Chapter 10: Capital Budgeting Cash Flows
_____________ is measured by the project's impact on uncertainty regarding the firm's future returns.
corporate, or within-firm, risk
When using accelerated depreciation, the project's net present value (NPV) is . (Hint: Round each element in your computation—including the project's net present value—to the nearest whole dollar.)
46,171
pure-play method
A method to determine market risk using the betas of single-product companies in a given industry.
Monte Carlo Simulation
A risk analysis computer-generated probability simulation of the most likely outcome given a set of probable future events.
LoRusso Industries has considerable operations in Indonesia, producing component electronic parts. LoRusso's Indonesian operation has been very successful, but the firm is now concerned about its host country preventing LoRusso from repatriating a majority of the profits. Which type of multinational capital budgeting risk is being illustrated by LoRusso's situation? Exchange-rate risk Political risk Stand-alone risk Market risk Corporate risk
Political risk
Terminal Cash Flow
Reflects cash flows at the end of the project's life
sensitivity analysis
The risk analysis method in which the effect of changes in the values of important variables on a project's cash flows are assessed.
Consider the case of Happy Dog Soap: Happy Dog Soap is considering an investment that will have the following sales, variable costs, and fixed operating costs: Year 1 Year 2 Year 3 Year 4 Unit sales (units) 4,200 4,100 4,300 4,400 Sales price $29.82 $30.00 $30.31 $33.19 Variable cost per unit $12.15 $13.45 $14.02 $14.55 Fixed operational costs except depreciation $41,000 $41,670 $41,890 $40,100 Accelerated depreciation rate 33% 45% 15% 7%
This project will require an investment of $20,000 in new equipment. The equipment will have no salvage value at the end of the project's four-year life. Happy Dog Soap pays a constant tax rate of 40%, and it has a required rate of return of 11%.
No other firm would take on this project if Happy Dog Soap turns it down. How much should Happy Dog Soap reduce the NPV of this project if it discovered that this project would reduce one of its division's net after-tax cash flows by $400 for each year of the four-year project? $931 $745 $1,365 $1,241
$1,241
Evaluating risk is an important part of the capital budgeting process. Which of the following is measured by its effect on the firm's beta coefficient? Corporate, or within-firm, risk Market, or beta, risk Stand-alone risk Risk-adjusted cost of capital
Market, or beta, risk
Externality
This phenomenon results from the effect that a project will have on the cash flows in other parts of the firm.
United Recycling Inc. is one of the largest recyclers of glass and paper products in the United States. The company is looking into expanding into the cardboard recycling business. The company's CFO has performed a detailed analysis of the proposed expansion. The company's CFO used sophisticated software to analyze a large number of scenarios and generate estimated rates of return and risk indexes.
following 2 ?s
Firms may take steps to reduce the risk of investing in foreign countries. Identify whether each of the following statements are true or false. Multinational capital budgeting is not always riskier than domestic investment. The firm may incur less risk, because of international diversification. Generally, the political risk related to foreign investment is added to the required rate of return. A technique to lower the risk of multinational capital budgeting is to finance the foreign subsidiary with capital raised in the host country. A tool to lower the risk of multinational capital budgeting is to purchase insurance against the loss from expropriation of funds.
true false true true
sunk cost
An incurred cost that does not affect the decision-making regarding a project
Happy Dog Soap spent $1,500.00 on a marketing study to estimate the number of units that it can sell each year. What should Happy Dog Soap do to take this information into account? Increase the NPV of the project $1,500.00. Increase the amount of the initial investment by $1,500.00. The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.
The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.
Repatriation of Earnings
The process whereby firms operating internationally remit to their home country any earnings generated in another country.
stand-alone risk
The risk associated with a single asset
Suppose Acme's new equipment is expected to sell for $200,000 at the end of its four-year useful life, and at the same time, the firm expects to recover all of its net operating working capital investment. The company chose to use straight-line depreciation, and the new equipment was fully depreciated by the end of its useful life. If the firm's tax rate is 40%, what is the project's total termination cash flow? $200,000 $464,000 $504,000 $120,000
Net sales proceeds from sale+Recovery of Net working capital = 200,000 x (1-40%) + 384,000= 504,000 The project's total termination cash flow is $504,000. By the end of its useful life, the equipment has been fully depreciated, which means it has a book value of $0. The firm expects the equipment to sell for a salvage value of $200,000. Therefore, the firm will earn $200,000 in profit on the sale of the equipment and will have to pay taxes on this profit. The amount of the tax will be $200,000 x 0.40 = $80,000, and the after-tax, or net, salvage value will be $120,000. The net operating working capital investment of $384,000 made in year 0 is recovered, so the firm will receive a cash inflow of $384,000. The following table shows the calculations for the project's total termination cash flow.
