Fin Ch. 8
A car dealership offers a car for $14,000 , with up to one year to pay for the car. If the interest rate is 5%, what is the net present value (NPV) of this offer to buyers who elect not to pay for the car for one year?
) $14,000 / (1 + 0.05) = $13,333.3333 ; $14,000 - $13,333 = $667
When using equivalent annual annuities to compare the costs of projects with different lives, you should not consider any changes in the expected replacement cost of equipment.
FALSE
When different projects put different demands on a limited resource, then net present value (NPV) is always the best way to choose the best project.
False
When different investment rules give conflicting answers, then decisions should be based on the Net Present Value rule, as it is the most reliable and accurate decision rule.
TRUE
You can evaluate alternative projects with different lives by calculating and comparing their equivalent annual annuity.
TRUE
3) Which of the following best describes the Net Present Value rule?
Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative.
Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?
Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the projectʹs lifetime.
A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following?
net present value (NPV)
You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is ________.
net present value (NPV)
Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment?
payback period
You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space
profitability index
3) When comparing two projects with different lives, why do you compute an annuity with an equivalent present value (PV) to the net present value (NPV)?
so that the projects can be compared on their cost or value created per year
The profitability index can break down completely when dealing with multiple resource restraints.
true
When an alternative decision rule disagrees with the net present value (NPV), the NPV should be followed.
true
Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%?
) Rule I only
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. At what dollar value should the NPV profile cross the vertical axis?
) The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.
6) Which of the following decision rules might best be used as a supplement to net present value (NPV) by a firm that favors liquidity?
) payback period
Most corporations measure the value of a project in terms of which of the following?
) present value (PV)
Which of the following is a disadvantage of the Net Present Value rule?
) relies on accurate estimate of the discount rate
Two mutually exclusive investment opportunities require an initial investment of $7 million. Investment A pays $2.0 million per year in perpetuity, while investment B pays $1.4 million in the first year, with cash flows increasing by 4% per year after that. At what cost of capital would an investor regard both opportunities as being equivalent?
-7 + 2.0 / r = -7 + 1 / (r - 0.04); r = 13%
What can you comment about the shape of the net present value (NPV) profile of a multiple IRR project?
A multiple IRR project will have a net present value (NPV) profile that cuts the discount rate axis as many times as there are IRRs because the point of intersections of the discount rate axis by the net present value (NPV) profile curve are the IRRs of the project.
A firm has an opportunity to invest $95,000 today that will yield $109,250 in one year. If interest rates are 4%, what is the net present value (NPV) of this investment?
A) $109,250 / (1 + 0.04) = $105,048.077 ; $105,048.077 - $95,000 = $10,048
An auto-parts company is deciding whether to sponsor a racing team for a cost of $1 million. The sponsorship would last for three years and is expected to increase cash flows by $570,000 per year. If the discount rate is 6.9%, what will be the change in the value of the company if it chooses to go ahead with the sponsorship?
A) NPV = -1,000,000 + 570,000 / (1 + 0.069 ) + 570,000 / (1 + 0.069 )2 + 570,000 / (1 + 0.069 )3 = $498,597
Which of the following situations can lead to IRR giving a different decision than NPV?
All of the above can lead to IRR giving a different decision than NPV.
Which of the following statements is FALSE?
An internal rate of return (IRR) will always exist for an investment opportunity.
Which of the following is true regarding the profitability index?
Attention must be taken when using it to make sure that all of the constrained resource is utilized.
10) A consultancy calculates that it can supply crude oil assaying services to a small oil producer for $115,000 per year for five years. There are some upfront costs the consultancy will require the oil producer to absorb. What is the maximum that these upfront costs could be, if the equivalent annual annuity to the oil company is to be under $160,000 , given that the cost of capital is 9%?
B) Annual difference = $160,000 - $115,000 = $45,000 ; PV over 5 years at 9% = $175,034
8) If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) will rank highest?
B) Project B
An investor is considering a project that will generate $900,000 per year for four years. In addition to upfront costs, at the completion of the project at the end of the fifth year there will be shut-down costs of $400,000 . If the cost of capital is 4.4%, based on the MIRR, at what upfront costs does this project cease to be worthwhile?
Bring all negative cash flows to time 0; thus, PV shut-down cost = -400,000 / (1 + 0.044 )5 = -$322,520.63 ;FV positive cash flows at time 5 = $4,013,810.7 ; PV of positive cash flows at time 0 = $3,139,085; NPV at 4.4% = 2.91 million
A mining company plans to mine a beach for rutile. To do so will cost $14 million up front and then produce cash flows of $7 million per year for five years. At the end of the sixth year the company will incur shut-down and clean-up costs of $6 million. If the cost of capital is 13.0%, then what is the MIRR for this project?
