C!% *+ ET-M!T-+. C%!&TER !.D '' R-/ !.!*0-
(Difculty: E = Easy, Easy, M = Medium, and T = Tough) Tough) Multiple Choice: Conceptual Easy: Relevant cash os 1
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!nse": d Di#: E
Which hich of the the fol follo lowi wing ng state tateme men nts is mos most cor corrrect? ct? a. The rate of depreci depreciation ation will will often aect aect operating operating cash ows, ows, even though though depreciation depreciation is not a cash expense. b. Corporations Corporations should should full account account for sun! costs costs when when ma!ing investmen investmentt decisions. decisions. c. Corporations Corporations should should full account account for opportunit opportunit costs costs when when ma!ing investment investment decision decisions. s. d. "tatem "tatement ents s a and and c are are corr correct ect.. e. #ll of the the statem statement ents s above above are cor corre rect. ct.
Relevant cash os $
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# comp compan an is con consid sider ering ing a new new pr pro%ect o%ect.. The The comp compan an& &s s C'( C'( plan plans s to cal calcu cula late te the the pro pro%e %ect ct&s &s ) )*+ *+ b discounting the relevant cash ows which include the initial up-front costs, the operating cash ows, ows, and the termin terminal al cash ows ows at the compan compan&s &s cost of capita capitall W#C W#CC. C. Which Which of the following factors should the C'( include when estimating the relevant cash ows? a. b. c. d. e.
#n sun! sun! costs costs assoc associat iated ed with with the pro%ec pro%ect. t. #n intere interest st expense expenses s associated associated with the the pro%ect. pro%ect. #n opportun opportunit it costs costs associated associated with the pro%ect. pro%ect. "tatem "tatement ents s b and c are are corre correct. ct. #ll of the the statem statement ents s above above are cor corre rect. ct.
Relevant cash os /
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#n sun! costs costs that were were incurred incurred in the past past prior to considerin considering g the proposed proposed pro%ect. pro%ect. #n opportunit opportunit costs costs that are are incurr incurred ed if the pro%ect pro%ect is underta underta!en !en.. #n externali externalities ties both positive positive and negative negative that are incurr incurred ed if the pro%ect pro%ect is underta!en. underta!en. "tatem "tatement ents s b and c are are corre correct. ct. #ll of the the statem statement ents s above above are cor corre rect. ct.
Relevant cash os .
!nse": d Di#: E
When When eval evalua uati ting ng pote potent ntia iall pro% pro%ec ects ts,, whic which h of the the follow followin ing g factor factors s shoul should d be inco incorp rpor orat ated ed as par partt of a pro%ect&s estimated cash ows? a. b. c. d. e.
0
!nse": c Di#: E
!nse": $ Di#: E
Which hich of the the fol follo lowi wing ng state tateme men nts is mos most cor corrrect? ct? a. When When evalua evaluating ting corpora corporate te pro%ect pro%ects s it is importan importantt to include include all sun! sun! costs costs in the estima estimated ted cash ows. b. When evaluating evaluating corporate corporate pro%ects pro%ects it is important important to include all relevant relevant extern externaliti alities es in the estimated cash ows. c. nterest nterest expense expenses s should be be included included in pro%ect pro%ect cash cash ows. ows. d. "tatem "tatement ents s a and and b are are corre correct. ct. e. #ll of the the statem statement ents s above above are cor corre rect. ct.
Chapter 11 - Page 1
Relevant cash os 2
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Whic Which h of the the fol follo lowin wing g is not not a cash cash ow ow tha thatt res resul ults ts fro from m the the deci decisi sion on to to acce accept pt a pro% pro%ec ect? t? a. b. c. d. e.
Change Changes s in net oper operati ating ng wor!in wor!ing g capita capital. l. "hipping "hipping and instal installat lation ion cost costs. s. "un "un! costs. ts. (ppo (pport rtun unit it cost costs. s. 3xte 3xtern rnal alit itie ies. s.
Relevant cash os 4
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!nse": c Di#: E
!nse": $ Di#: E .
When When eval evalua uati ting ng a new new pro% pro%ec ect, t, the the 5rm 5rm sho shoul uld d consid consider er all all of of the the follo followi wing ng fact factor ors s exce except pt66 a. Changes Changes in net operati operating ng wor!ing wor!ing capital capital attributa attributable ble to the pro%e pro%ect. ct. b. *revious *revious expenditu expenditures res associated associated with with a mar!et test test to determine determine the feasibilit feasibilit of the pro%ect, pro%ect, if the expenditures have been expensed for tax purposes. c. Curren Currentt rental rental income of a building building owned b the 5rm 5rm if it is is not used for this this pro%ect. pro%ect. d. The decline decline in sales of an existin existing g product product directl directl attribu attributable table to this this pro%ect. pro%ect. e. #ll of the the statem statement ents s above above should should be consider considered. ed.
Relevant cash os 7
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!nse": d Di#: E .
Whic Which h of the the foll follow owin ing g ite items shou should ld 8ev& 8ev&s s 8eve 8evera rage ge nc. nc. ta! ta!e into into acco accoun untt when hen eva evaluat luatin ing g a proposed prune %uice pro%ect? a. The compan compan spent 9/::,::: two two ears ears ago ago to renovate renovate its Cincinnati Cincinnati plant. plant. These renovations renovations were made in anticipation of another pro%ect that the compan ultimatel did not underta!e. b. f the compan compan did not proceed proceed with with the prune prune %uice pro%ect pro%ect,, the Cincinnat Cincinnatii plant could generate generate leasing income of 972,::: a ear. ear. c. f the compan compan proceeds proceeds with the the prune %uice %uice pro%ect, pro%ect, it it is estimated estimated that that sales sales of the compan&s compan&s apple %uice will fall b / percent a ear. d. "tatem "tatements ents b and and c are are corre correct. ct. e. #ll of the the state statement ments s above above are are corre correct. ct.
Relevant cash os ;
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!nse": d Di#: E .
Whic Which h of the fol follo lowi wing ng shou should ld a comp compan an consi conside derr in an ana anal lsi sis s when when eval evalua uati ting ng a prop propos osed ed pro%ect? a. The new pro%ect pro%ect is expect expected ed to reduce reduce sales of the the compan&s compan&s existing existing products products b 2 percent percent a ear. b. +acant acant facilities facilities not curren currentl tl leased leased out could instead instead be leased out for 91: million a ear ear. c. The compan compan spent spent 9/: million million last ear ear to impro improve ve the vacant vacant facilit facilities ies in which which the new pro%ect will be housed. d. "tatem "tatement ents s a and and b are are corre correct. ct. e. #ll of the the statem statement ents s above above are cor corre rect. ct.
Relevant cash os <
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!nse": d Di#: E .
=anc =ancoc! oc! 'urni urnitu turre nc. nc. is is cons consid ider erin ing g new expa expans nsion ion pla plans ns for for build building ing a new new stor store. e. n rev revie iewi wing ng the proposed new store, several members of the 5rm&s 5nancial sta have made a number of points regarding regarding the proposed pro%ect. Which of the following items should the C'( include include in the analsis when estimating the pro%ect&s p ro%ect&s net present present value )*+? a. The new store store is expected expected to ta!e ta!e awa sales sales from two of the 5rm&s 5rm&s existing existing stores stores located located in the same town.
Chapter 11 - Page 2
Relevant cash os 2
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Whic Which h of the the fol follo lowin wing g is not not a cash cash ow ow tha thatt res resul ults ts fro from m the the deci decisi sion on to to acce accept pt a pro% pro%ec ect? t? a. b. c. d. e.
Change Changes s in net oper operati ating ng wor!in wor!ing g capita capital. l. "hipping "hipping and instal installat lation ion cost costs. s. "un "un! costs. ts. (ppo (pport rtun unit it cost costs. s. 3xte 3xtern rnal alit itie ies. s.
Relevant cash os 4
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!nse": c Di#: E
!nse": $ Di#: E .
When When eval evalua uati ting ng a new new pro% pro%ec ect, t, the the 5rm 5rm sho shoul uld d consid consider er all all of of the the follo followi wing ng fact factor ors s exce except pt66 a. Changes Changes in net operati operating ng wor!ing wor!ing capital capital attributa attributable ble to the pro%e pro%ect. ct. b. *revious *revious expenditu expenditures res associated associated with with a mar!et test test to determine determine the feasibilit feasibilit of the pro%ect, pro%ect, if the expenditures have been expensed for tax purposes. c. Curren Currentt rental rental income of a building building owned b the 5rm 5rm if it is is not used for this this pro%ect. pro%ect. d. The decline decline in sales of an existin existing g product product directl directl attribu attributable table to this this pro%ect. pro%ect. e. #ll of the the statem statement ents s above above should should be consider considered. ed.
Relevant cash os 7
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!nse": d Di#: E .
Whic Which h of the the foll follow owin ing g ite items shou should ld 8ev& 8ev&s s 8eve 8evera rage ge nc. nc. ta! ta!e into into acco accoun untt when hen eva evaluat luatin ing g a proposed prune %uice pro%ect? a. The compan compan spent 9/::,::: two two ears ears ago ago to renovate renovate its Cincinnati Cincinnati plant. plant. These renovations renovations were made in anticipation of another pro%ect that the compan ultimatel did not underta!e. b. f the compan compan did not proceed proceed with with the prune prune %uice pro%ect pro%ect,, the Cincinnat Cincinnatii plant could generate generate leasing income of 972,::: a ear. ear. c. f the compan compan proceeds proceeds with the the prune %uice %uice pro%ect, pro%ect, it it is estimated estimated that that sales sales of the compan&s compan&s apple %uice will fall b / percent a ear. d. "tatem "tatements ents b and and c are are corre correct. ct. e. #ll of the the state statement ments s above above are are corre correct. ct.
Relevant cash os ;
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!nse": d Di#: E .
Whic Which h of the fol follo lowi wing ng shou should ld a comp compan an consi conside derr in an ana anal lsi sis s when when eval evalua uati ting ng a prop propos osed ed pro%ect? a. The new pro%ect pro%ect is expect expected ed to reduce reduce sales of the the compan&s compan&s existing existing products products b 2 percent percent a ear. b. +acant acant facilities facilities not curren currentl tl leased leased out could instead instead be leased out for 91: million a ear ear. c. The compan compan spent spent 9/: million million last ear ear to impro improve ve the vacant vacant facilit facilities ies in which which the new pro%ect will be housed. d. "tatem "tatement ents s a and and b are are corre correct. ct. e. #ll of the the statem statement ents s above above are cor corre rect. ct.
Relevant cash os <
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!nse": d Di#: E .
=anc =ancoc! oc! 'urni urnitu turre nc. nc. is is cons consid ider erin ing g new expa expans nsion ion pla plans ns for for build building ing a new new stor store. e. n rev revie iewi wing ng the proposed new store, several members of the 5rm&s 5nancial sta have made a number of points regarding regarding the proposed pro%ect. Which of the following items should the C'( include include in the analsis when estimating the pro%ect&s p ro%ect&s net present present value )*+? a. The new store store is expected expected to ta!e ta!e awa sales sales from two of the 5rm&s 5rm&s existing existing stores stores located located in the same town.
Chapter 11 - Page 2
b. The compan compan owns the the land land that is is being conside considered red for for use in the proposed proposed pro%ect. pro%ect. This land land could instead be leased to a local developer develope r. c. The compan compan spent 9$ million million two two ears ago to put put together together a national national adverti advertising sing campaign. campaign. This campaign helped generate the demand for some of its past products, which have helped ma!e it possible for the 5rm to consider opening a new store. d. "tatem "tatement ents s a and and b are are corre correct. ct. e. #ll of the the statem statement ents s above above are cor corre rect. ct. Relevant and inc"emental cash os 1:
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!nse": a Di#: E .
Twin win =ill =ills s nc. nc. is cons consid ider erin ing g a prop propos osed ed pro% pro%ec ect. t. >iven iven avail availab able le infor informa mati tion on,, it is cur currentl entl estimated that the proposed pro%ect is ris! but has a positive net present value. Which of the following factors would ma!e the compan less li!el to adopt the current pro%ect? a. t is reveale revealed d that that if the compan compan procee proceeds ds with the propose proposed d pro%ec pro%ect, t, the compan compan will lose two other accounts, both of which have positive )*+s. b. t is reveal revealed ed that the compan compan has an option to bac! bac! out of the pro%ect pro%ect $ ears from from now, if it is discovered to be unpro5table. c. t is reveale revealed d that if the compan compan proceeds proceeds with the pro%ect, pro%ect, it it will have have an option to repeat repeat the pro%ect 0 ears from now. d. "tatem "tatement ents s a and and b are are corre correct. ct. e. "tatem "tatement ents s b and and c are are corr correct ect..
.e p"o1ect cash os 11
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!nse": a Di#: E .
# comp compan an is consid consideri ering ng a propos proposed ed expa expansio nsion n to its facili facilitie ties. s. Which Which of of the the followi following ng s stat tateme ements nts is most correct? correct? a. n calcula calculating ting the pro%ect pro%ects s operat operating ing cash ows, ows, the 5rm 5rm should should not subtra subtract ct out 5nancing 5nancing costs such as interest expense, since these costs are alread included in the W#CC, which is used to discount the pro%ect&s net cash ows. b. "ince depreciat depreciation ion is a non-cash expense, expense, the the 5rm does not need need to !now the depreciati depreciation on rate when calculating the operating cash ows. c. When estimatin estimating g the pro%ect&s pro%ect&s operat operating ing cash ows, ows, it is importan importantt to include include an opportunit opportunit costs and sun! costs, but the 5rm should ignore cash ows from externalities since the are accounted for elsewhere. d. "tatem "tatement ents s a and and c are are corr correct ect.. e. )one )one of the sta statem tement ents s above above is corre correct. ct.
