finance exam 3

An asset used in a four-year project falls in the five-year MACRS class for tax purposes. The asset has an acquisition cost of $5.7 million and will be sold for $1.8 million at the end of the project. If the tax rate is 21 percent, what is the aftertax salvage value of the asset?

$1,628,841.60

The net present value of a project's cash inflows is $2,716 at a discount rate of 12 percent. The profitability index is 1.09 and the firm's tax rate is 34 percent. What is the initial cost of the project? $2,314.07 $2,018.50 $2,428.32 $2,491.74 $2,066.67

$2,491.74

Tanaka Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $445,000 is estimated to result in $160,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $40,000. The press also requires an initial investment in spare parts inventory of $20,000, along with an additional $2,800 in inventory for each succeeding year of the project. If the shop's tax rate is 22 percent and its discount rate is 9 percent, should the company buy and install the machine press?

$53,271.78

Santa Claus Enterprises has 87,000 shares of common stock outstanding at a current price of $39 a share. The firm also has two bond issues outstanding. The first bond issue has a total face value of $230,000, pays 7.1 percent interest annually, and currently sells for 103.1 percent of face value. The second bond issue consists of 5,000 bonds that are selling for $887 each. These bonds pay 6.5 percent interest annually and mature in eight years. The tax rate is 35 percent. What is the capital structure weight of the firm's debt? 57.93 percent 51.39 percent 55.50 percent 60.52 percent 71.86 percent

57.93 percent

Ursala, Inc., has a target debt-equity ratio of .65. Its WACC is 10.4 percent, and the tax rate is 23 percent. If the company's cost of equity is 14 percent, what is its pretax cost of debt? If the aftertax cost of debt is 5.8 percent, what is the cost of equity?

6.31% 13.39%

payback period rule

Accept if the payback period is less than some preset limit

decision rule of IRR

Accept the project if the IRR is greater thanthe required return

good decision criteria (5 things)

All cash flows considered? TVM considered? Risk-adjusted? Ability to rank projects? Indicates added value to the firm?

what does payback period ask?

How long does it take to recover the initial cost of a project? it is a "break-even" type measure

what is NPV asking

How much value is created fromundertaking an investment?

Disadvantages of payback period

Ignores the time value of money Requires an arbitrary cut off point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects

internal rate of return

Most important alternative to NPV Widely used in practice Intuitively appealing Based entirely on the estimated cash flows Independent of interest rates

Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion. Which one of the following terms describes this evaluation approach? Equity approach Aftertax approach Subjective approach Market play Pure play approach

Pure play approach

Which statement is true? An increase in the market value of preferred stock will increase a firm's weighted average cost of capital. The cost of preferred stock is unaffected by the issuer's tax rate. Preferred stock is generally the cheapest source of capital for a firm. The cost of preferred stock remains constant from year to year. Preferred stock is valued using the capital asset pricing model.

The cost of preferred stock is unaffected by the issuer's tax rate.

Which one of the following is the primary determinant of an investment's cost of capital? Life of the investment Amount of the initial cash outlay The investment's level of risk The source of funds used for the investment The investment's net present value

The investment's level of risk

Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent on which one of the following? The firm's overall source of funds Source of the funds used to build the facility Current tax rate The nature of the investment Firm's historical average rate of return

The nature of the investment

Which one of the following will occur when the internal rate of return equals the required return? The average accounting return will equal 1.0. The profitability index will equal 1.0. The profitability index will equal 0. The net present value will equal the initial cash outflow. The profitability index will equal the average accounting return.

The profitability index will equal 1.0.

