine
How about the increase in projected sales volume resulting from the new plant? This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(b) an incremental benefit; The incremental sales are probably the major benefit to be derived from the new plant
It has been proposed to replace an outmoded piece of equipment with a new machine. The company's sales demand has exceeded its machine capacity in the past. The new equipment has a higher output than the old machine. This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(b) an incremental benefit; The new sales that could be realized because of the new machine are incremental benefits
present value calculations (a) can hinder the creation of value, (b) can provide managers with a means of identifying the best investment choices, (c) cause managers to mix asset and financing considerations, (d) A & B, (e) B & C
(b) can provide managers with a means of identifying the best investment choices; Present value calculations allow managers to eliminate timing as a dimension of investment returns. Thus, investments can be compared regardless of the time frame over which the outlays are made of the return generated
As the interest rate used to discount future cash flows is increased, present value of future cash inflows (a) increases, (b) decreases, (c) remains the same
(b) decreases; The larger the interest rate used to compound the returns from an investment the larger will be the accumulated future value. Conversely, with a higher discount rate, a proportionately smaller amount of money needs to be set aside today to reach a target future amount. Thus, the present value decreases as the rate of discounting increases
NPV is the preferred method for ranking investments because (a) it quantifies the proportion of cash flows to initial investment, (b) it directly measures the creation of value, (c) it is insensitive to changes in the hurdle rate assumption, (d) A &B, (e) B & C
(b) it directly measures the creation of value; NPV reports in present dollar terms about how much value will be added to a company as the result of making a particular investment. Because it is an absolute measure, it is awkward to apply in a comparative perspective. NPV is inversely linked to the hurdle rate used to discount the cash flows - the higher the hurdle rate, the lower the NPV
If A & B were independent investment proposals and capital existed in abundant supply, which would you endorse for funding? (a) A Only, (b) B only, (c) A & B, (d) Neither
(c) A & B; Both projects meet the financial criterion imposed for projects for this risk level - that is, both earn returns in excess of 10% -- therefore, they should both be funded. It is only when capital is scarce (the normal state of affairs) that rationing among feasible projects is dictated
investment tax credit
amounts to a credit equal to a certain percentage of the cost of an investment and for capital budgeting purposes would be considered a reduction in the initial outlay
Internal Rate of Return (IRR)
the discount factor necessary to make an investment's net present value equal to zero
Acquisition costs include the cash payments that are required for ownership and any subsequent expenditures required to extend the life of the asset such as a major overhaul T/F
True
In every case, with total returns being equal, the investment which provides cash flow sooner is the superior choice T/F
True
Taxes may provide costs and benefits T/F
True
Rather than focusing on asset replacement, let's now consider plant expansion. What if a selling point of the new plant is that it increases capacity, but that capacity could be satisfied by running a second shift at the old plant. Should the wages that would be paid to the second shift work force be included in the analysis?
Yes; The point of differential analysis is to compare the company's status given the alternative of choices of actions. In this case, assuming that demand exists to justify the additional output, there are at least two solutions to the problem -- build a new plant or add a second shift. No doubt there are others. To compare apples with apples, it is essential to operate with consistent assumptions. The wages should be included in the analysis
sunk cost
cash flow that a company will have to bear even if the investment is not undertaken
payback
equal to the investment divided by the annual cash inflows. It is not a present value method used to rank alternatives
Net present value
equates the cost of the investment with the present value of its future cash flows. In order to obtain the present value, a discount factor must be used, typically the hurdle rate. Generally speaking, the hurdle rate measures the overall risk to the firm; when the value is positive it add value
the useful life of an asset
the estimated economic life of an asset which is the number of years an asset is expected to be productive
depreciable life
the number of years that the company will depreciate the asset and is a function of the depreciation method that is chosen
Internal Rate of Return
used frequently to measure profitability in investment analysis and bonds; uses discounted cash flows to determine where NPV=0
present value payback
uses discounted cash flows to determine how long an investment will take to payback
What is the major advantage of using present value index (PVI) instead of NPV or IRR for comparison of alternative investments? (a) analysts are more familiar with PVI, (b) PVI does a better job of measuring the time value of money, (c) PVI accounts for the relative size of the initial investment, (d) none of the above
(c) PVI accounts for the relative size of the initial investment
How about operating expenses for the new plant, which are comparatively lower than the old plant?
(c) an incremental cost. Since the new plant is not a replacement for the old plant, any expenses linked to its operation can be considered incremental costs
Consider the purchase of land, buildings and equipment. This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(c) an incremental cost; The price of land, buildings, and equipment is an incremental cost
Consider the situation in which it has been proposed to replace an outmoded piece of equipment with a new machine. Suppose the old machine had not been fully depreciated and that it would be sold when the new machine was installed. What about the tax shelter from the future depreciation of the old machine. This should be considered (a) irrelevant, (b) an incremental benefit, (c) an incremental cost
(c) an incremental cost; This sort of incremental analysis can be confusing.. If the old machine had been retained, its future depreciation would have provided a benefit because of the tax shelter. However, because the depreciation will be foregone, it should be an incremental cost. The proceeds from the sale would be an incremental benefit
Which of the following is not a present value method (a) NPV, (b) IRR, (c) Payback, (d) none of the above
(c) payback
Which of the following would not be included among the investment numbers of a capital budget (a) purchase price of asset, (b) trade-in value of an asset being replaced, (c) reduction in labor costs from a new asset, (d) investment tax credit from acquisitions, (e) installation cost of machinery
(c) reduction in labor costs from a new asset; The cash flows relevant to an investment include the purchase price of the asset plus whatever expenditures are necessary to make it operational (installation, labor, freight, etc.) less cash to be realized from the disposition of replacement equipment. Ongoing cash flows such as labor saving are the benefits to be realized from the investment and should not be included as part of the investment
If an investment's IRR is higher than the firm's chosen hurdle rate, then the investment (a) has a negative NPV, (b) is of greater risk than the overall risk of the firm, (c) should be qualitatively considered before selection, (d) A &B, (e) A, B & C
(c) should be qualitatively considered before selection; If the investment's IRR exceeds the hurdle rate, the NPV is positive, not negative. Also, if the return from a project exceeds the hurdle rate, no inference is made as to the relative risk of the investment of the firm.