Co"po"ate "is2 1$
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Which hich of the the fol follo lowi wing ng state tateme men nts is cor correct? ect? a. Well-diversi ell-diversi5ed 5ed stoc!holders stoc!holders do not consider corporate corporate ris! ris! when determining determining re@uir re@uired ed rates of return. b. Andiver Andiversi5e si5ed d stoc!h stoc!hold olders ers,, includ including ing the owners owners of small small busines businesses ses,, are are more more concer concerned ned about corporate ris! than mar!et ris!. c. 3mpir 3mpiric ical al stud studies ies of the the dete determ rmin inan ants ts of re@ui e@uirred rate rates s of retur eturn n ! ! have have foun found d that that onl onl mar!et ris! aects stoc! prices. d. Bar!et Bar!et ris! ris! is important important but does not have have a direct direct eect on stoc! stoc! price price because it onl onl aects beta. e. #ll of the the statem statement ents s above above are cor corre rect. ct.
Ris2 analysis 1/
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Which hich of the the foll follow owin ing g is not not disc discus usse sed d in the tex text as a met method hod for for ana anali ling ng ris ris! in capi capita tall Chapter 11 - Page 3
budgeting? a. b. c. d. e.
"ensitivit analsis. 8eta, or C#*B, analsis. Bonte Carlo simulation. "cenario analsis. #ll of the statements above are discussed in the text as methods for analing ris! in capital budgeting.
Chapter 11 - Page 4
Ris2 analysis 10
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!nse": c Di#: E
Dieber Technologies is considering two potential pro%ects, E and F. n assessing the pro%ects& ris!, the compan has estimated the beta of each pro%ect and has also conducted a simulation analsis. Their eorts have produced the following numbers6
3xpected )*+ "tandard deviation σ)*+ 3stimated pro%ect beta 3stimated correlation of pro%ect&s cash ows with the cash ows of the compan&s existing pro%ects.
*ro%ect E 9/2:,::: 91::,::: 1.0 Cash ows are not highl correlated with the cash ows of the existing pro%ects.
*ro%ect F 9/2:,::: 912:,::: :.; Cash ows are highl correlated with the cash ows of the existing pro%ects.
Which of the following statements is most correct? a. b. c. d. e.
*ro%ect E has a higher level of stand-alone ris! relative to *ro%ect F. *ro%ect E has a higher level of corporate ris! relative to *ro%ect F. *ro%ect E has a higher level of mar!et ris! relative to *ro%ect F. "tatements b and c are correct. #ll of the statements above are correct.
Ris2 analysis 12
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Currentl, *urcell *roducts nc. has a beta of 1.:, and the sales of all of its products tend to be positivel correlated with the overall econom and the overall mar!et. The compan estimates that a proposed new pro%ect has a higher standard deviation than the tpical pro%ect underta!en b the 5rm. The compan also estimates that the new pro%ect&s sales will do better when the overall econom is down and do poorl when the overall econom is strong. (n the basis of this information, which of the following statements is most correct? a. b. c. d. e.
The proposed new pro%ect has more stand-alone ris! than the 5rm&s tpical pro%ect. f underta!en, the proposed new pro%ect will increase the 5rm&s corporate ris!. f underta!en, the proposed new pro%ect will increase the 5rm&s mar!et ris!. "tatements a and b are correct. #ll of the statements above are correct.
Ris2 analysis 14
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!nse": a Di#: E .
!nse": e Di#: E .
n conducting its ris! analsis, =anratt nc. estimates that on a stand-alone basis, a proposed pro%ect&s estimated returns has more ris! than its existing pro%ects. The pro%ect is also expected to be more sensitive to movements in the overall econom and mar!et than are its existing pro%ects. =owever, =anratt estimates that the overall standard deviation of the compan&s total returns would fall if the compan were to go ahead with this pro%ect. (n the basis of this information, which of the following statements is most correct? a. The proposed pro%ect&s estimated returns have a higher standard deviation compared to the average existing pro%ect. b. The proposed pro%ect will reduce the compan&s corporate ris!. c. The proposed pro%ect will increase the compan&s mar!et ris!. d. The proposed pro%ect&s returns are not perfectl correlated with the returns of its existing pro%ects. e. #ll of the statements above are correct.
!ccepting "is2y p"o1ects
!nse": e Di#: E Chapter 11 - Page 5
17
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# 5rm is considering the purchase of an asset whose ris! is greater than the current ris! of the 5rm, based on an method for assessing ris!. n evaluating this asset, the decision ma!er should a. b. c. d.
ncrease the GG of the asset to reect the greater ris!. ncrease the )*+ of the asset to reect the greater ris!. Ge%ect the asset, since its acceptance would increase the 5rm&s ris!. gnore the ris! dierential, if the asset to be accepted would comprise onl a small fraction of the 5rm&s total assets. e. ncrease the cost of capital used to evaluate the pro%ect to reect the pro%ect&s higher ris!. Ris2 ad1ustment 1;
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!nse": $ Di#: E
Gis! in a revenue-producing pro%ect can best be ad%usted for b a. b. c. d. e.
gnoring it. #d%usting the discount rate upward for increasing ris!. #d%usting the discount rate downward for increasing ris!. *ic!ing a ris! factor e@ual to the average discount rate. Geducing the )*+ b 1: percent for ris! pro%ects.
Ris2 and p"o1ect selection 1<
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# compan estimates that an average-ris! pro%ect has a W#CC of 1: percent, a below-average ris! pro%ect has a W#CC of ; percent, and an above-average ris! pro%ect has a W#CC of 1$ percent. Which of the following independent pro%ects should the compan accept?
a. b. c. d. e. Ris2 and $:
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!nse": $ Di#: E
*ro%ect # has average ris! and an GG H < percent. *ro%ect 8 has below-average ris! and an GG H ;.2 percent. *ro%ect C has above-average ris! and an GG H 11 percent. #ll of the pro%ects above should be accepted. )one of the pro%ects above should be accepted. p"o1ect selection
!nse": c Di#: E
Iowningtown ndustries has an overall composite W#CC of 1: percent. This cost of capital reects the cost of capital for a Iowningtown pro%ect with average ris!J however, there are large ris! dierences among its pro%ects. The compan estimates that low-ris! pro%ects have a cost of capital of ; percent and high-ris! pro%ects have a cost of capital of 1$ percent. The compan is considering the following pro%ects6 *ro%ect # 8 C I 3
3xpected Geturn 12K 1$ 11 < 4
Gis! =igh #verage =igh Dow Dow
Which of the pro%ects should the compan select to maximie shareholder wealth? a. b. c. d. e.
# and 8. #, 8, and C. #, 8, and I. #, 8, C, and I. #, 8, C, I, and 3.
ensitivity, scena"io, and simulation analyses $1
.
Which of the following statements is most correct?
Chapter 11 - Page 6
!nse": c Di#: E
a. "ens "ensit itiv ivit it anal anals sis is is a good good wa wa to meas measur ure e mar! mar!et et ris! ris! beca because use it expl explic icit itl l ta! ta!es into into account diversi5cation eects. b. (ne advantage advantage of sensitivit sensitivit analsis analsis relative relative to scenario scenario analsis analsis is that it explicitl explicitl ta!es ta!es into account account the probab probabili ilit t of certai certain n eects eects occur occurrin ring, g, where whereas as scenar scenario io anals analsis is does does not consider probabilities. c. "imulatio "imulation n analsis analsis is a computerie computeried d version version of scenario scenario analsis analsis that uses continuou continuous s probabi probabilit lit distributions of the input variables. d. "tatem "tatement ents s a and and b are are corre correct. ct. e. #ll of the the statem statement ents s above above are cor corre rect. ct. Medium: Cash os and accounting measu"es $$
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!nse": d Di#: M
Which hich of the the fol follo lowi wing ng state tateme men nts is cor correct? ect? a. #n asset that that is sold for less less than boo! value value at the end of a pro%ect pro%ect&s &s life will will generate generate a loss for the 5rm and will cause an actual cash outow attributable to the pro%ect. b. (nl incrementa incrementall cash ows are releva relevant nt in pro%ect pro%ect analsis analsis and the proper increme incremental ntal cash ows are the reported accounting pro5ts because the form the true basis for investor and managerial decisions. c. t is unrealist unrealistic ic to expect expect that increases increases in net operating operating wor!ing wor!ing capital capital re@uire re@uired d at the start of an expansion pro%ect are are simpl recovered recovered at the pro%ect&s pro%ect&s completion. Thus, these cash ows are included onl at the start of a pro%ect. d. 3@uipment 3@uipment sold for more than than its boo! value at the the end of a pro%ect&s pro%ect&s life will will increase increase income income and, despite increasing taxes, will generate a greater cash ow than if the same asset is sold at boo! value. e. )one )one of the sta statem tement ents s above above is corre correct. ct.
Relevant cash os $/
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!nse": d Di#: M
#dams #udio #dams #udio is is cons conside iderin ring g wheth whether er to ma!e ma!e an an inves investme tment nt in a new new tpe tpe of of tech technolo nolog g.. Which Which of of the follow following ing factor factors s should should the compan compan consid consider er when when it decide decides s whethe whetherr to undert underta! a!e e the investment? a. The compan compan has alread alread spent 9/ million million resear researching ching the technolog technolog. b. The new technolog technolog will will aect the the cash ows ows produced produced b its other other operation operations. s. c. f the investme investment nt is not made, made, then the the compan compan will be able to to sell one of its its laboratori laboratories es for 9$ million. d. "tatem "tatement ents s b and c should should be cons consider idered. ed. e. #ll of the the statem statement ents s above above should should be consider considered. ed.
Relevant cash os $0
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!nse": d Di#: M
Dauri Daurier er nc. nc. is is a househ household old produ products cts 5rm 5rm tha thatt is consi consider dering ing devel developi oping ng a new new deter detergen gent. t. n evalu evaluat ating ing whether to go ahead with the new detergent pro%ect, which of the following items should Daurier explicitl explicitl include in its cash ow analsis? a. The compan compan will produce produce the detergen detergentt in a vacant facilit facilit that that the renovat renovated ed 5ve ears ago ago at a cost of 97::,:::. b. The compan will will need to use some some e@uipment e@uipment that it could could have leased leased to another compan compan.. This e@uipment lease could have generated 9$::,::: per ear in after-tax after-tax income. c. The new detergent detergent is li!el li!el to signi5cantl signi5cantl reduce reduce the sales sales of the other deterg detergent ent products products the compan currentl sells. d. "tatem "tatement ents s b and c are are corre correct. ct. Chapter 11 - Page 7
e. #ll of the the statem statement ents s above above are cor corre rect. ct. Relevant cash os $2
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!nse": d Di#: M
"anf "anfor ord d L "on "on nc. nc. is thin thin!i !ing ng abou aboutt expand pandin ing g thei theirr busi busine nes ss b open openin ing g anoth nother er shop shop on propert the purchased 1: ears ago. Which of the following items should be included in the analsis of this endeavor? a. The propert propert was was cleared cleared of trees trees and brush brush 5ve ears ears ago at a cost cost of 92,:::. b. The new shop is expec expected ted to aect the pro5ta pro5tabil bilit it of the exist existing ing shop since since some some current current customers customers will transfer transfer their business business to the new shop. The 5rm estimates estimates that pro5ts pro5ts at the existing shop will decrease b 1: percent. c. "anford "anford L "on can lease the the entire entire propert propert to another another compan compan that that wants to to grow owers owers on the lot for 92,::: per ear. d. 8oth stateme statements nts b and and c should should be include included d in the analsi analsis. s. e. #ll of the the statement statements s above should should be include included d in the analsi analsis. s.
Relevant cash os $4
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!nse": d Di#: M
*ic!l *ic!les es Corp Corp.. is a compa compan n that that sells sells bott bottled led iced iced tea. tea. The compan compan is thin thin!in !ing g about about expa expandin nding g its operations into the bottled lemonade business. Which of the following factors should the compan incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade business? a. f the compan compan enters enters the lemonade lemonade business, business, its iced iced tea sales sales are expec expected ted to fall 2 percent percent as some consumers switch from iced tea to lemonade. b. Two ears ago ago the compan spent spent 9/ million to renovat renovate e a building for a proposed proposed pro%ect pro%ect that that was never underta!en. f the pro%ect is adopted, the plan is to have the lemonade produced in this building. c. f the compan compan doesn&t doesn&t produc produce e lemonad lemonade, e, it can lease the buildin building g to another another compan compan and receive after-tax after-tax cash ows of 92::,::: 92::,:: : a ear. ear. d. "tatem "tatement ents s a and and c are are corr correct ect.. e. #ll of the the statem statement ents s above above are cor corre rect. ct.
-nc"emental cash os $7
.