3 areas of finance

corporate, financial institutions, investments

definition of IRR

discount rate that makes NPV 0

pro forma financial statements

financial statements projecting future years' operations

method for estimated growth rate

find percent change each year. then find average

what does cost of capital indicate

how the market views the risk of the firms assets

what does npv measure

how well this project will meet the goal of increasing shareholder wealth

The opportunities that a manager has to modify a project once the project has started are called: sensitivity choices. managerial options. scenario adjustments. restructuring options. erosion control measures.

managerial options.

is it a relevant cash flow? financing costs

no

is it a relevant cash flow? sunk costs

no

captial rationing

occurs when a firm ordivision has limited resources

Cost of Preferred Stock

preferred stocks are a perpetuity, so use constant dividend formula

is it a relevant cash flow? net working capital

yes

The Book Store is considering a new four-year expansion project that requires an initial fixed asset investment of $2.1 million. The fixed asset will be depreciated straight-line to zero over its four-year life, after which time it will be worthless. The project is estimated to generate $.98 million in annual sales, with costs of $.79 million. If the tax rate is 34 percent, what is the OCF for this project? $303,900 $650,400 $284,280 $325,400 $291,640

$303,900

what is the NPV at a discount rate of zero percent? What if the discount rate is 10 percent? If it is 20 percent? If it is 30 percent? yr cash flow 0 -18,700 1 9,400 2 10,400 3 6,500

$7,600 $3,324.04; $117.13; −$2,356.80

What is the net present value of the following cash flows if the relevant discount rate is 5.75 percent? yr. cash flow 0 11,400 1. -2500 2. -2500 3. -9500

-$1,232.68

What is the net present value of a project with the following cash flows if the discount rate is 15 percent? yr. cash flow 0. -48,100 1 15,600 2 28,900 3 15,200

-$2,687.98

A project has the following cash flows: yr cash flow 0 74,000 1 -49,000 2 -41,000 What is the IRR for this project? If the required return is 12 percent, should the firm accept the project? What is the NPV of this project? What is the NPV of the project if the required return is zero percent? 24 percent? What is going on here? Sketch the NPV profile to help you with your answer.

14.57%; −$2,434.95; −$16,000; $7,818.94

your company just paid a dividend of 2$ per share. dividends are expected to grow at a steady rate of 6% per year. The current stock price is $15.65. The company's equity beta is 1.5, the current risk free rate is 6%, and expected market risk premium is 9%. What is the cost of equity?

19.5%

A firm evaluates all of its projects by applying the IRR rule. If the required return is 14 percent, should the firm accept the following project? yr. cash flow 0 -41,000 1 20,000 2 23,000 3 14,000

19.58%

Kara, Inc., imposes a payback cutoff of three years for its international investment projects. If the company has the following two projects available, should it accept either of them? yr. cash flow A. cash flow B 0 -40,000. -55,000 1 14,000. 11,000 2 18,000 13,000 3 17,000 16,000 4 11,000 255,000

2.47 years; 3.06 years

Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share? 7.31 percent 8.37 percent 7.54 percent 8.19 percent 8.33 percent

7.31 percent

You are given the following information concerning Parrothead Enterprises: -Debt: 15,000 5.9 percent coupon bonds outstanding, with 17 years to maturity and a quoted price of 104. These bonds pay interest semiannually. -Common stock: 375,000 shares of common stock selling for $81.50 per share. The stock has a beta of .95 and will pay a dividend of $3.80 next year. The dividend is expected to grow by 5 percent per year indefinitely. -Preferred stock: 10,000 shares of 4.2 percent preferred stock selling at $86 per share. Market: -11 percent expected return, risk-free rate of 3.6 percent, and a 22 percent tax rate. Calculate the company's WACC.

8.12%

what criteria must NPV meet? (4)

Considers all CFs Considers TVM Adjusts for risk Can rank mutually exclusive projects

Nu Tek is comprised of four separate operating divisions. For this year, the firm has decided to allocate capital funds using a soft rationing approach. Which one of the following applies to this situation? -Division managers will be limited to accepting a single new project each. -Division managers are being given blanket approval to accept all positive net present value projects. -Division managers should expect to be treated equally, at least initially, in the capital distribution process. -Division managers will not receive any funding for new projects but will be allowed to expand current operations. -Division managers will not receive capital funding for any project.

Division managers should expect to be treated equally, at least initially, in the capital distribution process.