A shortcoming of the simple payback method is that it (a) does not account for the time value of money, (b) does not recognize cash flows beyond the payback period, (c) relies heavily on salvage values, (d) A & B, (e) A, B & C
(d) A & B; Payback is generally thought to have two weaknesses; it disregards the timing of cash receipts within the payback period and it ignores all receipts that occur after the payback has been achieved
Residual cash flows are estimated when (a) the useful lives of alternatives are different, (b) one asset has a shorter economic life than its alternatives, (c) it is not convenient to evaluate the total useful life of an asset, (d) A & B, (e) A, B & C
(d) A & B; two or more investment alternatives rarely have the same useful life. Estimating residual cash flows is a means of compensating for differences in the useful lives of the alternatives. Residual cash flows should never be estimated simply as a matter of convenience
residual cash flows are estimated (a) when the useful lives of alteernatives differ, (b) when future depreciation of an old asset is lost, (c) in order to quantify cash flows of an investment beyond the chosen time horizon, (d) A & C, (e) A, B & C
(d) A & C; residual values are entered into cash flow forecasts in recognition of the fact that an investment cannot be evaluated into perpetuity. When comparing two investments with unequal lives, the residual value of the longer-lived asset is assumed to be realized at the termination of the shorter-lived asset, in this way assuring comparability of the investments
A differential analysis (a) should be used only to compare an alternative to the status quo, (b) can be used to compare any set of alternatives, (c) is easier to comprehend if a consistent frame of reference is employed, (d) B & C, (e) A, B & C
(d) B & C; A differential analysis is similar to examining incremental cash flows - it reveals how the results of one course of action differ from results of another course. Incremental analysis is an extreme case of differential analysis because the alternative is compared with the status quo
For capital budgeting purposes, an asset's depreciable life is (a) always equal to the time horizon of an evaluation, (b) equal to the asset's useful life, (c) equal to the asset's economic life, (d) an arbitrary period dictated by the tax code, (e) none of the above
(d) an arbitrary period dictated by the tax code; The only depreciation relevant to capital budgeting is an analysis of cash flows. Depreciation is a noncash expense; its value to a firm is that it reduced the amount of tax dollars a company must pay
Hurdle rates are used in an attempt to (a) screen out weak investments, (b) quantify the firm's opportunity costs, (c) quantify the firm's risk, (d) A &B, (e) A, B & C
(e) A, B & C; All of the statements regarding the use of hurdle rates are true
Capital budgeting includes (a) generation of ideas, (b) evaluation and ranking of alternatives, (c) selection and monitoring of investments, (d) B & C, (e) A, B & C
(e) A, B &C. Capital budgeting is a process that begins with brainstorming, continues through evaluation of the project returns, and is not complete until the performance of the investment has been analyzed after it has been brought online
Present value calculations allow managers to (a) choose assets which create the most value, even if their cash flows are timed differently, (b) choose the least expensive form of financing, (c) create value for the firm, (d) A & C, (e) A, B & C
(e) All of the statements are true
The present value of cash flow allows an investor to asses (a) the value of a present cash flow projected into the future, (b) the value of a stream of cash flows in terms of the best and most certain alternative, (c) what equivalent present payment would be equally acceptable in lieu of the investment under consideration, (d) A & B, (e) B & C
(e) B & C; these are both true because they address the concept of opportunity cost and timing - comparing a future stream of cash flows in terms of value today. Choice A describes future value, not present value.
Value is created in a firm through (a) asset acquisitions, which improve earnings or efficiencies, (b) capitalization decisions, (c) the reduction of operational and financial risks, (d) A & C, (e) A & B & C
(e) Value can be created through either side of the balance sheet. The traditional view of building value suggests investments in new assets which generate income in excess of their cost. However, value can also be created through financing, for example, by reducing the perceived risk of the firm.
what value of PVI would you guess would indicate the minimum acceptable return for a project to be approved?
1 - If the discounted cash inflows from a project equal the cash outflows, then the PVI is equal to one. As the inflows increase, the PVI grows larger than one
On the basis of the numbers above which project would you support A or B? Project A: Payback 2.7, PV Paybakc 3.4, NPV $8,065, PVI 1.4, IRR 24.9%; Project B: Payback 2.5, PV Payback 3.0, NPV $6,973, PVI 1.14, IRR 16.1%
A; The most telling indicators are the PVI and IRR. In addition, B requires an investment of $50,000 to provide a return of $6,783. Project A generates a greater net present value from an investment, 40% as large
a future feasibility study to determine the environmental impact of a planned investment should not be included in the incremental cash flows of an investment analysis T/F
False; The key word here is future. if the study must be performed before the investment can be undertaken, then it should be included among the relevant cash flows. Had the study already taken place, it would be classified as a sunk cost and should be ignored in the analysis
If Jack could muster $12K for the stock yielding 10% and planned to pay the tuition in two years would he have enough money?
No; The future value of Jack's $12K is $12,000*(1.10^2)=$14,520. He might have to get a student loan for the rest