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Whic Which h of the the follo followi wing ng const constit itut utes es an exam exampl ple e of a cost cost that that is not incr increm emen enta tal, l, and and ther theref efor ore, e, not not relevant relevant in a capital budgeting decision? a. # 5rm has a parce parcell of land that can be used used for a new plant plant site, or alter alternative nativel, l, can be used used to grow watermelons. b. # 5rm can can produce produce a new cleaning cleaning product product that will will generate generate new new sales, sales, but some of the new new sales will be from customers who switch from another product the compan c urrentl urrentl produces. c. # 5rm orders orders and receiv receives es a piece piece of new e@uipment e@uipment that is shipped shipped across across the countr countr and re@uires 9$2,::: in installation and set-up costs. d. "tatements "tatements a, b, and c are are examples examples of incremental incremental cash ows, ows, and therefor therefore, e, relevant relevant cash cash ows. e. )one of the state statements ments above above is an example example of an incremen incremental tal cash cash ow. ow.
-nc"emental cash os $;
.
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Which Which of the followin following g is not consider considered ed a relev relevant ant concer concern n in deter deter-- mining mining incre incremen mental tal cash cash ows ows for a new product? a. The use of factor factor oor space that that is curre currentl ntl unused unused but availab available le for producti production on of an product. b. Gevenues Gevenues from from the existing existing product product that would would be lost as a result result of some customers customers switching switching to the new product.
Chapter 11 - Page 8
c. "hipping "hipping and installa installation tion costs costs assoc associat iated ed with prepar preparing ing the machine machine to be used to produc produce e the new product. d. The cost cost of a produ product ct anal anals sis is comple complete ted d in the previ previou ous s tax tax ear ear and spec speci5c i5c to the the new new product. e. )one )one of the the stat statem emen ents ts above. above. #ll #ll of the the stat statem emen ents ts above above are are relev elevan antt conc concer erns ns in estimating relevant cash ows attributable to a new p roduct. Cash o estimation $<
.
Whic Which h of the foll follow owin ing g rule rules s are esse essent ntia iall to succ succes essf sful ul cash cash ow ow esti estima mate tes, s, and and ulti ultima mate tel l,, to successful capital budgeting analsis? a. b. c. d. e.
The retur return n on invested invested capital capital is the the onl releva relevant nt cash ow ow.. (nl incrementa incrementall cash ows are are relevant relevant to the acceptMr acceptMre%ect e%ect decisio decision. n. Total cash cash ows are relevant relevant to capital capital budgeting analsis analsis and the acceptMre acceptMre%ect %ect decision. decision. "tatem "tatement ents s a and and b are are corre correct. ct. #ll of the the statem statement ents s above above are cor corre rect. ct.
Cash o estimation /:
.
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Which hich of the the fol follo lowi wing ng state tateme men nts is cor correct? ect? a. n a capital capital budgeting budgeting analsis analsis where where part of the funds funds used to 5nance 5nance the pro%ect pro%ect are are raised raised as debt, failure to include interest expense as a cost i n the cash ow statement when determining the pro%ect&s cash ows will lead to an upward bias in the )*+. )*+. b. The preceding preceding statement statement would would be true if NupwardO NupwardO were were replaced replaced with Ndownwa Ndownward.O rd.O c. The existence existence of Nexter Nexternalit nalitiesO iesO reduces reduces the )*+ )*+ to a level level below the value value that would would exist exist in the absence of o f externalities. d. f one of the assets assets to be used b a potent potential ial pro%e pro%ect ct is alread alread owned b the 5rm, and and if that that asset could be leased to another 5rm if the new pro%ect were not underta!en, then the net rent that could be obtained should be charged as a cost to the pro%ect under consideration. e. The rent rent referr referred ed to in statement statement d is a sun! sun! cost, and and as such it should should be ignored. ignored.
Co"po"ate "is2 /1
.
n the theor or, , the the dec decis isio ion n ma!er ma!er sho shoul uld d view view mar! mar!et et ris ris! ! as bei being ng of pri prima mar r impo import rtan ance ce.. within-5rm, or corporate, ris! is relevant to a 5rm&s a. b. c. d. e.
.
=owe =oweve ver, r,
Well-diversi ell-diversi5ed 5ed stoc!holders stoc!holders,, because it ma ma aect debt capacit capacit and operating operating income. Banagement, Banagement, because because it aects aects %ob %ob stabilit stabilit. Creditors Creditors,, because because it aects aects the 5rm&s 5rm&s credit credit worthin worthiness. ess. "tatem "tatement ents s a and and c are are corr correct ect.. #ll of the the statem statement ents s above above are cor corre rect. ct.
ensitivity, scena"io, and simulation analyses /$
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Which hich of the the fol follo lowi wing ng state tateme men nts is cor correct? ect? a. "ensitivit "ensitivit analsis analsis is incomplete incomplete because because it fails fails to consider the the range of li!el li!el values values of !e variables as reected in their probabilit distributions. b. n comparin comparing g two pro%e pro%ects cts using using sensit sensitivi ivit t analsis analsis,, the one with the steeper steeper lines lines would be considered less ris!, because a small error in estimating a variable, such as unit sales, would produce onl a small error in the pro%ect&s )*+. )*+. c. The primar primar advantage advantage of simulation simulation analsis analsis over scenari scenario o analsis is that that scenario scenario analsis analsis re@uires re@uires a relativel relativel powerful powerful computer, computer, coupled with an ePcient ePcient 5nancial 5nancial planning planning softwar software e pac!age, pac!age, whereas whereas simulation simulation analsis analsis can be done using a *C with a spreadsheet spreadsheet program program or even a calculator. Chapter 11 - Page 9
d. "ensitivit analsis is a ris! analsis techni@ue that considers both the sensitivit of )*+ to changes in !e variables and the li!el range of variable values. e. "tatements c and d are correct. Monte Ca"lo simulation //
.
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Bonte Carlo simulation a. Can be useful for estimating a pro%ect&s stand-alone ris!. b. s capable of using probabilit distributions for variables as input data instead of a single numerical estimate for each variable. c. *roduces both an expected )*+ or GG and a measure of the ris!iness of the )*+ or GG. d. "tatements a and b are correct. e. #ll of the statements above are correct.
Chapter 11 - Page 10
Ris2 ad1ustment /0
.
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The (neonta Chemical Compan is evaluating two mutuall exclusive pollution control sstems. "ince the compan&s revenue stream will not be aected b the choice of control sstems, the pro%ects are being evaluated b 5nding the *+ of each set of costs. The 5rm&s re@uired rate of return is 1/ percent, and it adds or subtracts / percentage points to ad%ust for pro%ect ris! dierences. "stem # is %udged to be a high-ris! pro%ect because it might cost much more to operate than is expected. "stem #&s ris!-ad%usted cost of capital is a. 1: percentJ this might seem illogical at 5rst but it correctl ad%usts for ris!, when outows rather than inows are being discounted. b. 1/ percentJ the 5rm&s cost of capital should not be ad%usted when evaluating outow-onl pro%ects. c. 14 percentJ since # is more ris!, its cash ows should be discounted at a higher rate because this correctl penalies the pro%ect for its high ris!. d. "omewhere between 1: percent and 14 percent, with the answer depending on the ris!iness of the relevant inows. e. ndeterminate, or, more accuratel, irrelevant, because for such pro%ects we would simpl select the process that meets the re@uirements with the lowest re@uired investment.
Multiple Choice: &"o$lems Easy: Ta3es on gain on sale /2
.
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"t. Qohn&s *aper is considering purchasing e@uipment toda that has a depreciable cost of 91 million. The e@uipment will be depreciated on a B#CG" 2-ear basis, which implies the following depreciation schedule6 Fear 1 $ / 0 2 4
B#CG" Iepreciation Gates :.$: :./$ :.1< :.1$ :.11 :.:4
#ssume that the compan sells the e@uipment after three ears for 90::,::: and the compan&s tax rate is 0: percent. What would be the tax conse@uences resulting from the sale of the e@uipment? a. There are no tax conse@uences. b. The compan would have to pa 900,::: in taxes. c. The compan would have to pa 914:,::: in taxes. d. The compan would receive a tax credit of 91$0,:::. e. The compan would receive a tax credit of 90;,:::. -nvento"y and .&4 /4
.
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Go%as Computing is developing a new software sstem for one of its clients. The sstem has an upfront cost of 972 million at t H :. The client has forecasted its inventor levels for the next 5ve ears as shown below6 Fear
nventor
Chapter 11 - Page 11
1 $ / 0 2
91.: billion 1.$ billion 1.4 billion $.: billion $.$ billion
Go%as forecasts that its new software will enable its client to reduce inventor to the following levels6 Fear 1 $ / 0 2
nventor 9:.; billion 1.: billion 1.0 billion 1.7 billion 1.< billion
#fter Fear 2, the software will become obsolete, so it will have no further impact on the client&s inventor levels. Go%as& client is evaluating this software pro%ect as it would an other capital budgeting pro%ect. The client estimates that the weighted average cost of capital for the software sstem is 1: percent. What is the estimated )*+ in millions of dollars of the new software sstem? a. b. c. d. e.
9$//.24 90;<.<; 94$2.1$ 9;1/.22 9<24.0/
.&4 ith e3te"nalities /7
.
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3llison *roducts is considering a new pro%ect that develops a new laundr detergent, W(W. The compan has estimated that the pro%ect&s )*+ is 9/ million, but this does not consider that the new laundr detergent will reduce the revenues received on its existing laundr detergent products. "peci5call, the compan estimates that if it develops W(W the compan will lose 92::,::: in aftertax cash ows during each of the next 1: ears because of the cannibaliation of its existing products. 3llison&s W#CC is 1: percent. What is the net present value )*+ of underta!ing W(W after considering externalities?
a. b. c. d. e. Medium:
9$,<$7,714.:: 9/,:::,:::.:: -9 7$,$;/.22 9$,;:7,$$;.:: -9/,:7$,$;/.22
!5te"6ta3 salvage value /;
.
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'or a new pro%ect, #rmstead nc. had planned on depreciating new machiner that costs 9/:: million on a 0-ear, straight-line basis. "uppose now, that #rmstead decides to depreciate the new machiner on an accelerated basis according to the following depreciation schedule6
Fear 1 $ Chapter 11 - Page 12
B#CG" Iepreciation Gates $:K /$
/ 0 2 4
1< 1$ 11 4
The pro%ect for which the machiner has been purchased ends in four ears, and as a result the machiner is going to be sold at its salvage value of 92:,:::,:::. Ander this accelerated depreciation method, what is the after-tax cash ow expected to be generated b the sale of the e@uipment in Fear 0? #ssume the 5rm&s tax rate is 0: percent. a. b. c. d. e.
9/1,;::,::: 901,4::,::: 92:,0::,::: 921,4::,::: 97$,$::,:::
.e p"o1ect .&4 /<
.
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>iven the following information, calculate the )*+ of a proposed pro%ect6 Cost H 90,:::J estimated life H / earsJ initial decrease in accounts receivable H 91,:::, which must be restored at the end of the pro%ect&s lifeJ estimated salvage value H 91,:::J earnings before taxes and depreciation H 9$,::: per earJ tax rate H 0: percentJ and cost of capital H 1; percent. The applicable depreciation rates are // percent, 02 percent, 12 percent, and 7 percent. a. 91,1/7 b. -9 121 c. 9 1/7 d. 9 ;:0 e. 9 200
.e p"o1ect .&4 0:
.
Bars nc. is considering the purchase of a new machine that will reduce manufacturing costs b 92,::: annuall. Bars will use the B#CG" accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 2-ear operating life for 91:,:::. The 5rm expects to be able to reduce net operating wor!ing capital b 912,::: when the machine is installed, but re@uired net operating wor!ing capital will return to its original level when the machine is sold after 2 ears. Bars& marginal tax rate is 0: percent, and it uses a 1$ percent cost of capital to evaluate pro%ects of this nature. The applicable depreciation rates are $: percent, /$ percent, 1< percent, 1$ percent, 11 percent, and 4 percent. f the machine costs 94:,:::, what is the pro%ect&s )*+? a. b. c. d. e.
-912,/<0 -910,: -92;,21$ -9$1,0 -904,<:1
.e p"o1ect .&4 01
.
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"tanton nc. is considering the purchase of a new machine that will reduce manufacturing costs b 92,::: annuall and increase earnings before depreciation and taxes b 94,::: annuall. "tanton will use the B#CG" method to depreciate the machine, and it expects to sell the machine at the end of its 2-ear operating life for 91:,::: before taxes. "tanton&s marginal tax rate is 0: percent, and it uses a < percent cost of capital to evaluate pro%ects of this tpe. The applicable
Chapter 11 - Page 13
depreciation rates are $: percent, /$ percent, 1< percent, 1$ percent, 11 percent, and 4 percent. f the machine&s cost is 90:,:::, what is the pro%ect&s )*+? a. b. c. d. e.
91,:10 9$,$<$ 97,22: 9 ;17 92,:0:
.e p"o1ect .&4 0$
.
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Baple Bedia is considering a proposal to enter a new line of business. n reviewing the proposal, the compan&s C'( is considering the following facts6 The new business will re@uire the compan to purchase additional 5xed assets that will cost 94::,::: at t H :. 'or tax and accounting purposes, these costs will be depreciated on a straight-line basis over three ears. #nnual depreciation will be 9$::,::: per ear at t H 1, $, and /. • #t the end of three ears, the compan will get out of the business and will sell the 5xed assets at a salvage value of 91::,:::. • The pro%ect will re@uire a 92:,::: increase in net operating wor!ing capital at t H :, which will be recovered at t H /. • The compan&s marginal tax rate is /2 percent. The new business is expected to generate 9$ million in sales each ear at t H 1, $, and /. • The operating costs excluding deprecia-tion are expected to be 91.0 million per ear. • The pro%ect&s cost of capital is 1$ percent. •
What is the pro%ect&s net present value )*+? a. b. c. d. e.