Which one of the following methods of analysis ignores the time value of money? Net present value Internal rate of return Discounted cash flow analysis Payback Profitability index

Payback

Which one of the following indicators offers the best assurance that a project will produce value for its owners? PI equal to zero Negative rate of return Positive AAR Positive IRR Positive NPV

Positive NPV

if npv is positive we

accept the project

cost of debt

the required return on company debt YTM on existing debt estimates current rates based on the bond rating expected on new debt

For the firm in Problem 6, suppose the book value of the debt issue is $75 million. In addition, the company has a second debt issue, a zero coupon bond with eight years left to maturity; the book value of this issue is $30 million, and it sells for 81 percent of par. What is the total book value of debt? The total market value? What is the aftertax cost of debt now?

$105,000,000; $102,300,000; 3.02%

Dog Up! Franks is looking at a new sausage system with an installed cost of $385,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which the sausage system can be scrapped for $60,000. The sausage system will save the firm $135,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 21 percent and the discount rate is 10 percent, what is the NPV of this project? In the previous problem, suppose the fixed asset actually qualifies for 100 percent bonus depreciation. All the other facts are the same. What is the new NPV?

$108,951.33

Consider a three-year project with the following information: initial fixed asset investment = $347,600; straight-line depreciation to zero over the three-year life; zero salvage value; price per unit = $49.99; variable costs per unit = $30.82; fixed costs per year = $187,000; quantity sold per year = 65,500 units; tax rate = 35 percent. How sensitive is OCF to an increase of one unit in the quantity sold? $12.46 $11.67 $8.67 $9.08 $13.40

$12.46

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for this project? In the previous problem, suppose the project requires an initial investment in net working capital of $250,000, and the fixed asset will have a market value of $180,000 at the end of the project. What is the project's Year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV?

$179,537.00

Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South Park to produce garden tools. The company bought some land six years ago for $2.8 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead. If the land were sold today, the company would net $3.2 million. The company wants to build its new manufacturing plant on this land; the plant will cost $14.3 million to build, and the site requires $825,000 worth of grading before it is suitable for construction. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why?

$18,325,000

Three years ago, Stock Tek purchased some five-year MACRS property for $82,600. Today, it is selling this property for $31,500. How much tax will the company owe on this sale if the tax rate is 34 percent? The MACRS allowance percentages are as follows, commencing with Year 1: 20.00, 32.00, 19.20, 11.52, 11.52, and 5.76 percent. -$2,451.81 -$5,857.08 $0 $5,857.08 $2,621.81

$2,621.81

A project that provides annual cash flows of $15,300 for nine years costs $74,000 today. Is this a good project if the required return is 8 percent? What if it's 20 percent? At what discount rate would you be indifferent between accepting the project and rejecting it?

$21,577.39; −$12,326.21; 14.62%

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for this project? In the previous problem, suppose the fixed asset actually qualifies for 100 percent bonus depreciation. All the other facts are the same. What is the project's Year 1 net cash flow now? Year 2? Year 3? What is the new NPV?

$221,767.55

A proposed project requires an initial cash outlay of $49,000 for equipment and an additional cash outlay of $18,700 in Year 1 to cover operating costs. During Years 2 through 4, the project will generate cash inflows of $42,500 a year. What is the net present value of this project at a discount rate of 11.6 percent? $26,343.72 $26,391.08 $25,810.33 $24,399.99 $23,602.18

$26,343.72

Cinram Machines has the following estimates for its new gear assembly project: price = $1,870 per unit; variable costs = $949 per unit; fixed costs = $1.4 million; quantity = 42,000 units. Suppose the company believes all of its estimates are accurate only to within ± 3 percent. What value should the company use for its total variable costs when performing its best-case scenario analysis? $38,578,064 $39,822,128 $38,216,051 $41,802,137 $40,864,538

$39,822,128

The Green Tomato purchased a parcel of land six years ago for $389,900. At that time, the firm invested $128,000 grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $48,000 a year. The Green Tomato is now considering building a hotel on the site as the rental lease is expiring. The current value of the land is $415,000. The firm has no loans or mortgages secured by the property. What value should be included in the initial cost of the hotel project for the use of this land? $0 $389,900 $415,000 $229,000 $101,900