How do managers typically deal with within-firm risk and beta risk when they are evaluating a potential project? Subjectively Quantitatively
Subjectively
Based on the information given, determine which of the statements is correct. The company's CFO conducted a sensitivity analysis to evaluate the project's financial model. The company's CFO used a Monte Carlo simulation to evaluate the project's financial model.
The company's CFO used a Monte Carlo simulation to evaluate the project's financial model.
The basic principles of capital budgeting are valid for both domestic and multinational capital budgeting analysis. However, it is important to recognize the unique risks that multinational firms face when they perform capital budgeting analysis in a foreign market. For instance, a U.S.-based multinational firm might conduct business in Brazil, but any profits made must be repatriated, or returned, to the parent company and converted to U.S. dollars. There are significant risks inherent in these rather simple operations. In the table below, correctly identify whether each type of risk being described is an exchange-rate risk or a political risk. The risk of higher than expected taxes, tighter repatriation, or currency controls by the host country The risk of expropriation (seizure) of a foreign subsidiary's assets by the host country or restrictions on cash flows to the parent company The risk related to the foreign currency cash flows that will be turned over to the parent company and converted into U.S. dollars
The risk of higher than expected taxes, tighter repatriation, or currency controls by the host country = Political Risk The risk of expropriation (seizure) of a foreign subsidiary's assets by the host country or restrictions on cash flows to the parent company = Political Risk The risk related to the foreign currency cash flows that will be turned over to the parent company and converted into U.S. dollars = Exchange-Rate-Risk
Chrome Printing is evaluating two mutually exclusive projects. They both require a $5 million investment today and have expected NPVs of $1,000,000. Management conducted a full risk analysis of these two projects, and the results are shown below. Risk Measure Project A Project B Standard deviation of project's expected NPVs $400,000 $200,000 Project beta 0.9 0.7 Correlation coefficient of project cash flows (relative to the firm's existing projects) 0.6 0.4 Which of the following statements about these projects' risk is correct? Check all that apply. Project A has more stand-alone risk than Project B. Project A has more market risk than Project B. Project B has more corporate risk than Project A. Project A has more corporate risk than Project B.
Project A has more stand-alone risk than Project B. Project A has more market risk than Project B. Project A has more corporate risk than Project B.
incremental cash flow
Cash flow created by investing in a capital project
WSP Inc. is involved in a wide range of unrelated projects. The company will pursue any project that it thinks will create value for its stockholders. Consequently, the risk level of the company's projects tends to vary a great deal from project to project. If WSP Inc. does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur over time? Check all that apply. The firm's overall risk level will increase. The firm will increase in value. The firm could potentially reject projects that provide a higher rate of return than the company should require.
The firm's overall risk level will increase. The firm could potentially reject projects that provide a higher rate of return than the company should require.
Which of the following represent the effect of the current project's acceptance on the cash flows of Chrome Manufacturing's other projects? (They can be either positive or negative, and because they depend on whether the current project is accepted, they should be included in the analysis.) Opportunity costs An externality Sunk costs
an externality
When using straight-line depreciation, the project's NPV is ________ . (Hint: Again, round each element in your computation—including the project's net present value—to the nearest whole dollar.)
$45,829
In contrast, Acme's initial investment outlay is _______.
3,360,000 + (640,000 - 256,000) = 3,360,000 + 384,000 = 3,744,000 To calculate the initial investment outlay, you need to adjust the total cost of the investment to reflect the expected changes in net operating working capital. The operating current assets are expected to increase by $640,000, while the spontaneous liabilities are expected to increase by $256,000. Therefore, the net operating working capital will increase by $384,000. The total initial investment outlay is shown in the following table and exhibits a negative sign to reflect that it is a cash outflow.