92/4,4<7 9 ;4,;;2 9 ;1,$0/ 9 24,//1 9241,4:<
.e p"o1ect .&4 0/
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BacIonald *ublishing is considering entering a new line of business. n analing the potential business, their 5nancial sta has accumulated the following information6 The new business will re@uire a capital expenditure of 92 m illion at t H :. This expenditure will be used to purchase new e@uipment. This e@uipment will be depreciated according to the following depreciation schedule6 • •
Fear 1 $ / 0
B#CG" Iepreciation Gates :.// :.02 :.12 :.:7
The e@uipment will have no salvage value after four ears. • f BacIonald goes ahead with the new business, inventories will rise b 92::,::: at t H :, and its accounts paable will rise b 9$::,::: at t H :. This increase in net operating wor!ing capital will be recovered at t H 0. •
Chapter 11 - Page 14
The new business is expected to have an economic life of four ears. The business is expected to generate sales of 9/ million at t H 1, 90 million at t H $, 92 million at t H /, and 9$ million at t H 0. 3ach ear, operating costs excluding depreciation are expected to be 72 percent of sales. The compan&s tax rate is 0: percent. • • The compan&s weighted average cost of capital is 1: percent. • The compan is ver pro5table, so an accounting losses on this pro%ect can be used to reduce the compan&s overall tax burden. •
What is the expected net present value )*+ of the new business? a. b. c. d. e.
9 70:,$<; -91,724,<$< -91,;//,7$0 -91,<41,;// R92,<1<,<70
.e p"o1ect .&4 00
.
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Gio >rande 8oo!stores is considering a ma%or expansion of its business. The details of the proposed expansion pro%ect are summaried below6 The compan will have to purchase 92::,::: in e@uipment at t H :. This is the depreciable cost. • The pro%ect has an economic life of four ears. • The cost can be depreciated on a B#CG" /-ear basis, which implies the following depreciation schedule6 •
Fear 1 $ / 0
B#CG" Iepreciation Gates :.// :.02 :.12 :.:7
#t t H :, the pro%ect re@uires that inventories increase b 92:,::: and accounts paable increase b 91:,:::. The change in net operating wor!ing capital is expected to be full recovered at t H 0. The pro%ect&s salvage value at the end of four ears is expected to be 9:. • • The compan forecasts that the pro%ect will generate 9;::,::: in sales the 5rst two ears t H 1 and $ and 92::,::: in sales during the last two ears t H / and 0. • 3ach ear the pro%ect&s operating costs excluding depreciation are expected to be 4: percent of sales revenue. The compan&s tax rate is 0: percent. • • The pro%ect&s cost of capital is 1: percent. •
What is the net present value )*+ of the proposed pro%ect? a. 912<,102 b. 91/0,$;; c. 914$,;17 d. 912:,774 e. -9$27,:4:
Chapter 11 - Page 15
.e p"o1ect .&4 02
.
Four compan is considering a machine that will cost 91,::: at Time : and can be sold after / ears for 91::. To operate the machine, 9$:: must be invested at Time : in inventoriesJ these funds will be recovered when the machine is retired at the end of Fear /. The machine will produce sales revenues of 9<:: per ear for / ears and variable operating costs excluding depreciation will be 2: percent of sales. (perating cash inows will begin 1 ear from toda at Time 1. The machine will have depreciation expenses of 92::, 9/::, and 9$:: in Fears 1, $, and /, respectivel. The compan has a 0: percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this pro%ect if the pro%ect&s income is negative, and a 1: percent cost of capital. nation is ero. What is the pro%ect&s )*+? a. b. c. d. e.
9 4.$0 9 7.;< 9 ;.;7 9 <.12 91:.01
.e p"o1ect .&4 04
.
9 7,47/.71 91$,;21.72 917,0/4.;0 9$0,<;<.47 9/$,7;0.$2
.e p"o1ect .&4 .
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Four compan is considering a machine that will cost 92:,::: at Time : and that can be sold after / ears for 91:,:::. 91$,::: must be invested at Time : in inventories and receivablesJ these funds will be recovered when the operation is closed at the end of Fear /. The facilit will produce sales revenues of 92:,::: per ear for / ears and variable operating costs excluding depreciation will be 0: percent of sales. )o 5xed costs will be incurred. (perating cash inows will begin 1 ear from toda at t H 1. 8 an act of Congress, the machine will have depreciation expenses of 90:,:::, 92,:::, and 92,::: in Fears 1, $, and /, respectivel. The compan has a 0: percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this pro%ect if the pro%ect&s income is negative, and a 12 percent cost of capital. nation is ero. What is the pro%ect&s )*+? a. b. c. d. e.
07
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8uc!ee 8oo!s is considering opening a new production facilit in Toledo, (hio. n deciding whether to proceed with the pro%ect, the compan has accumulated the following information6 •
•
•
•
• • •
The estimated up-front cost of constructing the facilit at t H : is 91: million. 'or tax purposes the facilit will be depreciated on a straight-line basis over 2 ears. The compan plans to operate the facilit for 0 ears. t estimates toda that the facilit&s salvage value at t H 0 will be 9/ million. f the facilit is opened, 8uc!ee will have to increase its inventor b 9$ million at t H :. n addition, its accounts paable will increase b 91 million at t H :. The compan&s net operating wor!ing capital will be recovered at t H 0. f the facilit is opened, it will increase the compan&s sales b 97 million each ear for the 0 ears that it will be operated t H 1, $, /, and 0. The operating costs excluding depreciation are expected to e@ual 9/ million a ear. The compan&s tax rate is 0: percent. The pro%ect&s cost of capital is 1$ percent.
What is the pro%ect&s net present value )*+? Chapter 11 - Page 16
a. b. c. d. e.
9:.$; million 9:.2: million 9:.4/ million 91.:1 million 91.$4 million
.e p"o1ect .&4 0;
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8urress 8everages is considering a pro%ect where the would open a new facilit in "eattle, Washington. The compan&s C'( has assembled the following information regarding the proposed pro%ect6 t would cost 92::,::: toda at t H : to construct the new facilit. The cost of the facilit will be depreciated on a straight-line basis over 5ve ears. • f the compan opens the facilit, it will need to increase its inventor b 91::,::: at t H :. 97:,::: of this inventor will be 5nanced with accounts paable. • The C'( has estimated that the pro%ect will generate the following amount of revenue over the next three ears6 •
Fear 1 Fear $ Fear /
Gevenue H 91.: million Gevenue H 91.$ million Gevenue H 91.2 million
(perating costs excluding depreciation e@ual 7: percent of revenue. • The compan plans to abandon the facilit after three ears. #t t H /, the pro%ect&s estimated salvage value will be 9$::,:::. #t t H /, the compan will also recover the net operating wor!ing capital investment that it made at t H :. The pro%ect&s cost of capital is 10 percent. • • The compan&s tax rate is 0: percent. •
What is the pro%ect&s net present value )*+? a. b. c. d. e.
9 4<,$:7 917;,<04 9$;4,/41 917:,02/ 9$$0,021
.e p"o1ect .&4 0<
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Bills Bining is considering an expansion pro%ect. The proposed pro%ect has the following features6 The pro%ect has an initial cost of 92::,:::. This is also the amount that can be depreciated using the following depreciation schedule6 •
Fear 1 $ / 0
B#CG" Iepreciation Gates :.// :.02 :.12 :.:7
Chapter 11 - Page 17
f the pro%ect is underta!en, at t H : the compan will need to increase its inventories b 92:,:::, and its accounts paable will rise b 91:,:::. This net operating wor!ing capital will be recovered at the end of the pro%ect&s life t H 0. • f the pro%ect is underta!en, the compan will realie an additional 94::,::: in sales over each of the next four ears t H 1, $, /, and 0. The compan&s operating costs not including depreciation will e@ual 90::,::: a ear. • The compan&s tax rate is 0: percent. • #t t H 0, the pro%ect&s economic life is complete, but it will have a salvage value before-tax of 92:,:::. The pro%ect&s W#CC is 1: percent. • • The compan is ver pro5table, so an accounting losses on this pro%ect can be used to reduce the compan&s overall tax burden. •
What is the pro%ect&s net present value )*+? a. b. c. d. e.
911,1$$.;7 92:,//:.10 920,474.2< 94;,//4.;4 9;:,:/2.2$
.e p"o1ect -RR 2:
.
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#s one of its ma%or pro%ects for the ear, "teinbec! Iepot is considering opening up a new store. The compan&s C'( has collected the following information, and is proceeding to evaluate the pro%ect. •
•
•
•
•
The building would have an up-front cost at t H : of 910 million. 'or tax purposes, this cost will be depreciated over seven ears using straight-line depreciation. The store is expected to remain open for 5ve ears. #t t H 2, the compan plans to sell the store for an estimated pre-tax salvage value of 9; million. The pro%ect also re@uires the compan to spend 92 million in cash at t H : to purchase additional inventor for the store. #fter purchasing the inventor, the compan&s net operating wor!ing capital will remain unchanged until t H 2. #t t H 2, the compan will be able to full recover this 92 million. The store is expected to generate sales revenues of 912 million per ear at the end of each of the next 5ve ears. (perating costs excluding depreciation are expected to be 91: million per ear. The compan&s tax rate is 0: percent.
What is the pro%ect&s internal rate of return GG? a. b. c. d. e.
12./2K 1/.<0K 1:.40K 1$.02K /.4:K
Ris26ad1usted .&4 21
.
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*ar!er *roducts manufactures a variet of household products. The compan is considering introducing a new detergent. The compan&s C'( has collected the following information about the proposed product. )ote6 Fou ma or ma not need to use all of this information, use onl relevant information. • •
The pro%ect has an anticipated economic life of 0 ears. The compan will have to purchase a new machine to produce the detergent. The machine has an up-front cost t H : of 9$ million. The machine will be depreciated on a straight-line
Chapter 11 - Page 18
•
•
• •
•
•
basis over 0 ears that is, the compan&s depreciation expense will be 92::,::: in each of the 5rst four ears t H 1, $, /, and 0. The compan anticipates that the machine will last for four ears, and that after four ears, its salvage value will e@ual ero. f the compan goes ahead with the proposed product, it will have an eect on the compan&s net operating wor!ing capital. #t the outset, t H :, inventor will increase b 910:,::: and accounts paable will increase b 90:,:::. #t t H 0, the net operating wor!ing capital will be recovered after the pro%ect is completed. The detergent is expected to generate sales revenue of 91 million the 5rst ear t H 1, 9$ million the second ear t H $, 9$ million the third ear t H /, and 91 million the 5nal ear t H 0. 3ach ear the operating costs not including depreciation are expected to e@ual 2: percent of sales revenue. The compan&s interest expense each ear will be 91::,:::. The new detergent is expected to reduce the after-tax cash ows of the compan&s existing products b 9$2:,::: a ear t H 1, $, /, and 0. The compan&s overall W#CC is 1: percent. =owever, the proposed pro%ect is ris!ier than the average pro%ect for *ar!erJ the pro%ect&s W#CC is estimated to be 1$ percent. The compan&s tax rate is 0: percent.
What is the net present value of the proposed pro%ect? a. b. c. d. e.
-9 742,<:/.<7 -91,::4,42<.2; -9 ;$0,01;.4$ -9 ;/;,<<7.;< -9 77;,2;/.0/
Ris26ad1usted .&4 2$
.
+irus "topper nc., a supplier of computer safeguard sstems, uses a cost of capital of 1$ percent to evaluate average-ris! pro%ects, and it adds or subtracts $ percentage points to evaluate pro%ects of more or less ris!. Currentl, two mutuall exclusive pro%ects are under consideration. 8oth have a cost of 9$::,::: and will last 0 ears. *ro%ect #, a ris!ier-than-average pro%ect, will produce annual end-ofear cash ows of 971,1:0. *ro%ect 8, a less-than-average-ris! pro%ect, will produce cash ows of 9104,011 at the end of Fears / and 0 onl. +irus "topper should accept a. b. c. d. e.
8 with a )*+ of 91:,::1. 8oth # and 8 because both have )*+s greater than ero. 8 with a )*+ of 9;,:0$. # with a )*+ of 97,177. # with a )*+ of 912,<4;.
Ris26ad1usted .&4 2/
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#n all-e@uit 5rm is analing a potential pro%ect that will re@uire an initial, after-tax cash outla of 92:,::: and after-tax cash inows of 94,::: per ear for 1: ears. n addition, this pro%ect will have an after-tax salvage value of 91:,::: at the end of Fear 1:. f the ris!-free rate is 4 percent, the return on an average stoc! is 1: percent, and the beta of this pro%ect is 1.2:, what is the pro%ect&s )*+? a. 91/,$1: b. 9 0,<:2 c. 9 7,1$1 d. -9 4,12; e. -91$,;7<
Ris26ad1usted .&4
!nse": c Di#: M Chapter 11 - Page 19
20
.
