Module 5-6

___________. results from the use of fixed - cost assets or funds to magnify returns to a firm's owners.

Leverage

The primary purpose of capital budgeting is to:

Maximize the shareholders wealth

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 fixed costs

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Mutually Exclusive

The "gold standard" of investment criteria refers to:

NPV

Which of the following statements is correct?

The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.

Capital rationing may be beneficial to a firm if it:

weeds out proposals with weaker or biased NPVs.

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; • 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​ $27,603,445 (excluding​ land, hint: land is not subject to​ depreciation).

$2,600,000 + $27,603,445 = $30,203,445

What are advantages of payback period?

- Does not require complex calculations - Measures Liquidity, Easy to communicate - Does not require discount rate

The disadvantages of the IRR period method is that it:

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

Jon Stevens, BNSF Vice President and Controller describes the capital spending process primarily as

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

Identify which of these are the relevant cash flows when considering a capital budgeting project.

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

List steps of the capital budgeting process

1. proposal generation 2. review and analysis 3. decision making 4. implementation 5. follow-up

What is the PI for project A with a cost of capital of 8%. Year Project A Project B 0 ($42,000) ($45,000) 1 $14,000 $28,000 2 $14,000 $12,000 3 $14,000 $10,000 4 $14,000 $10,000 5 $14,000 $10,000

1.33

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%? (Hint: Watch Video #9 - I. Capital Budgeting and Cash Flows - Annualized NPV and EAC @ $WIKI_REFERENCE$/pages/capital-budgeting-and-cash-flows-the-lectures?module_item_id=g9a89e790298905497957e6a4658e2a67

25,773.54

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. Depr % 1. 33.33 2. 44.45 3. 14.81 4. 7.41 What is the total cash flow in year 3?

25,860.64

Suppose the capital budget in the lecture example worksheet in $WIKI_REFERENCE$/pages/capital-budgeting-and-cash-flows-the-lectures?module_item_id=g9a89e790298905497957e6a4658e2a67 Video #11 was $100,000. What is the NPV of the best project(s)? Click here Download herefor the spreadsheet and open the "Capital Rationing" worksheet.

45,000

A corporation is contemplating an expansion project. The CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the corporations cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows?

Any opportunity costs associated w/ the project

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 NPV I=8 enter down arrow Cpt NPV= 183.48 PI= (183.48+5,000)/5,000 PI= 1.03669 PI=103.67%

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.

CFO= -100,000,000 CO1= -20,000,000 FO1= 1 CO2= 80,000,000 FO2= 1 CO3= 90,000,000 FO3= 1 I=11% CPT IRR= 15.95%

A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $86,510,569 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 NPV?

CFO= -86,510,569 CO1= -20,000,000 FO1= 1 CO2= 80,000,000 FO2= 1 CO3= 90,000,000 FO3= 1 I= 11% CPT NPV= 26,208,432

What types of analyses do the BNSF strategic studies team conduct?

Discounted cash flow & Sensitivity

What types of projects does the BNSF strategic studies team evaluate?

Discretionary

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

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

False

Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a projects initial investment from the present value of its cash inflows discounted at a rate equal to the firms cost of capital

False

According to the article, "Sunk cost fallacy: Throwing good money after bad." How can banks limit loses from bad loans?

Increase bank executive turnover

Generally, increases in leverage result in______________ return and _____________________ risk.

Increased; Increased

What is the amount of the operating cash flow for a firm with $303,516 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate?

Operating cash flows = Profit before tax x ( 1 - T ) + Depreciation 303,516*(1-0.35)+100,000= 297,285.4

Which of the following statements is correct for a project with a negative NPV?

The cost of capital exceeds the IRR

Revenues generated by a new fad product are forecast as follows: Year Revenues 1 $33,599 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 = $33,599 Expenses= (.5*$33,599)= -16,799.5 Depreciation= (40,000/5)=. -8,000 = EBIT 33,599-16,799.5-8,000= 8,799.5 Tax= 8,799.5*.20= -1,759.9 NI (Net Income)= 8,799.5-1,759.9= 7,039.6 Depreciation=. 40,000/5= +8,000= OCF 7,039.6+8,000= 15,039.6 OCF for year 1= 15,040

The degree of operating leverage has which of the following characteristics?

The DOL relates the change in sales to the change in net operating income.

Match those following concepts for first principle

The investment decision: invest in assets that earn a return greater than the minimum acceptable hurdle rate The financing decision: find the right kind of debt for your firm and the right mix of debt and equity to fund your operations The dividend decision: if you can't find investments that make your minimum acceptable rate, return the cash to the owners of your business

The internal rate of return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0

True

The multiple IRR problem occurs when the signs of a projects cash flows change more than once.

True

If a 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggest:

deemphasizing that variable as a critical factor.

In theory, a firm should maintain financial leverage consistent with a capital structure that

maximizes the owner's wealth

Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the 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 a 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​ $20,000,000 (excluding​ land, hint: the land is not subject to​ depreciation).​ • If the project is​ undertaken, at t​ = 0 the company will need to increase its inventories by​ $3,500,000, accounts receivable by​ $1,500,000, and its accounts payable by​ $2,000,000. This net operating working capital will be recovered at the end of the​ project's life​ (t =​ 10).​ • 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). What is the operating cash flow​ @ t=1? Round to nearest whole dollar value. What is the operating cash flow​ @ t=2? Round to nearest whole dollar value. What are the after tax proceeds from the sale of the factory​ (i.e., ATSV)? Round to nearest whole dollar value. What is the total cash flow at​ t=10? Round to nearest whole dollar value. What is the​ project's NPV? Round to nearest whole dollar value.

operating cash flow​ @ t=1? 3,212,500 operating cash flow​ @ t=2? 3,212,500 What are the after tax proceeds from the sale of the factory​ (i.e., ATSV)? 4,500,000 What is the total cash flow at​ t=10? 10,712,500 What is the​ project's NPV? (3,066,994.50)