Bring all negative cash flows to time 0;thus, PV shut-down cost = -6 / (1 + 0.13)6 = 2.88191116 ; FVpositivecashflowsattime6=51.2589405; MIRRoftheproject=-87.10%.
Martin is offered an investment where for $6000 today, he will receive $6180 in one year. He decides to borrow $6000 from the bank to make this investment. What is the maximum interest rate the bank needs to offer on the loan if Martin is at least to break even on this investment?
C) ($6180 - $6000 ) = 3% $6000
A farmer sows a certain crop. It costs $240,000 to buy the seed, prepare the ground, and sow the crop. In one yearʹs time it will cost $93,200 to harvest the crop. If the crop will be worth $350,000 , and the interest rate is 7%, what is the net present value (NPV) of this investment?
C) (350,000 - $93,200 ) - 240,000 = $0
A florist is buying a number of motorcycles to expand its delivery service. These will cost $78,000 but are expected to increase profits by $3000 per month over the next four years. What is the payback period in this case?
D) Payback period = 78,000 / 3000 = 26.00 months
A company buys a color printer that will cost $16,000 to buy, and last 5 years. It is assumed that it will require servicing costing $500 each year. What is the equivalent annual annuity of this deal, given a cost of capital of 8%?
D) Using a financial calculator,NPV = -$17,996 equivalent annual annuity = -$4507
A security company offers to provide CCTV coverage for a parking garage for ten years for an initial payment of $50,000 and additional payments of $30,000 per year. What is the equivalent annual annuity of this deal, given a cost of capital of 5%?
D) Using a financial calculator,NPV = -$281,652 equivalent annual annuity = -$36,475
The owners of a chain of fast-food restaurants spend $25 million installing donut makers in all their restaurants. This is expected to increase cash flows by $11 million per year for the next five years. If the discount rate is 5.3%, were the owners correct in making the decision to install donut makers?
D) Using financial calculator, enter CF0 = -25,000,000 , CF1 = 11,000,000 , F1 = 5; calculate NPV for I = 5.3% = $22,231,874.40 . YES
Internal rate of return (IRR) can reliably be used to choose between mutually exclusive projects.
FALSE
Preference for cash today versus cash in the future in part determines net present value (NPV).
FALSE
The internal rate of return (IRR) rule will agree with the Net Present Value rule even when positive cash flows precede negative cash flows.
FALSE
What is a safe method to use when confronted with mutually exclusive projects?
Generally the net present value (NPV) method will give the correct decision in case of mutually exclusive projects.
A garage is comparing the cost of buying two different car hoists. Hoist A will cost $20,000, will require servicing of $1000 every two years, and last ten years. Hoist B will cost $15,000, require servicing of $800 per year, and last eight years. If the cost of capital is 7%, which is the better option, given that the firm has an ongoing requirement for a hoist?
Hoist B, since it has a greater equivalent annual annuity.
According to Graham and Harveyʹs 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________.
IRR, NPV, Payback period
Which of the following statements is FALSE?
If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive.
Which of the following is NOT a limitation of the payback period rule?
It is difficult to calculate.
Which of the following is NOT a limitation of the payback rule?
It is difficult to calculate.
Is there a unique way for calculating the MIRR to resolve the multiple IRR situation?
No there are several ways of computing the MIRR and each of them are subject to their respective assumptions.
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. If her discount rate is 6%, should she accept the project?
No, because the NPV is negative at that rate.
A security firm is offered $80,000 in one year for providing CCTV coverage of a property. The cost of providing this coverage to the security firm is $74,000, payable now, and the interest rate is 8.5%. Should the firm take the contract?
No, since net present value (NPV) is negative.
A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?
No, since the value of the cash flows over the first two years are less than the initial investment.
Should personal preferences for cash today versus cash tomorrow play a role in the net present value (NPV) decision-making process?
No; personal preferences for cash flow should not affect the decision-making process. A manager should decide based on always maximizing the net present value (NPV).
What are some potential problems in using internal rate of return (IRR) for mutually exclusive projects?
One has to be careful when evaluating mutually exclusive projects especially using internal rate of return (IRR) as they may lead to incorrect decision making.
A janitorial services firm is considering two brands of industrial vacuum cleaners to equip their staff. Option A will cost $1,500, require servicing of $200 per year, and it will last five years. Option B will cost $1,000, require servicing of $100 per year, and it will last three years. If the cost of capital is 8%, which is the better option, given that the firm has an ongoing requirement for vacuum cleaners?
Option B, since it has a greater equivalent annual annuity.
When comparing mutually exclusive projects which have different scales, you must know the dollar impact of each investment rather than percentage returns.
TRUE
1) Net present value (NPV) is usefully supplemented by internal rate of return (IRR), since IRR gives a good indication of the sensitivity of any decision made to changes in the discount rate.