Geal Time "stems nc. is considering the development of one of two mutuall exclusive new computer models. 3ach will re@uire a net investment of 92,:::. The cash ows for each pro%ect are shown below6
1 $ /
Fear 9$,::: $,2:: $,$2:
*ro%ect # 9/,::: $,4:: $,<::
*ro%ect 8
Bodel 8, which will use a new tpe of laser dis! drive, is considered a high-ris! pro%ect, while Bodel # is an average-ris! pro%ect. Geal Time adds $ percentage points to arrive at a ris!-ad%usted cost of capital when evaluating high-ris! pro%ects. The cost of capital used for average-ris! pro%ects is 1$ percent. Which of the following statements regarding the )*+s for Bodels # and 8 is most correct? a. )*+# H 9 /;:J )*+8 H 91,;12 b. )*+# H 9 1<7J )*+8 H 91,2<: c. )*+# H 9 /;:J )*+8 H 91,2<: d. )*+# H 92,/;:J )*+ 8 H 94,2<: e. )*+# H 9 1<7J )*+8 H 91,;12 Ris26ad1usted discount "ate 22
.
The Anlimited, a national retailing chain, is considering an investment in one of two mutuall exclusive pro%ects. The discount rate used for *ro%ect # is 1$ percent. 'urther, *ro%ect # costs 912,:::, and it would be depreciated using B#CG". t is expected to have an after-tax salvage value of 92,::: at the end of 4 ears and to produce after-tax cash ows including depreciation of 90,::: for each of the 4 ears. *ro%ect 8 costs 910,;12 and would also be depreciated using B#CG". 8 is expected to have a ero salvage value at the end of its 4-ear life and to produce after-tax cash ows including depreciation of 92,1:: each ear for 4 ears. The Anlimited&s marginal tax rate is 0: percent. What ris!-ad%usted discount rate will e@uate the )*+ of *ro%ect 8 to that of *ro%ect #? a. b. c. d. e.
12K 14K 1;K $:K 1$K
Ris26ad1usted discount "ate 24
.
;K 1:K 1$K 10K 14K
Discounting "is2y outos .
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California Bining is evaluating the introduction of a new ore production process. Two alternatives are available. *roduction *rocess # has an initial cost of 9$2,:::, a 0-ear life, and a 92,::: net salvage value, and the use of *rocess # will increase net cash ow b 91/,::: per ear for each of the 0 ears that the e@uipment is in use. *roduction *rocess 8 also re@uires an initial investment of 9$2,:::, will also last 0 ears, and its expected net salvage value is ero, but *rocess 8 will increase net cash ow b 912,$07 per ear. Banagement believes that a ris!-ad%usted discount rate of 1$ percent should be used for *rocess #. f California Bining is to be indierent between the two processes, what ris!ad%usted discount rate must be used to evaluate 8? a. b. c. d. e.
27
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#labama *ulp Compan #*C can control its environmental pollution using either N*ro%ect (ld TechO or
Chapter 11 - Page 20
N*ro%ect )ew Tech.O 8oth will do the %ob, but the actual costs involved with *ro%ect )ew Tech, which uses unproved, new state-of-the-art technolog, could be much higher than the expected cost levels. The cash outows associated with *ro%ect (ld Tech, which uses standard proven technolog, are less ris!. The are about as uncertain as the cash ows associated with an average pro%ect. #*C&s cost of capital for average-ris! pro%ects is normall set at 1$ percent, and the compan adds / percent for high-ris! pro%ects but subtracts / percent for low-ris! pro%ects. The two pro%ects in @uestion meet the criteria for high and average ris!, but the 5nancial manager is concerned about appling the normal rule to such cost-onl pro%ects. Fou must decide which pro%ect to recommend, and ou should recommend the one with the lower *+ of costs. What is the *+ of costs of the better pro%ect? Cash (utows Fears6 : 1 $ / 0 *ro%ect )ew Tech 1,2:: /12 /12 /12 /12 *ro%ect (ld Tech 4:: 4:: 4:: 4:: 4:: a. b. c. d. e.
-9$,2$1 -9$,/<< -9$,027 -9$,20/ -9$,0$$
Discounting "is2y outos 2;
.
Bid-"tate 3lectric Compan must clean up the water released from its generating plant. The compan&s cost of capital is 1: percent for average-ris! pro%ects, and that rate is normall ad%usted up or down b $ percentage points for high- and low-ris! pro%ects. Clean-up *lan #, which is of average ris!, has an initial cost of -91,::: at Time :, and its operating cost will be -91:: per ear for its 1:-ear life. *lan 8, which is a high-ris! pro%ect, has an initial cost of -9/::, and its annual operating cost over Fears 1 to 1: will be -9$::. What is the proper *+ of costs for the better pro%ect? a. b. c. d. e.
-91,0/:.:0 -91,2$2.;; -91,410.04 -91,40$.:$ -91,7$;.1<
Discounting "is2y outos 2<
.
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Four compan must ensure the safet of its wor! force. Two plans are being considered for the next 1: ears6 1 nstall a high electri5ed fence around the propert at a cost of 91::,:::. Baintenance and electricit would then cost 92,::: per ear over the 1:-ear life of the fence. $ =ire securit guards at a cost of 9$2,::: paid at the end of each ear. 8ecause the compan plans to build new head@uarters with a Nstate of the artO securit sstem in 1: ears, the plan will be in eect onl until that time. Four compan&s cost of capital is 12 percent for average-ris! pro%ects, and that rate is normall ad%usted up or down b $ percentage points for high- and low-ris! pro%ects. *lan 1 is considered to be of low ris! because its costs can be predicted @uite accuratel. *lan 8, on the other hand, is a high-ris! pro%ect because of the diPcult of predicting wage rates. What is the proper *+ of costs for the better pro%ect? a. b. c. d. e.
-91:0,$44.$: -9114,042.:< -91$/,$
Chapter 11 - Page 21
Ris2y p"o1ects 4:
.
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Cochran Corporation has a weighted average cost of capital of 11 percent for pro%ects of average ris!. *ro%ects of below-average ris! have a cost of capital of < percent, while pro%ects of above-average ris! have a cost of capital e@ual to 1/ percent. *ro%ects # and 8 are mutuall exclusive, whereas all other pro%ects are independent. )one of the pro%ects will be repeated. The following table summaries the cash ows, internal rate of return GG, and ris! of each of the pro%ects. Fear : 1 $ / 0
*ro%ect # -9$::,::: 44,::: 44,::: 44,::: 44,:::
*ro%ect 8 -91::,::: /:,::: /:,::: 0:,::: 0:,:::
*ro%ect C -91::,::: /:,::: /:,::: /:,::: 0:,:::
*ro%ect I -91::,::: /:,::: /:,::: 0:,::: 2:,:::
*ro%ect 3 -91::,::: 0:,::: $2,::: /:,::: /2,:::
1$.11:K 8elow #verage
10.:/;K 8elow #verage
1:.;0;K #verage
14.4/4K #bove #verage
11.4/:K #bove #verage
GG *ro%ect Gis!
Which pro%ects will the 5rm select for investment? a. b. c. d. e.
*ro%ects6 *ro%ects6 *ro%ects6 *ro%ects6 *ro%ects6
#, 8, C, I, 3 8, C, I, 3 8, I #, I 8, C, I
cena"io analysis 41
.
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Slott Compan encounters signi5cant uncertaint with its sales volume and price in its primar product. The 5rm uses scenario analsis in order to determine an expected )*+, which it then uses in its budget. The base-case, best-case, and worst-case scenarios and probabilities are provided in the table below. What is Slott&s expected )*+ in thousands of dollars, standard deviation of )*+ in thousands of dollars, and coePcient of variation of )*+? *robabilit of (utcome Worst case :./: 8ase case :.2: 8est case :.$: a. b. c. d. e.
3xpected 3xpected 3xpected 3xpected 3xpected
)*+ )*+ )*+ )*+ )*+
Anit "ales +olume 4,::: 1:,::: 1/,:::
"ales *rice 9/,4:: 0,$:: 0,0::
H 9/2,:::J U )*+ H H 9/2,:::J U)*+ H H 91:,/::J U)*+ H H 91/,<::J U)*+ H H 91:,/::J U)*+ H
)*+ n Thousands -94,::: 1/,::: $;,:::
17,2::J C+)*+ H $.:: 11,447J C+)*+ H :.// 1$,:;/J C+)*+ H 1.17 ;,074J C+)*+ H :.41 1/,<::J C+)*+ H 1./2
+ptimal p"o1ect selection 4$
.
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Qac!son Corporation is evaluating the following four independent, investment opportunities6 *ro%ect # 8 C I
Chapter 11 - Page 22
Cost 9/::,::: 12:,::: $::,::: 0::,:::
Gate of Geturn 10K 1: 1/ 11
Qac!son&s target capital structure is 4: percent debt and 0: percent e@uit. The ield to maturit on the compan&s debt is 1: percent. Qac!son will incur otation costs for a new e@uit issuance of 1$ percent. The growth rate is a constant 4 percent. The stoc! price is currentl 9/2 per share for each of the 1:,::: shares outstanding. Qac!son expects to earn net income of 91::,::: this coming ear and the dividend paout ratio will be 2: percent. f the compan&s tax rate is /: percent, which of the pro%ects will be accepted? a. b. c. d. e.
*ro%ect # *ro%ects # and C *ro%ects #, C, and I #ll of the investment pro%ects will be ta!en. )one of the investment pro%ects will be ta!en.
Tough: .e p"o1ect .&4 4/
.
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8lair 8oo!stores is thin!ing about expanding its facilities. n considering the expansion, 8lair&s 5nance sta has obtained the following information6 •
The expansion will re@uire the compan to purchase toda t H : 92 million of e@uipment. The e@uipment will be depreciated over the following four ears at the following rate6 Fear Fear Fear Fear
•
• •
•
•
•
//K 02 12 7
The expansion will re@uire the compan to increase its net operating wor!ing capital b 92::,::: toda t H :. This net operating wor!ing capital will be recovered at the end of four ears t H 0. The e@uipment is not expected to have an salvage value at the end of four ears. The compan&s operating costs, excluding depreciation, are expected to be 4: percent of the compan&s annual sales. The expansion will increase the compan&s dollar sales. The pro%ected increases, all relative to current sales are6 Fear Fear Fear Fear
•
16 $6 /6 06
16 $6 /6 06
9/.: million /.2 million 0.2 million 0.: million
'or example, in Fear 0 sales will be 90 million more than the would have been had the pro%ect not been underta!en. #fter the fourth ear, the e@uipment will be obsolete, and will no longer provide an additional incremental sales. The compan&s tax rate is 0: percent and the compan&s other divisions are expected to have positive tax liabilities throughout the pro%ect&s life. f the compan proceeds with the expansion, it will need to use a building that the compan alread owns. The building is full depreciatedJ however, the building is currentl leased out. The compan receives 9/::,::: before-tax rental income each ear paable at ear end. f the compan proceeds with the expansion, the compan will no longer receive this rental income. The pro%ect&s W#CC is 1: percent. What is the proposed pro%ects )*+?
Chapter 11 - Page 23
a. b. c. d. e. .e p"o1ect 40
.
-91,:/0,;74 -91,$0;,/7; -91,2;<,;;2 -92,01:,2$/ -9 70;,/7; .&4
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'oxglove Corp. is faced with an investment pro%ect. The following information is associated with this pro%ect6
Fear 1 $ / 0
)et ncomeV 92:,::: 4:,::: 7:,::: 4:,:::
B#CG" Iepreciation Gates :.// :.02 :.12 :.:7
V#ssume no interest expenses and a ero tax rate. The pro%ect involves an initial investment of 91::,::: in e@uipment that falls in the /-ear B#CG" class and has an estimated salvage value of 912,:::. n addition, the compan expects an initial increase in net operating wor!ing capital of 92,::: that will be recovered in Fear 0. The cost of capital for the pro%ect is 1$ percent. What is the pro%ect&s net present value? Gound our 5nal answer to the nearest whole dollar. a. b. c. d. e.
912/,;0: 912<,:71 914$,0:< 914;,4:0 91;$,/00
.e p"o1ect .&4 42
.
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*ierce *roducts is deciding whether it ma!es sense to purchase a new piece of e@uipment. The e@uipment costs 91::,::: paable at t H :. The e@uipment will provide cash inows before taxes and depreciation of 902,::: at the end of each of the next four ears t H 1, $, /, and 0. The e@uipment can be depreciated according to the following schedule6
Fear 1 $ / 0
B#CG" Iepreciation Gates :.// :.02 :.12 :.:7
#t the end of four ears the compan expects to be able to sell the e@uipment for an after-tax salvage value of 91:,:::. The compan is in the 0: percent tax brac!et. The compan has a weighted average cost of capital of 11 percent. 8ecause there is more uncertaint about the salvage value, the compan has chosen to discount the salvage value at 1$ percent. What is the net present value )*+ of purchasing the e@uipment? a. 9 <,10:.7; b. 914,0<;.7$ c. 9$:,240.$/ Chapter 11 - Page 24
d. 9$$,;2/.<: e. 9$;.<;$.40
Chapter 11 - Page 25
.e p"o1ect .&4 44
.
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Dugar ndustries is considering an investment in a proposed pro%ect that re@uires an initial expenditure of 91::,::: at t H :. This expenditure can be depreciated at the following annual rates6
Fear 1 $ / 0 2 4
B#CG" Iepreciation Gates :.$: :./$ :.1< :.1$ :.11 :.:4
The pro%ect has an economic life of six ears. The pro%ect&s revenues are forecasted to be 9<:,::: a ear. The pro%ect&s operating costs not including depreciation are forecasted to be 92:,::: a ear. #fter six ears, the pro%ect&s estimated salvage value is 91:,:::. The compan&s W#CC is 1: percent, and its corporate tax rate is 0: percent. What is the pro%ect&s net present value )*+? a. b. c. d. e.
9/1,4;0 9//,;0/ 9/0,447 9/;,;0: 902,02/
.e p"o1ect -RR 47
.