$415,000

Burke's Corner currently sells blue jeans and T-shirts. Management is considering adding fleece tops to its inventory. The tops would sell for $49 each with expected sales of 3,200 tops annually. By adding the fleece tops, management feels the company will sell an additional 150 pairs of jeans at $79 a pair and 220 fewer T-shirts at $18 each. The variable cost per unit is $36 on the jeans, $7 on the T-shirts, and $21 on the fleece tops. The project's depreciation expense is $23,000 a year and the fixed costs are $21,000 annually. The tax rate is 34 percent. What is the project's operating cash flow? $47,935.80 $52,201.20 $55,755.80 $43,209.90 $38,419.70

$55,755.80

Consider an asset that costs $311,000 and is depreciated straight-line to zero over its six-year tax life. The asset is to be used in a four-year project; at the end of the project, the asset can be sold for $58,000. If the relevant tax rate is 34 percent, what is the aftertax cash flow from the sale of this asset? $73,526.67 $68,411.19 $70,103.33 $40,466.67 $42,473.33

$73,526.67

A proposed new investment has projected sales of $515,000. Variable costs are 36 percent of sales, and fixed costs are $173,000; depreciation is $46,000. Prepare a pro forma income statement assuming a tax rate of 21 percent. What is the projected net income?

$87,374

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for this project?

$970,250

Jim's Hardware is adding a new product to its sales lineup. Initially, the firm will stock $36,000 of the new inventory, which will be purchased on 30 days' credit from a supplier. The firm will also invest $13,000 in accounts receivable and $11,000 in equipment. What amount should be included in the initial project costs for net working capital? -$49,000 -$47,000 -$3,000 -$13,000 -$24,000

-$13,000

A project has an initial requirement of $318,000 for fixed assets and $29,500 for net working capital. The fixed assets will be depreciated to a zero book value over the four-year life of the project and have an estimated salvage value of $110,000. All of the net working capital will be recouped at the end of the project. The annual operating cash flow is $96,200 and the discount rate is 14 percent. What is the project's net present value if the tax rate is 34 percent? $14,265.87 $8,048.51 -$6,749.48 -$7,880.06 $17,919.19

-$6,749.48

disadvantages of IRR

-Can produce multiple answers -Cannot rank mutually exclusive projects -Reinvestment assumption flawed

What is the primary reason why the cash flow from assets (CFA) is adjusted when used to value a firm? -Depreciation is a non-cash expense so both it and the depreciation tax shield must be eliminated from the CFA. -Net working capital (NWC) is excluded from firm valuations so the change in NWC must be added back to the "normal" CFA calculation -Interest expense is a financing cost and thus the tax benefit of this expense needs to be eliminated from the CFA. -CFA is normally based on historical performance but since firm valuations are forward looking the CFA must be adjusted for timing. -The CFA must be lowered by the amount of the noncash expenses to ascertain a more accurate firm value.

-Interest expense is a financing cost and thus the tax benefit of this expense needs to be eliminated from the CFA.

advantages of IRR

-Preferred by executives bc : Intuitively appealing and Easy to communicate the value of a project -If the IRR is high enough, may not need to estimate a required return -Considers all cash flows -Considers time value of money -Provides indication of risk

3 important questions with business finance

-What long-term investments should the firm take on? -Where will we get the long-term financing to pay for the investments? -How will we manage the everyday financial activities of the firm?

Suppose you have a project with a payback period exactly equal to the life of the project. What do you know about the IRR of the project? Suppose that the payback period is never. What do you know about the IRR of the project now?

0%; <0%

What is the profitability index for the following set of cash flows if the relevant discount rate is 10 percent? What if the discount rate is 15 percent? If it is 22 percent? yr. cash flow 0 -14,800 1 8,400 2 7,600 3 4,300

1.159; 1.073; .970

Coore Manufacturing has the following two possible projects. The required return is 12 percent. yr cash flow Y cash flow Z 0 -55,600 -89,000 1 26,900 36,000 2 19,600 34,800 3 22,700 32,500 4 16,600 29,300 What is the profitability index for each project? What is the NPV for each project? Which, if either, of the projects should the company accept?