TRUE
Net present value (NPV) is the difference between the present value (PV) of the benefits and the present value (PV) of the costs of a project or investment.
TRUE
The Net Present Value rule implies that we should compare a projectʹs net present value (NPV) to zero.
TRUE
The payback rule is based on the idea that an opportunity that pays back its initial investment quickly is a worthwhile opportunity.
TRUE
Tanner is choosing between two investment options. He can invest $500 now and get (guaranteed) $550 in one year, or invest $500 now and get (guaranteed) $531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer?
Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.
What is the Net Present Value rule?
The Net Present Value rule states to accept a project if its net present value (NPV) is greater than zero
The present value (PV) of an investment is ________.
The amount that an investment would yield if the benefit were realized today
What is the decision criteria using internal rate of return (IRR) rule?
The decision criteria using internal rate of return (IRR) rule for project type cash flows is to accept projects if the internal rate of return (IRR) is greater than the cost of capital.
What is the decision criterion using the Net Present Value rule?
The decision criteria using the Net Present Value rule is to reject projects if their net present value (NPV) is less than zero.
A lawn maintenance company compares two ride-on mowersthe Excelsior, which has an expected working-life of six years, and the Grassassinator, which has a working life of four years. After examining the equivalent annual annuities of each mower, the company decides to purchase the Excelsior. Which of the following, if true, would be most likely to make them change that decision?
The mower is only expected to be needed for three years.
Under what situation can the net present value (NPV) profile be upward sloping?
The net present value (NPV) profile can be upward sloping if the benefits of the cash flows occur before the costs. In that case the net present value (NPV) profile will be a rising function of discount rates.
What is the general shape of the net present value (NPV) profile?
The net present value (NPV) profile for most projects is a downward sloping graph cutting the x-axis at the project internal rate of return (IRR). DOWNWARD SLOPING
What is the decision criterion while using the payback rule?
The payback rule does not have any decision criteria. Consequently, decision making using payback rule is rather subjective.
Which of the following statements is FALSE?
The payback rule is reliable because it considers the time value of money and depends on the cost of capital.
How can you calculate the y-intercept of a net present value (NPV) profile without using TVM concepts?
The y-intercept of a net present value (NPV) profile is the algebraic sum of the project cash flows, since the discount rate is zero at that point.
6) The owner of a number of gas stations is considering installing coffee machines in his gas stations. It will cost $270,000 to install the coffee machines, and they are expected to boost cash flows by $120,536 per year for their five-year working life. What must the cost of capital be if this investment has a profitability index of 1?
Using a financial calculator, PMT = 120,536 , N = 5, PV = 540,000 , compute I = 3.78%.
A manufacturer of video games develops a new game over two years. This costs $830,000 per year with one payment made immediately and the other at the end of two years. When the game is released, it is expected to make $1.20 million per year for three years after that. What is the net present value (NPV) of this decision if the cost of capital is 10%?
Using a financial calculator, enter CF0 = -830,000 , CF1 = 0, F1 = 1, CF2 = -830,000 , F2 = 1, CF3 = 1,200,000 , F3 = 3; calculate NPV for I = 10 = $950,349 .
A local government awards a landscaping company a contract worth $1.5 million per year for five years for maintaining public parks. The landscaping company will need to buy some new machinery before they can take on the contract. If the cost of capital is 6%, what is the most that this equipment could cost if the contract is to be worthwhile for the landscaping company?
Using a financial calculator, enter PMT = 1.5, N = 5, I = 6%; calculate PV = $6.32 million.
Jenkins Security has learned that a rival has offered to supply a parking garage with security for ten years for $45,000 up front and a further $15,000 per year. If Jenkins Security offers to provide security for eight years for an upfront cost of $60,000 and a separate yearly payment, by what maximum amount can this yearly payment be over $20,000, so that Jenkinsʹ offer matches the equivalent annual annuity of their rivalʹs offer? (Assume a cost of capital of 5%.)
Using a financial calculator,spreading $45,000 over 10 years = $5827.70587 ; thus, EAA = $9172.29413 ; spreading $60,000 over 8 years = $9283.30882 ; thus, the difference = -$111 .
3) An orcharder spends $110,000 to plant pomegranate bushes. It will take four years for the bushes to provide a usable crop. He estimates that every year for 20 years after that he will receive a crop worth $10,500 per year. If the discount rate is 9%, what is the net present value (NPV) of this investment?
Using financial calculator, enter CF0 = -110,000 , CF1 = 0, F1 = 4, CF2 = 10,500 , F2 = 20; calculate NPV for I = 9% = -$42,098 .
17) How do you apply the Net Present Value rule when multiple projects are available and you have the added constraint of accepting only one project?
When making an investment decision under the availability of multiple projects, take the alternative with the highest net present value (NPV).
A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct?
Yes, because it agrees with the Net Present Value rule.
) Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices?
Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan.