#fter a long drought, the manager of Dong 8ranch 'arms is considering the installation of an irrigation sstem that will cost 91::,:::. t is estimated that the irrigation sstem will increase revenues b 9$:,2:: annuall, although operating expenses other than depreciation will also increase b 92,:::. The sstem will be depreciated using B#CG" over its depreciable life 2 ears to a ero salvage value. The applicable depreciation rates are $: percent, /$ percent, 1< percent, 1$ percent, 11 percent, and 4 percent. f the tax rate is 0: percent, what is the pro%ect&s GG? a. b. c. d. e.
1$.4K -1./K 1/.:K 1:.$K -0.;K
.&4 and "is26ad1usted discount "ate 4;
.
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>arcia *aper is deciding whether to build a new plant. The proposed pro%ect would have an up-front cost at t H : of 9/: million. The pro%ect&s cost can be depreciated on a straight-line basis over three ears. Conse@uentl, the depreciation expense will be 91: million in each of the 5rst three ears, t H 1, $, and /. 3ven though the pro%ect is depreciated over three ears, the pro%ect has an economic life of 5ve ears. The pro%ect is expected to increase the compan&s sales b 9$: million. "ales will remain at this higher level for each ear of the pro%ect t H 1, $, /, 0, and 2. The operating costs, not including depreciation, e@ual 4: percent of the increase in annual sales. The pro%ect&s interest expense is 92 million per ear and the compan&s tax rate is 0: percent. The compan is ver pro5table, so an accounting losses on this pro%ect can be used to reduce the compan&s overall tax burden. The pro%ect does not re@uire an additions to net operating wor!ing capital. The compan estimates that the pro%ect&s after-tax salvage value at t H 2 will be 91.$ million. The pro%ect is of average ris!, and,
Chapter 11 - Page 26
therefore, the C'( has decided to discount the operating cash ows at the compan&s overall W#CC of 1: percent. =owever, the salvage value is more uncertain, so the C'( has decided to discount it at 1$ percent. What is the net present value )*+ of the proposed pro%ect? a. 911.;4 million b. 910./< million c. -9$4.:0 million d. -91$.22 million e. -9 1.1; million Multiple Part: (The following information applies to the next four problems.) The president of Geal Time nc. has as!ed ou to evaluate the proposed ac@uisition of a new computer. The computer&s price is 90:,:::, and it falls in the B#CG" /-ear class. The applicable depreciation rates are // percent, 02 percent, 12 percent, and 7 percent. *urchase of the computer would re@uire an increase in net operating wor!ing capital of 9$,:::. The computer would increase the 5rm&s before-tax revenues b 9$:,::: per ear but would also increase operating costs b 92,::: per ear. The computer is expected to be used for three ears and then sold for 9$2,:::. The 5rm&s marginal tax rate is 0: percent, and the pro%ect&s cost of capital is 10 percent. .e p"o1ect investment 4<
.
What is the net investment re@uired at t H :?
a. -90$,::: b. -90:,::: c. -9/;,4:: d. -9/7,4:: e. -9/4,4:: +pe"ating cash o 7:
.
9 <,::: 91:,$0: 911,4;7 91/,02/ 914,$::
.on6ope"ating cash os .
91;,1$: 91<,::: 9$1,::: 9$2,::: 9$7,:::
.e p"o1ect .&4 .
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What is the total value of the terminal ear non-operating cash ows at the end of Fear /? a. b. c. d. e.
7$
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What is the operating cash ow in Fear $? a. b. c. d. e.
71
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What is the pro%ect&s )*+? a. 9$,4$$ b. 9$,;:/ Chapter 11 - Page 27
c. 9$,<17 d. 92,71$ e. 94,0/; (The following information applies to the next four problems.) Fou have been as!ed b the president of our compan to evaluate the proposed ac@uisition of a new specialpurpose truc!. The truc!&s basic price is 92:,:::, and it will cost another 91:,::: to modif it for special use b our 5rm. The truc! falls in the B#CG" /-ear class, and it will be sold after three ears for 9$:,:::. The applicable depreciation rates are // percent, 02 percent, 12 percent, and 7 percent. Ase of the truc! will re@uire an increase in net operating wor!ing capital spare parts inventor of 9$,:::. The truc! will have no eect on revenues, but it is expected to save the 5rm 9$:,::: per ear in before-tax operating costs, mainl labor. The 5rm&s marginal tax rate is 0: percent. .e p"o1ect investment 7/
.
What is the net investment in the truc!? That is, what is the Fear : net cash ow?
a. -92:,::: b. -92$,4:: c. -922,;:: d. -94$,::: e. -942,::: +pe"ating cash o 70
.
917,;$: 91;,$20 91<,<$: 9$:,1$1 9$1,7/7
.on6ope"ating cash os .
91:,::: 91$,::: 912,4;: 914,::: 91;,:::
.e p"o1ect .&4 .
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What is the total value of the terminal ear non-operating cash ows at the end of Fear /? a. b. c. d. e.
74
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What is the operating cash ow in Fear 1? a. b. c. d. e.
72
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The truc!&s cost of capital is 1: percent. What is its )*+? a. -91,207 b. -9 24$ c. 9 : d. 9 24$ e. 91,:/0 (The following information applies to the next four problems.)
8ruener Getail is considering opening a new store. n evaluating the proposed pro%ect the compan&s C'( has collected the following information6 Chapter 11 - Page 28
t will cost 91: million to construct the new store. These costs will be incurred at t H :. These costs will be depreciated on a straight-line basis over the next 1: ears. The compan will need an additional 92 million of inventor to stoc! the new store. 9$ million of this inventor will be 5nanced with accounts paable, the other 9/ million will be paid for in cash. The cost of this net increase in operating wor!ing capital will be incurred at t H :. #ssume that this net operating wor!ing capital is full recovered at t H 0. The new store will be open for four ears. Iuring each of the four ears t H 1, $, /, and 0 the store will produce the following 5nancial pro%ections in millions of dollars6
•
•
•
tH1 38TI# Iepreciation 38T 7.: Taxes $.; )et income
tH$ 9;.: 1.: 7.: $.; 0.$
tH/ 9;.: 1.: 7.: $.; 0.$
tH0 9;.: 1.: 7.: $.; 0.$
9;.: 1.:
0.$
8ruener 5nances its pro%ects with 1:: percent e@uitJ thus, there is no interest expense. The compan has a 1: percent weighted average cost of capital. The compan assigns a 7 percent cost of capital for its low-ris! pro%ects, a 1: percent cost of capital for its average-ris! pro%ects, and a 1/ percent cost for its above-average ris! pro%ects. 8ruener estimates that this new store has average ris!, so therefore the proposed pro%ect&s cost of capital is 1: percent. +pe"ating cash os 77
.
What are the pro%ect&s after-tax operating cash ows for each of the four ears? a. b. c. d. e.
9$.; 9/.4 90.$ 90.; 92.$
million million million million million
!5te"6ta3 salvage value 7;
.
90.2 94.: 94.4 94.< 97.2
million million million million million
.e p"o1ect .&4 .
!nse": d Di#: M .
The C'( estimates that the store can be sold after four ears for 97.2 million. 8ruener&s tax rate is 0: percent. What is the store&s after-tax salvage value at t H 0? a. b. c. d. e.
7<
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#ssuming the store is sold after four ears for 97.2 million, what is the pro%ect&s net present value )*+? a. b. c. d. e.
9 4.;7 million 9 7.0< million 9 7.<< million 91:.$2 million 91:.42 million
cena"io analysis
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Chapter 11 - Page 29
;:
.
#fter ta!ing into account all of the relevant cash ows from the previous @uestion, the compan&s C'( has estimated the pro%ect&s )*+ and has also put together the following scenario analsis6 "cenario Count taxes increased Count taxes unchanged Count taxes decreased
*rob. of "cenario (ccurring $2K 2: $2
3xpected )*+ 9 2 million ; million 1: million
(n the basis of the numbers calculated above, the C'( estimates that the standard deviation of the pro%ect&s )*+ is $.:4. The compan tpicall calculates a pro%ect&s coePcient of variation C+ and uses this information to assess the pro%ect&s ris!. =ere is the scale that 8ruener uses to evaluate pro%ect ris!6 Gange for CoePcient of +ariation C+ C+ :./ :.$ X C+ X :./ C+ X :.$
Gis! #ssessment =igh ris! #verage ris! Dow ris!
*ro%ect&s W#CC 1$K 1: ;
(n the basis of this scenario analsis, which of the following statements is most correct? a. The pro%ect&s expected )*+ is 97.72 million. b. The pro%ect would be classi5ed as an average-ris! pro%ect. c. f the pro%ect were classi5ed as a high-ris! pro%ect, the compan should go bac! and recalculate the pro%ect&s )*+ using the higher cost o f capital estimate. d. "tatements a and b are correct. e. #ll of the statements above are correct. (The following information applies to the next two problems.) Bitts 8everage nc. manufactures and distributes fruit %uice products. Bitts is considering the development of a new prune %uice product. Bitts& C'( has collected the following information regarding the proposed pro%ect6 The pro%ect can be operated at the compan&s Iaton plant, which is currentl vacant. The pro%ect will re@uire that the compan spend 91 million toda t H : to purchase a new machine. 'or tax purposes, the e@uipment will be depreciated on a straight-line basis. The compan plans to use the machine for all / ears of the pro%ect. #t t H /, the e@uipment is expected to have no salvage value. The pro%ect will re@uire a 9$::,::: increase in net operating wor!ing capital at t H :. The cost of the net operating wor!ing capital will be full recovered at t H /. The pro%ect is expected to increase the compan&s sales 91 million a ear for three ears t H 1, $, and /. The pro%ect&s annual operating costs excluding depreciation are expected to be 4: percent of sales. The compan&s tax rate is 0: percent. The compan is extremel pro5table, so an losses incurred from the prune %uice pro%ect can be used to partiall oset taxes paid on the compan&s other pro%ects. The pro%ect has a W#CC e@ual to 1: percent.
• •
•
•
• • •
•
.e p"o1ect .&4 ;1
.
What is the pro%ect&s net present value? a. -914$,4$1 b. -912<,040
Chapter 11 - Page 30
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c. -910$,:/2 d. -91/2,$:1 e. -91$1,/1/ !5te"6ta3 salvage value ;$
.
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There is a possibilit that the compan ma be forced to end the pro%ect after onl the second ear. f forced to end the pro%ect, the compan will have to sell its e@uipment. f it sells its e@uipment after the second ear, Bitts expects to sell it for 90::,:::. What is the after-tax salvage value that would be incorporated into the pro%ect&s cash ow analsis? a. b. c. d. e.
9/;/,///.// 9/4$,000.2: 9/7/,///.// 9/;/,///.// 90::,:::.:: (The following information applies to the next two problems.)
8uchol 8rands is considering the development of a new !etchup product. The !etchup will be sold in a variet of dierent colors and will be mar!eted to oung children. n evaluating the proposed pro%ect, the compan has collected the following information6 The compan estimates that the pro%ect will last for four ears. The compan will need to purchase new machiner that has an up-front cost of 9/:: million incurred at t H :. #t t H 0, the machiner has an estimated salvage value of 92: million. The machiner will be depreciated on a 0-ear straight-line basis. *roduction on the new !etchup product will ta!e place in a recentl vacated facilit that the compan owns. The facilit is empt and 8uchol does not intend to lease the facilit. The pro%ect will re@uire a 94: million increase in inventor at t H :. The compan expects that its accounts paable will rise b 91: million at t H :. #fter t H :, there will be no changes in net operating wor!ing capital, until t H 0 when the pro%ect is completed, and the net operating wor!ing capital is completel recovered. The compan estimates that sales of the new !etchup will be 9$:: million each of the next four ears. The operating costs, excluding depreciation, are expected to be 91:: million each ear. The compan&s tax rate is 0: percent. The pro%ect&s W#CC is 1: percent.
• •
• •
•
• • • •
+pe"ating cash os ;/
.
What is the pro%ect&s after-tax operating cash ow the 5rst ear t H 1? a. b. c. d. e.
9$$.2 902.: 94:.: 97$.2 9<:.:
million million million million million
.e p"o1ect .&4 ;0
.
!nse": e Di#: M .
!nse": a Di#: M .
What is the pro%ect&s estimated net present value )*+? a. b. c. d.
-91:.:7 -9$2.<$ -904.01 -94:.:7
million million million million Chapter 11 - Page 31
e. 9 2.7; million e$ !ppendi3 ''! Multiple Choice: Conceptual Easy: .&4 and dep"eciation 11#- ;2.
!nse": c Di#: E
(ther things held constant, which of the following would increase the )*+ of a pro%ect being considered? a. # shift from B#CG" to straight-line depreciation. b. Ba!ing the initial investment in the 5rst ear rather than spreading it over the 5rst three ears. c. # decrease in the discount rate associated with the pro%ect. d. #n increase in re@uired net operating wor!ing capital. e. #ll of the statements above will increase the pro%ect&s )*+.
Medium: Dep"eciation cash os 11#- ;4.
!nse": c Di#: M
Which of the following statement completions is incorrect? 'or a pro5table 5rm, when B#CG" accelerated depreciation is compared to straight-line depreciation, B#CG" accelerated allowances produce a. b. c. d.