1.193; 1.142 $10,749.87; $12,638.74

Suppose Wacken, Ltd., just issued a dividend of $2.73 per share on its common stock. The company paid dividends of $2.31, $2.39, $2.48, and $2.58 per share in the last four years, respectively. If the stock currently sells for $43, what is your best estimate of the company's cost of equity capital using arithmetic average growth rate in dividends? What if you use the geometric growth rate?

10.89%; 10.88%

what is the weighted average cost of capital for a firm with 3 million shares outstanding at $50, $25 million preferred stock, and $75 million debt. Cost of equity is 14%, cost of preferred stock is 9%, cost of debt is 10%, corporate tax rate is 40%.

11.1%

Gnomes R Us is considering a new project. The company has a debt-equity ratio of .45. The company's cost of equity is 11.2 percent, and the aftertax cost of debt is 4.9 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +3 percent. What is the WACC it should use for the project?

12.24%

S&W has 21,000 shares of common stock outstanding at a price of $29 a share. It also has 2,000 shares of preferred stock outstanding at a price of $71 a share. The firm has 7 percent, 12-year bonds outstanding with a total market value of $386,000. The bonds are currently quoted at 100.6 percent of face and pay interest semiannually. What is the capital structure weight of the firm's preferred stock if the tax rate is 34 percent? 12.49 percent 9.00 percent 8.24 percent 11.84 percent 13.63 percent

12.49 percent

your company is expected to pay a dividend of $4.40 per share next year. Dividends have grown at a steady 5.1% per year and the market expected to continue. The current stock price is $50. What is the cost of equity?

13.9%

what is the cost of equity capital? company's beta is 1.2, current risk free rate is 7%, and expected market risk premium is 6%

14.2%

Andouille Spices, Inc., has the following mutually exclusive projects available. The company has historically used a three-year cutoff for projects. The required return is 10 percent. yr cash flow F cash flow G 0 -215,000 -318,000 1 104,800 74,600 2 92,300 96,500 3 87,600 125,600 4 78,000 168,800 5 70,800 189,200 Calculate the payback period for both projects. Calculate the NPV for both projects. Which project, if any, should the company accept?

2.20 years; 3.13 years $119,605.17; $159,706.37

What is the payback period for the following set of cash flows? yr cash flow 0. -7700 1. 1,900 2. 3,000 3. 2,300 4. 1,700

3.29 years

Ginger Industries stock has a beta of 1.08. The company just paid a dividend of $.85, and the dividends are expected to grow at 4 percent. The expected return on the market is 11.3 percent, and Treasury bills are yielding 3.4 percent. The most recent stock price is $72. Calculate the cost of equity using the dividend growth model method. Calculate the cost of equity using the SML method. Why do you think your estimates in (a) and (b) are so different?

5.23% 11.93%

Sunrise, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 23 years to maturity that is quoted at 96 percent of face value. The issue makes semiannual payments and has an embedded cost of 5 percent annually. What is the company's pretax cost of debt? If the tax rate is 21 percent, what is the aftertax cost of debt?

5.30%; 4.19%

what is the cost of debt for a company with a current bond issue price at $1253.72 with a coupon rate of 12% paid semiannually and 15 years to maturity. interest is tax deductible and corporate tax rate is 40%.

5.34%

Greenbriar Cotton Mill is spending $284,000 to update its facility. The company estimates that this investment will improve its cash inflows by $50,500 a year for 8 years. What is the payback period? 4.03 years 4.95 years 5.48 years 5.62 years The project never pays back.