Which of the following are components of Net Working Capital? Cash Interest Expense Property Plant and Equipment Inventories Accounts Receivable Accounts Payable Shareholder's Equity Cumulative Depreciation
Cash Inventories Accounts Receivable Accounts Payable
The owner of Café Bakka is considering investing in a new point-of-sale system. He spent $10,000 on his current point-of-sale system five years ago. The new point-of-sale technology will cost $25,000, and will dramatically improve the speed at which his counter staff will be able to take orders, and reduce the owner's administrative work. How should the owner account for the cost of the current point-of-sale technology when performing the capital budgeting analysis to determine whether or not to purchase the new point-of-sale technology? He should ignore the cost of the current point-of-sale system when evaluating the cost of the new point-of-sale system. He should include the cost of the current point-of-sale system as part of the cost of the new point-of-sale system.
He should ignore the cost of the current point-of-sale system when evaluating the cost of the new point-of-sale system. In this example, the current point-of-sale technology is a sunk cost, because it has already been paid for and the owner cannot get his money back for it. He should simply ignore the cost of the current point-of-sale system when deciding whether or not to purchase the new point-of-sale system.
The project will require an initial investment of $15,000, but the project will also be using a company-owned truck that is not currently being used. This truck could be sold for $4,000, after taxes, if the project is rejected. What should Hungry Whale Electronics do to take this information into account? The company does not need to do anything with the value of the truck because the truck is a sunk cost. Increase the amount of the initial investment by $4,000. Increase the NPV of the project by $4,000.
Increase the amount of the initial investment by $4,000.
Yatta Net International has manufacturing, distribution, retail, and consulting divisions. Projects undertaken by the manufacturing and distribution divisions tend to be low-risk projects, because these divisions are well established and have predictable demand. The company started its retail and consulting divisions within the last year, and it is unknown if these divisions will be profitable. The company knew that opening these new divisions would be risky, but its management believes the divisions have the potential to be extremely profitable under favorable market conditions. The company is currently using its WACC to evaluate new projects for all divisions. If Yatta Net International does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur over time? Check all that apply. The firm will become less risky. The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company. The firm will reject too many relatively safe projects.
The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company. The firm will reject too many relatively safe projects.
Using the __________ depreciation method will result in the greater NPV for the project.
accelerated
Acme Manufacturing is considering a project that requires an investment in new equipment of $3,200,000, with an additional $160,000 in shipping and installation costs. Acme estimates that its accounts receivable and inventories need to increase by $640,000 to support the new project, some of which is financed by a $256,000 increase in spontaneous liabilities (accounts payable and accruals). The total cost of Acme's new equipment is __________ and consists of the price of the new equipment plus the ________.
3,200,000 + 160,000 = 3,360,000 asset's installation, shipping, and delivery costs. The total cost of the equipment should reflect all costs associated with acquiring the equipment, including the shipping and installation costs. Therefore, the total cost of the equipment is $3,360,000.
Which of the following factors should Chrome Manufacturing include in its capital budgeting analysis? Check all that apply. If the current project is accepted, sales in another of Chrome's divisions for a competing product will decline. Chrome expects its accounts receivable to increase by $70,000 as a result of the project. Chrome's preferred stock pays $250,000 in dividends each year. Chrome's annual interest expense is $3 million, which is partly due to debt raised for this project.
If the current project is accepted, sales in another of Chrome's divisions for a competing product will decline. Chrome expects its accounts receivable to increase by $70,000 as a result of the project. Chrome Manufacturing should ignore the dividends paid to preferred shareholders and the accompanying interest expense. These are financing cash flows that are reflected in the firm's required rate of return. If they were explicitly included in the analysis, you would double-count the effects of the firm's financing decisions. In contrast, changes to the firm's net operating working capital, including its accounts receivable and accounts payable, should be included in the analysis. Moreover, all forecasted and actual cash flows used in the analysis of capital budgeting projects should be expressed and evaluated using after-tax dollars, rather being based on pre-tax dollars. If the project causes Chrome's revenue from other projects to change, then an externality occurs. Externalities should be accounted for, because they represent marginal cash flows generated by the decision. For example, an externality occurs when one of Chrome's projects affects the sales of another of the firm's divisions.