=igher depreciation charges in the earl ears of an asset&s life. Darger cash ows in the earlier ears of an asset&s life. Darger total undiscounted pro5ts from the pro%ect over the pro%ect&s life. "maller accounting pro5ts in the earl ears, assuming the compan uses the same depreciation method for tax and boo! purposes. e. )one of the statements above. #ll of the statements above are correct. e$ !ppendi3 ''7 Multiple Choice: Conceptual Medium: Replacement cash outos 118-;7.
!nse": d Di#: M
>iven the following information, what is the re@uired cash outow associated with the ac@uisition of a new machineJ that is, in a pro%ect analsis, what is the cash outow at t H :? *urchase price of new machine 9;,::: nstallation charge $,::: Bar!et value of old machine $,::: 8oo! value of old machine 1,::: nventor decrease if new machine is installed 1,::: #ccounts paable increase if new machine is installed 2:: Tax rate /2K Cost of capital 12K a. b. c. d.
Chapter 11 - Page 32
-9 -9 -9 -9
;,<;: 4,04: 2,$:: 4,;2:
e. -91$,:$: Tough: Replacement decision 118-;;.
!nse": $ Di#: T
Topsider nc. is considering the purchase of a new leather-cutting machine to replace an existing machine that has a boo! value of 9/,::: and can be sold for 91,2::. The old machine is being depreciated on a straight-line basis, and its estimated salvage value / ears from now is ero. The new machine will reduce costs before taxes b 97,::: per ear. The new machine has a /-ear life, it costs 910,:::, and it can be sold for an expected 9$,::: at the end of the third ear. The new machine would be depreciated over its /-ear life using the B#CG" method. The applicable depreciation rates are :.//, :.02, :.12, and :.:7. #ssuming a 0: percent tax rate and a cost of capital of 14 percent, 5nd the new machines )*+. a. -9 $,;$$ b. 9 1,42; c. 9 0,24: d. 912,/70 e. 9 <,;$1
Replacement decision 118-;<.
!nse": a Di#: T
Beals on Wings nc. supplies prepared meals for corporate aircraft as opposed to public commercial airlines, and it needs to purchase new broilers. f the broilers are purchased, the will replace old broilers purchased 1: ears ago for 91:2,::: and which are being depreciated on a straight-line basis to a ero salvage value 12-ear depreciable life. The old broilers can be sold for 94:,:::. The new broilers will cost 9$::,::: installed and will be depreciated using B#CG" over their 2-ear class lifeJ the will be sold at their boo! value at the end of the 5fth ear. The applicable depreciation rates are :.$:, :./$, :.1<, :.1$, :.11, and :.:4. The 5rm expects to increase its revenues b 91;,::: per ear if the new broilers are purchased, but cash expenses will also increase b 9$,2:: per ear. f the 5rms cost of capital is 1: percent and its tax rate is /2 percent, what is the )*+ of the broilers? a. -94:,400 b. 917,<7$ c. 9$;,021 d. -900,22/ e. 9 2,:$1
Replacement decision 118-<:.
!nse": c Di#: T
Boms Coo!ies nc. is considering the purchase of a new coo!ie oven. The original cost of the old oven was 9/:,:::J it is now 2 ears old, and it has a current mar!et value of 91/,///.//. The old oven is being depreciated over a 1:-ear life toward a ero estimated salvage value on a straight-line basis, resulting in a current boo! value of 912,::: and an annual depreciation expense of 9/,:::. The old oven can be used for 4 more ears but has no mar!et value after its depreciable life is over. Banagement is contemplating the purchase of a new oven whose cost is 9$2,::: and whose estimated salvage value is ero. 3xpected before-tax cash savings from the new oven are 90,::: a ear over its full B#CG" depreciable life. Iepreciation is computed using B#CG" over a 2-ear life, and the cost of capital is 1: percent. The applicable depreciation rates are :.$:, :./$, :.1<, :.1$, :.11, and Chapter 11 - Page 33
:.:4. #ssume a 0: percent tax rate. What is the net present value of the new oven? a. -9$,01; b. -91,7/1 c. 9$,4/2 d. 9 14/ e. 91,7/1 Replacement p"o1ect -RR 118-<1.
!nse": c Di#: T
Tech 3ngineering Compan is considering the purchase of a new machine to replace an existing one. The old machine was purchased 2 ears ago at a cost of 9$:,:::, and it is being depreciated on a straight-line basis to a ero salvage value over a 1:-ear life. The current mar!et value of the old machine is 910,:::. The new machine, which falls into the B#CG" 2-ear class, has an estimated life of 2 ears, it costs 9/:,:::, and Tech plans to sell the machine at the end of the 5fth ear for 91,:::. The applicable depreciation rates are :.$:, :./$, :.1<, :.1$, :.11, and :.:4. The new machine is expected to generate before-tax cash savings of 9/,::: per ear. The compans tax rate is 0: percent. What is the GG of the proposed pro%ect?
a. 0.1K b. $.$K c. :.:K d. -1.2K e. -/./K Replacement p"o1ect 118-<$.
!nse": d Di#: T
EFY Banufacturing Corporation currentl has production e@uipment that has 0 ears of remaining life. The e@uipment was purchased a ear ago at a cost of 91:,:::. The annual depreciation for this machine is 91,;:: and its expected salvage value is 91,:::. The e@uipment can be sold toda for 9;,:::. The compan has been considering the purchase of a new machine that will replace the existing one. The new e@uipment costs 912,::: and would increase sales through increased production b 9$,::: per ear and decrease operating costs b 91,::: per ear. The e@uipment falls into the /-ear B#CG" class and will be worthless after 0 ears. The applicable depreciation rates are :.//, :.02, :.12, and :.:7. The compans tax rate is 0: percent and its cost of capital is 1$ percent. 8 how much would the value of the compan change if it accepts the replacement pro%ect?
a. 9$,11$.:2 b. 9 / 1;.$7 c. -92,;;7.<2 d. 9 2 2$.4$ e. 91,0<7.<1 .e p"o1ect .&4 118-
!nse": d Di#: T
'oxglove Corp. is faced with an investment pro%ect. The following information is associated with this pro%ect6
Fear 1 $ Chapter 11 - Page 34
)et ncomeV 92:,::: 4:,:::
B#CG" Iepreciation Gates :.// :.02
/ 0
7:,::: 4:,:::
:.12 :.:7
V#ssume no interest expenses and a ero tax rate. The pro%ect involves an initial investment of 91::,::: in e@uipment that falls in the /-ear B#CG" class and has an estimated salvage value of 912,:::. n addition, the compan expects an initial increase in net wor!ing capital of 92,::: which will be recovered in ear 0. The cost of capital for the pro%ect is 1$ percent. What is the pro%ect&s net present value? Gound our 5nal answer to the nearest whole dollar. a. b. c. d. e.
912/,;0: 912<,:71 914$,0:< 914;,4:0 91;$,/00
Chapter 11 - Page 35
!.ER C%!&TER !.D +*8T-+. ''
1.
Relevant cash flows
Answer: d
Diff: E
Statements a and c are true; therefore, statement d is the correct answer. Net cash flow = Net income + depreciation; therefore, depreciation affects operating cash flows. Sunk costs should be disregarded when making investment decisions, while opportunity costs should be considered when making investment decisions, as they represent the best alternative use of an asset. .
Relevant cash flows
Answer: c
Diff: E
!he correct answer is c. Sunk costs should be e"cluded from the analysis, and interest e"pense is incorporated in the #$%% so it should not be incorporated in the pro&ect's cash flows. (.
Relevant cash flows
Answer: d
Diff: E
Sunk costs should be ignored, but e"ternalities and opportunity costs should be included in the pro&ect evaluation. !herefore, the correct choice is statement d. ).
Relevant cash flows
Answer: b
Diff: E
Sunk costs are never included in pro&ect cash flows, so statement a is false. *"ternalities are always included, so statement b is true. Since the weighted average cost of capital includes the cost of debt, and this is the discount rate used to evaluate pro&ect cash flows, interest e"pense should not be included in pro&ect cash flows. !herefore, statement c is false. .
Relevant cash flows
Answer: c
Diff: E
.
Relevant cash flows
Answer: b
Diff: E
N
-.
Relevant cash flows
Answer: d
Diff: E
N
!he correct answer is statement d. Statement a is a sunk cost and should not be included. Statement b is an opportunity cost and should be included. Statement c is an e"ternality and should be included. !herefore, statement d is the correct choice.
.
Relevant Answer: d
cash Diff: E
flows N
!he correct answer is statement d. Statement c is incorrect because it is a sunk cost. /oth statements a and b are correct, since statement a impacts e"pected cash flows and statement b is a relevant opportunity cost. 0.
Relevant cash flows
Answer: d
Diff: E
N
!he correct answer is statement d. Statement a is correct. !his represents a future loss in revenue to the firm. Statement b is also correct because the firm needs to consider the best alternative use of the land. Statement c, on the other hand, is N! correct since it represents a sunk cost. So, Statement d is the correct choice. 12.
Relevant and incremental cash flows
Answer: a
Diff: E
N
Statement a is true; the other statements are false. 3f the company lost two other accounts with positive N45s, this would obviously be a huge negative when considering the proposed pro&ect. 3f the firm has an option to abandon a pro&ect if it is unprofitable, this would make the company more likely to accept the pro&ect. $n option to repeat a pro&ect is a plus not a negative. 11.
New project cash flows
Answer: a
Diff: E
N
Statement a is true; the others are false. 6epreciation cash flows must be considered when calculating operating cash flows. 3n addition, e"ternality cash flows should be considered; however, sunk costs are not included in the analysis. 1.
Corporate risk
Answer: b
Diff: E
1(.
Risk analysis
Answer: e
Diff: E
1).
Risk analysis
Answer: c
Diff: E
Statement a is false. Stand7alone risk is measured by standard deviation. !herefore, since 8's standard deviation is higher than 9's, 8 has higher stand7 alone risk than 9. Statement b is false. %orporate risk is measured by the correlation of pro&ect cash flows with other company cash flows. !herefore, since 8's cash flows are highly correlated with the cash flows of e"isting pro&ects, while 9's are not, 8 has higher corporate risk than 9. :arket risk is measured by beta. !herefore, since 9's beta is greater than 8's, statement c is true. 1.
Risk analysis
Answer: a
Diff: E
N
!he correct answer is statement a. Since the proposed new pro&ect has a higher standard deviation than the firm's typical pro&ect, it has more stand7alone risk than the firm's typical pro&ect. Statement b is incorrect; it will actually lower corporate risk. Statement c is incorrect; we do not know what effect the pro&ect will have on the firm's market risk. 1.
Risk analysis
Answer: e
Diff: E
N
!he correct answer is statement e. Statement a comes directly from the first sentence. Statement c comes from the second sentence. Statements b and d follow directly from the third sentence. 1-.
Accepting risky projects
Answer: e
Diff: E
1.
Risk adjstment
Answer: b
Diff: E
10.
Risk and project selection
Answer: b
Diff: E
2.
Risk and project selection
Answer: c
Diff: E
6etermine the reuired rate of return on each pro&ect.
4ro&ect $
*"pected eturn 1>
isk
euired return for the risk level 1>
/ % 6 *
1 11 0
$verage
12 1
!he company will accept all pro&ects whose e"pected return e"ceeds reuired return. !herefore, it will accept 4ro&ects $, /, and 6. 1.
!ensitivity" scenario" and simlation analyses
Answer: c
its
Diff: E
Statement a is false; sensitivity analysis measures a pro&ect's stand7alone risk. Statement b is false; sensitivity analysis doesn't consider probabilities, while scenario analysis does. Statement c is true. .
Cash flows and acconting measres
Answer: d
Diff: #
(.
Relevant cash flows
Answer: d
Diff: #
Statements b and c are true; therefore, statement d is the correct choice. !he @( million spent on researching the technology is a sunk cost and should not be considered in the investment decision. ).
Relevant cash flows
Answer: d
Diff: #
Statement a is a sunk cost and sunk costs are never included in the capital budgeting analysis. !herefore, statement a is not included. Statement b is an opportunity cost and should be included in the capital budgeting analysis. Statement c is the cannibaliAation of e"isting products, which will cause the company to forgo cash flows and profits in another division. !herefore, it is included in the capital budgeting analysis. !herefore, the correct answer is statement d.
.
Relevant cash flows
Answer: d
Diff: #
Statements b and c are true; therefore, statement d is the correct choice. !he cost of clearing the land is a sunk cost and should not be considered in the analysis. !he e"pected impact of the new store on the e"isting store should be considered. 3n addition, the opportunity to lease the land represents an opportunity cost of opening the new store on the land and should be considered. .
Relevant cash flows
Answer: d
Diff: #
Statements a and c are true; therefore, statement d is the correct choice. *"ternalities and opportunity costs should be considered in the analysis, while sunk costs should not be included. -.
$ncremental cash flows
Answer: d
Diff: #
.
$ncremental cash flows
Answer: d
Diff: #
0.
Cash flow estimation
Answer: b
Diff: #
(2.
Cash flow estimation
Answer: d
Diff: #
Statement d is true. !he forgone rent is an Bopportunity costC that should be charged to the pro&ect under consideration. Note that Statements a and b are false. !he cash flows should not consider interest because financial costs are included in the analysis by discounting at the #$%%. 3f interest were deducted to find cash flows, then this cost would be Bdouble counted,C and the N45 would be downward biased. 3gnoring interest when determining cash flows produces no bias in the N45 whatsoever. Note also that e"ternalities can be either positive or negative77they tend to be negative if the new pro&ect is a substitute for an e"isting product, but positive if the new pro&ect is complementary to the firm's other products. (1.