5.62 years

Calculate the WACC for a company with 34% tax rate : Debt: 7,500, 6.8% coupon bonds outstanding, with 11 years to maturity and a quoted price of 97.9. These bondspay interest semiannually. Common stock: 284,000 shares of common stock selling for $68 per share. The stock has a beta of 1.04 and willpay a dividend of $2.62 next year. The dividend is expected to grow by 2.5% per year indefinitely. Preferred stock: 9,000 shares of $8 dividend preferred stock selling at $88 per share. 14.6% expected market return, 4.1% risk-free rate

9%

what is the cost of issuing preferred stocks of $111.11 with an annual dividend of $10.

9%

Branson Manufacturing has a target debt-equity ratio of .35. Its cost of equity is 11 percent, and its pretax cost of debt is 6 percent. If the tax rate is 21 percent, what is the company's WACC?

9.38%

The Tribiani Co. just issued a dividend of $2.90 per share on its common stock. The company is expected to maintain a constant 4.5 percent growth rate in its dividends indefinitely. If the stock sells for $56 a share, what is the company's cost of equity?

9.91%

Cost to a firm for capital funding

= the return to the providers of those funds

Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales. Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion? Another brick-and-mortar store that also sells online A wholesale toy distributor A toy store that sells online only The oldest online retailer of any product Derek's own store

A toy store that sells online only

what criteria must IRR meet? (4)

Account for the time value of money? Account for the risk of the cash flows? Provide an indication about the increase in value? Permit project ranking?

what criteria must payback period meet? (4)

Account for the time value of money? Account for the risk of the cash flows? Provide an indication about the increase in value? Permit project ranking?

Boone Brothers remodels homes and replaces windows. Ace Builders constructs new homes. If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return for the project? Boone Brothers' cost of capital Ace Builders' cost of capital Average of Boone Brothers' and Ace Builders' cost of capital Lower of Boone Brothers' or Ace Builders' cost of capital Higher of Boone Brothers' or Ace Builders' cost of capital

Ace Builders' cost of capital

what is capital budgeting (5 things)

Analysis of potential projects Long-term decisions Large expenditures Difficult/impossible to reverse Determines firm's strategic direction

We are evaluating a project that costs $1.68 million, has a six-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 90,000 units per year. Price per unit is $37.95, variable cost per unit is $23.20, and fixed costs are $815,000 per year. The tax rate is 21 percent, and we require a return of 11 percent on this project. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales. In the previous problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within ±10 percent. Calculate the best-case and worst-case NPV figures.

Base-case NPV = $3,020,917.19 Worst-case NPV = −$2,089,860.22

Joe and Rich are both considering investing in a project that costs $25,500 and is expected to produce cash inflows of $15,800 in Year 1 and $15,300 in Year 2. Joe has a required return of 8.5 percent but Rich demands a return of 12.5 percent. Who, if either, should accept this project? Joe, but not Rich Rich, but not Joe Neither Joe nor Rich Both Joe and Rich Joe, and possibly Rich, who will be neutral on this decision as his net present value will equal zero

Both Joe and Rich

incremental cash flow for a project

Corporate cash flow with the project Minus Corporate cash flow without the project

Ariana, Inc., is considering a project that will result in initial aftertax cash savings of $3.8 million at the end of the first year, and these savings will grow at a rate of 1.9 percent per year, indefinitely. The firm has a target debt-equity ratio of .55, a cost of equity of 10.6 percent, and an aftertax cost of debt of 3.2 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstances should the company take on the project?

Cost < $47,063,523.77

The net present value profile illustrates how the net present value of an investment is affected by which one of the following? Project's initial cost Discount rate Timing of the project's cash inflows Inflation rate Real rate of return

Discount rate

weaknesses of sensitivity analysis.

Does not reflect diversification. Says nothing about the likelihood of change in a variable Ignores relationships among variables

Advantages of Payback Period

Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity

Trendsetters has a cost of equity of 14.6 percent. The market risk premium is 8.4 percent and the risk-free rate is 3.9 percent. The company is acquiring a competitor, which will increase the company's beta to 1.4. What effect, if any, will the acquisition have on the firm's cost of equity capital? No effect Decrease of .62 percent Decrease of .84 percent Increase of 1.06 percent Increase of .13 percent

Increase of 1.06 percent

best, dominant method for capital budgeting

NPV

Your firm is contemplating the purchase of a new $535,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $30,000 at the end of that time. You will save $165,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $60,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 24 percent, what is the IRR for this project? In the previous problem, suppose your required return on the project is 11 percent and your pretax cost savings are $150,000 per year. Will you accept the project? What if the pretax cost savings are only $100,000 per year?

NPV @ $150,000 cost savings = $19,166.51 NPV @ $100,000 cost savings = −$121,277.58

npv vs irr

NPV and IRR will generally give the same decision - Exceptions: [Non-conventional cash flows (Cash flow sign changes more than once) - Mutually exclusive projects (Initial investments are substantially different - Timing of cash flows is substantially different - Will not reliably rank projects)]

You are looking at a new project and have estimatedthe following cash flows, net income and book value data yr. CF. NI 0. -165,000 1. 63,120. 13,620 2. 70,800 3,300 3. 91,080 29,100 require rate=12% avg book value=72,000 NPV? payback period? IRR?

NPV= 12,627.41 payback period=2.34 IRR=16.13%

NPV > 0 means

Project is expected to add value to the firm Will increase the wealth of the owners

strengths of sensitivity analysis

Provides indication of stand-alone risk. Identifies dangerous variables. Gives some breakeven information.

has 18,000 shares of stock outstanding that are currently valued at $82 a share and provide a rate of return of 13.2 percent. also has 600 bonds outstanding that have a face value of $1,000, a market price of $1,032, and a coupon rate of 7 percent. These bonds mature in 7 years and pay interest semiannually. tax rate is 35percent. The firm is considering expanding by building a new superstore. will require an initial investment of $9.3 million and is expected to produce cash inflows of $1.07 million annually over its 10-year life. risks associated are comparable to the risks of the firm's current operations. initial investment will be depreciated on a straight line basis to a zero book value over the life of the project. At the end of the 10 years, the firm expects to sell the superstore for an aftertax value of $4.7 million. accept or reject the superstore project and why?

Reject; The NPV -$1.15 million.

Which one of the following statements is correct? The internal rate of return is the most reliable method of analysis for any type of investment decision. The payback method is biased toward short-term projects. The modified internal rate of return is most useful when projects are mutually exclusive. The average accounting return is the most difficult method of analysis to compute. The net present value method is applicable only if a project has conventional cash flows.

The payback method is biased toward short-term projects.

A piece of newly purchased industrial equipment costs $1.475 million and is classified as seven-year property under MACRS. Calculate the annual depreciation allowances and end-of-the-year book values for this equipment. LO 2

Year 7 allowance = $131,717.50

China Importers would like to spend $215,000 to expand its warehouse. However, the company has a loan outstanding that must be repaid in 2.5 years and thus will need the $215,000 at that time. The warehouse expansion project is expected to increase the cash inflows by $60,000 in the first year, $140,000 in the second year, and $150,000 a year for the following 2 years. Should the firm expand at this time? Why or why not? Yes; because the money will be recovered in 1.69 years Yes; because the money will be recovered in 1.87 years Yes; because the money will be recovered in 2.10 years No; because the project never pays back No; because the money will not be recovered in time to repay the loan

Yes; because the money will be recovered in 2.10 years

The Flour Baker is considering a project with the following cash flows. Should this project be accepted based on its internal rate of return if the required return is 18 percent? yr. cash flow 0. -49,000 1. 9,500 2. 26,200 3. 38,700 Yes; because the project's rate of return is 7.78 percent Yes; because the project's rate of return is 16.08 percent Yes; because the project's rate of return is 19.47 percent No; because the project's rate of return is 19.47 percent No; because the project's rate of return is 16.08 percent

Yes; because the project's rate of return is 19.47 percent

Dani Corp. has 5.5 million shares of common stock outstanding. The current share price is $83, and the book value per share is $5. The company also has two bond issues outstanding. The first bond issue has a face value of $80 million, has a coupon rate of 5.5 percent, and sells for 109 percent of par. The second issue has a face value of $45 million, has a coupon rate of 5.8 percent, and sells for 108 percent of par. The first issue matures in 21 years, the second in six years. What are the company's capital structure weights on a book value basis? What are the company's capital structure weights on a market value basis? Which are more relevant, the book or market value weights? Why?

a. 1803; .8197 b. .7707; .2293

Consider the following two mutually exclusive projects: yr cash flow A cash flow B 0 -215,000 -57,000 1 34,000 32,900 2 45,000 24,300 3 51,000 18,300 4 270,000 17,800 Whichever project you choose, if any, you require a return of 13 percent on your investment. a. If you apply the payback criterion, which investment will you choose? Why? b. If you apply the NPV criterion, which investment will you choose? Why? c. If you apply the IRR criterion, which investment will you choose? Why? Id. f you apply the profitability index criterion, which investment will you choose? Why? Based on your answers in parts (a) through (d), which project will you finally choose? Why?

a. 3.31 years; 1.99 years b. $51,271.71; $14,745.40 c. 20.75%; 26.71% d. 1.238; 1.259

stand-alone principle

allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return that: is based on the actual source of funds that will be used to fund the project. creates a positive net present value for the project. reflects the size and life of the project. most closely correlates with the proposed investment's internal rate of return. best matches the risk level of the proposed investment

best matches the risk level of the proposed investment

What are relevant cash flows?

cash flows that will only occur if the project is accepted Incremental cash flows

The reinvestment approach to the modified internal rate of return: -individually discounts each separate cash flow back to the present. -reinvests all the cash flows, including the initial cash flow, to the end of the project. -discounts all negative cash flows to the present and compounds all positive cash flows to the end of the project. -discounts all negative cash flows back to the present and combines them with the initial cost. -compounds all of the cash flows, except for the initial cash flow, to the end of the project.

compounds all of the cash flows, except for the initial cash flow, to the end of the project.

Northern Companies has three separate divisions. Each year, the company determines the amount it can afford to spend in total for capital expenditures and then allocates one-third of that amount to each division. This allocation process is called: soft rationing. hard rationing. opportunity cost allocation. divisional separation. strategic planning.

soft rationing.

Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a lower rate as the risk level declines. Kate is applying the ___ approach. pure play divisional rating subjective straight WACC equity rating

subjective

A cost that should be ignored when evaluating a project because that cost has already been incurred and cannot be recouped is referred to as a(n): fixed cost. forgotten cost. variable cost. opportunity cost. sunk cost.

sunk cost.

The analysis of a new project should exclude: tax effects. erosion effects. side effects. sunk costs. opportunity costs.

sunk costs.

All else constant, the weighted average cost of capital for a risky, levered firm will decrease if: the firm's bonds start selling at a premium rather than at a discount. the market risk premium increases. the firm replaces some of its debt with preferred stock. corporate taxes are eliminated. the dividend yield on the common stock increases.

the firm's bonds start selling at a premium rather than at a discount.

the more sensitive NPV is to change

the greater the forecasting risk

cost of equity

the return required by equity investors given the risk of the cash flows from the firm use dividend growth model or SML/CAPM

When a firm faces hard rationing,: -all positive net present value projects will be accepted. -each division within a firm will be allocated an amount for capital expenditures that will be less than the total value of its positive net present value projects. -there will be no available funds for capital expenditures. -the firm will fund only those projects that create value for its shareholders. -the firm will finance only the projects that have the highest profitability index values.

there will be no available funds for capital expenditures.

hard rationing

type of capital rationing capital will never beavailable for this project

soft rationing

type of capital rationing the limited resources are temporary, often self-imposed profitability index is a useful tool when faced with soft rationing

if npv=0

we don't accept the project because Project's inflows are "exactlysufficient to repay the invested capitaland provide the required rate of return"

WACC

weighted average cost of capital of raising capital by issuing equity and debt

is it a relevant cash flow? opportunity costs

yes

is it a relevant cash flow? side effects/erosion

yes

is it a relevant cash flow? tax effects

yes