Corporate risk
Answer: e
Diff: #
(.
!ensitivity" scenario" and simlation analyses
Answer: a
Diff: #
((.
#onte Carlo simlation
Answer: e
Diff: #
().
Risk adjstment
Answer: a
Diff: #
k$ = 1(> 7 (> = 12>. 3f the cash flows are cost7only outflows, and the analyst wants to correctly reflect their risk, the discount rate should be ad&usted downward Din this case by subtracting ( percentage pointsE to make the discounted flows comparatively larger.
(
.
%a&es
on
gain
Answer: b
on
sale
Diff: E
#hen the machine is sold the total accumulated depreciation on it isF D2.2 + 2.( + 2.10E × @1,222,222 = @-12,222. !he book value of the euipment isF @1,222,222 7 @-12,222 = @02,222. !he machine is sold for @)22,222, so the gain is @)22,222 7 @02,222 = @112,222. !a"es are calculated as @112,222 × 2.) = @)),222. (.
$nventory and N'(
Answer: d
Diff: E
N
#e are given the up7front cost. !he new software system's cash flows are the annual cash amounts freed up by not having to invest in inventory. 2 1 ( ) 8ears 12> G G G G G G 7-,222,222 +22,222,222 +22,222,222 +22,222,222 +(22,222,222 +(22,222,222
N45 = 7@-,222,222 + +
@22,222,222
@(22,222,222 )
D1.1E
D1.1E
+
+
@22,222,222
D1.1E
+
@22,222,222 (
D1.1E
@(22,222,222 +
D1.1E
N45 = 7@-,222,222 + @11,1,222 + @1,0,222 + @12,(,222 + @2),02),222 + @1,-,222 N45 = @1(,2,222.
(-.
N'( with e&ternalities
Answer: c
Diff: E
Step 1F
%alculate the N45 of the negative e"ternalities due to the cannibaliAation of e"isting pro&ectsF *nter the following input data in the calculatorF %H2 = 2 ; %H 1712 = 722222; 3 = 12; and then solve for N45 = @(,2-,(..
Step F
ecalculate the new pro&ect's N45 after considering e"ternalitiesF + @(,222,222 7 @(,2-,(. = 7@-,(..
(
.
After)ta& Answer: c
salvage Diff: #
vale N
!he book value of the machinery at the end of 8ear ) is 2.1- × @(22,222,222 = @1,222,222. !he salvage value of the machinery is @2,222,222, so the company has a loss of @2,222,222 7 @1,222,222 = @1,222,222.
(0.
New project N'( !ime lineF 2 k = 1> 1 G G 7(,222 1,- N45 = I
Answer: e
G 1,02
Diff: #
( 8ears G 1,1
6epreciation cash flowsF 8ear 1 ( )
:$%S 6epreciation ates 2.(( 2.) 2.1 2.2-
6epreciable /asis @),222 ),222 ),222 ),222
$nnual 6epreciation @1,(2 1,22 22 2 @),222
4ro&ect analysis worksheetF 2 3
33
3nitial outlay 1E %ost E 6ecrease in N#% (E !otal net investment perating flowsF )E */! and depreciation E per. income after ta"es Dline ) × 2.E E 6epreciation Dfrom tableE -E !a" savings from
1
(
D@),222E 1,222 D@(,222E @,222
@,222
@,222
1,22 1,(2
1,22 1,22
1,22 22
depreciation Dline × 2.)E E Net operating cash flows Dlines + -E 333 !erminal year cash flowsF 0E *stimated salvage value 12E !a" on salvage value DD@1,222 7 @2E × 2.)E 11E eturn of N#% 1E !otal termination %Hs 35 Net cash flowsF JJJJJJ 1(E Net %Hs D@(,222E Numerical solutionF @1,- N45 = 7@(,222 + 1.1
+
@1,02
D1.1E
+
@1,1+ (
D1.1E
-2
)2
@1,-
@1,02
@1,))2 @1,222
JJJJJJ @1,-
DE D1,222E D@ E JJJJJJ @1,1
JJJJJJ @1,02
= @)).) K @)).
Hinancial calculator solutionF 3nputsF %H 2 = 7(222; %H 1 = 1-; %H = 102; %H ( = 1,1; 3 = 1. utputF N45 = @)).) ≈ @)).
)2.
New project N'(
!ime lineF 2 1 k = 1> G G 7)+,222 -,22 N45 = I
Answer: d
G 12,2
6epreciation cash flowsF :$%S 6epreciation 8ear ates 1 2.2 2.( ( 2.10 ) 2.1 2.11 2.2
( G -,+2
) G +,2
6epreciable /asis @2,222 2,222 2,222 2,222 2,222 2,222
Diff: #
+ 8ears G 71,02
$nnual 6epreciation @1,222 10,22 11,)22 -,22 ,22 (,22 @2,222
4ro&ect analysis worksheetF 2 1 ( 3nitial outlay 1E :achine cost D@2,222E E 6ecrease in N#% 1,222 (E !otal net inv. D@),222E 33 perating cash flows )E /! eduction in cost @ ,222 @ ,222 @ ,222 @ E $fter7ta" dec. in cost (,222 (,222 (,222 E 6eprec. Dfrom tableE 1,222 10,22 11,)22 -E !a" savings deprec. Dline × 2.)E ),22 -,2 ),2 E Net operating %Hs Dlines + -E @ -,22 @12,2 @ -,2 @ 333 !erminal year %Hs 0E *stimated salvage value 12E !a" on salvage value LD@12,222 7 @(,22ED2.)EM
)
3
,222 @ ,222 (,222 (,222 -,22 ,22 ,2
,)2
,2 @ ,)2 @12,222 D,2E
11E 1E 35 Net 1(E
eturn of N#% D1,222E !otal termination %Hs D-,2E %Hs JJJJJJJ JJJJJJJ JJJJJJJ JJJJJJJ JJJJJJJ JJJJJJJ Net %Hs D@),222E @ -,22 @12,2 @ -,2 @ ,2D@ 1,02E
Numerical solutionF @-,22 @12,2 + N45 = 7@),222 + 1.1 D1.1E = 7@1,)0(.) K 7@1,)0(.
+
@-,+2 (
D1.1E
+
@+,2 )
D1.1E
+
−@1,02 +
D1.1E
Hinancial calculator solutionF 3nputsF %H2 = 7)222; %H1 = -22; %H = 122; %H ( = -2; %H) = 2; %H = 7102; 3 = 1. utputF N45 = 7@1,)0(.) ≈ 7@1,)0(.
)1.
New project N'(
!ime lineF 2 k = 0> G 7)2,222 N45 = I
1 G 0,22
Answer: b
G 11,-2
( G 0,)2
6epreciation cash flowsF :$%S 6epreciation 8ear ates 1 2.2 2.( ( 2.10 ) 2.1 2.11 2.2
) G ,+2
6epreciable /asis @)2,222 )2,222 )2,222 )2,222 )2,222 )2,222
Diff: #
+ 8ears G 1+,(2
$nnual 6epreciation @ ,222 1,22 -,22 ),22 ),)22 ,)22 @)2,222
4ro&ect analysis worksheetF 2 3nitial outlay 1E :achine cost D@)2,222E E N#% 77 (E !otal net inv. D@)2,222E 33 perating cash flows )E 3nc. in earnings before deprec. ta"es @ E $fter7ta" increase in earnings Dline ) × 2.E E /efore ta" reduction in cost -E $fter ta" reduction in cost Dline × 2.)E E 6eprec. Dfrom tableE 0E 6eprec. ta" savings Dline × 2.)E 12E Net operating %Hs Dlines + - + 0E @ 333 !erminal year %Hs 11E *stimated salvage value 1E !a" on salvage value LD@12,222 7 @,)22ED2.)EM 1(E eturn of N#% 1)E !otal termination %Hs
1
(
)
3
,222 @ ,222 @ ,222 @ ,222 @ ,222 (,22
(,22
(,22
(,22
(,22
,222
,222
,222
,222
,222
(,222 ,222
(,222 1,22
(,222 -,22
(,222 ),22
(,222 ),)22
(,22
,12
(,2)2
1,02
1,-2
0,22 @11,-2 @ 0,)2 @ ,2 @ ,(2 @12,222 D(,2)2E 77 ,02
35
Net %Hs 1E Net %Hs
JJJJJJJ JJJJJJJ JJJJJJJ JJJJJJJ JJJJJJJ JJJJJJJ D@)2,222E @ 0,22 @11,-2 @ 0,)2 @ ,2 @1,(2
Numerical solutionF @0,22 @11,-2 + N45 = 7@)2,222 + 1.20 D1.20E = @,01.02 K @,0.
+
@0,)2 (
D1.20E
+
@,+2 )
D1.20E
+
@1+,(2 +
D1.20E
Hinancial calculator solutionF 3nputsF %H 2 = 7)2222; %H 1 = 022; %H = 11-2; %H ( = 0)2; %H) = 2; %H = 1(2; 3 = 0. utputF N45 = @,01.02 ≈ @,0. ).
New project N'(
*uipment purchase N#%
Answer: a
7@
2 22,222 72,222
Sales increase perating costs 6epreciation per. inc. before ta"es !a"es D(>E per. inc. after ta"es +6epreciation perating cash flow ecovery of N#% *uipment sale !a"es on sale JJJJJJJJJJJ Net %Hs 7@ 2,222
1
Diff: #
(
@,222,222 1,)22,222 22,222 @ )22,222 1)2,222 @ 2,222 22,222 @ )2,222
@,222,222 1,)22,222 22,222 @ )22,222 1)2,222 @ 2,222 22,222 @ )2,222
JJJJJJJJJJ @ )2,222
JJJJJJJJJJ @ )2,222
@,222,222 1,)22,222 22,222 @ )22,222 1)2,222 @ 2,222 22,222 @ )2,222 2,222 +122,222 7(,222 @ -,222
N45 = 7@2,222 + @)2,222O1.1 + @)2,222OD1.1E + @-,222OD1.1E ( = 7@2,222 + @)12,-1).0 + @(,-20.1 + @)20,-(.) = @(,0-.11 ≈ @(,0-. )( .
New project N'(
Answer: b
6epreciation cash flowsF :$%S 6epreciation 8ear ates 1 2.(( 2.) ( 2.1 ) 2.28ear 4ro&ect cost N#%P
2 7@,222,222 7(22,222
1
6epreciable /asis @,222,222 @,222,222 @,222,222 @,222,222
Sales @(,222,222 @),222,222 perating costs D->E ,2,222 (,222,222 6epreciation 1,2,222 ,2,222 per. inc. before ta"es 7@ 022,222 7@1,2,222 !a"es D)2>E 7(2,222 722,222 per. inc. after ta"es 7@ )2,222 7@ -2,222 4lusF 6epreciation 1,2,222 ,2,222 perating %H @1,112,222 @1,22,222 ecovery of N#% Net %Hs 7@,(22,222 @1,112,222 @1,22,222
Diff: #
$nnual 6epreciation @1,2,222 ,2,222 -2,222 (2,222 @,222,222 (
)
@,222,222 (,-2,222 -2,222 @ 22,222 22,222 @ (22,222 -2,222 @1,22,222
@,222,222 1,22,222 (2,222 @ 12,222 2,222 @ 02,222 (2,222 @ ))2,222 (22,222 @ -)2,222
@1,22,222
P$n increase in inventories is a use of funds for the company, and an increase in accounts payable is a source of funds for the company. !hus, the change in net operating working capital will be @22,222 7 @22,222 = 7@(22,222 at time 2.
N45 = 7@,(22,222 + @1,112,222O1.12 + @1,22,222OD1.12E + @1,22,222OD1.12E ( + @-)2,222OD1.12E ) N45 = 7@,(22,222 + @1,220,201 + @1,(0,0 + @-,1 + @2,)(2 N45 = 7@1,-,00. ))
.
New
project
Answer: a
6epreciation cash flowsF :$%S 6epreciation 8ear ates 1 2.(( 2.) ( 2.1 ) 2.2-
4ro&ect cost N#%
2 D@22,222E D)2,222E
Sales perating costs 6epreciation per. costs bef. ta"es !a"es D)2>E per. costs after ta"es 4lusF 6epreciation ecovery of N#% Net %Hs D@)2,222E N45
).
6epreciable /asis @22,222 22,222 22,222 22,222
1
@22,222 )2,222 1,222 @1,222 ,222 @ 0(,222 1,222 JJJJJJJJ @,222
Diff: #
$nnual 6epreciation @1,222 ,222 -,222 (,222 @22,222
(
@22,222 )2,222 ,222 @ 0,222 (,222 @ -,222 ,222 JJJJJJJJ @,222
@22,222 (22,222 -,222 @1,222 2,222 @ -,222 -,222 JJJJJJJJ @12,222
)
@22,222 (22,222 (,222 @1,222 ,222 @ 00,222 (,222 )2,222 @1-),222
7@)2,222 + @,222O1.12 + @,222OD1.12E + @12,222OD1.12E( @1-),222OD1.12E) = 7@)2,222 + @(),).) + @((,2-. + @11,0-. + @11,)).() = @10,1)). ≈ @10,1). =
New project N'(
%ost N#%
Answer: b
2 D@1,222E D22E
Sales %osts 6epreciation per. inc. before ta"es !a"es D)2>E per. inc. after ta"es $dd 6epreciation perating %Hs Salvage value !a" on S5 ecovery of N#% Net %Hs D@1,22E
1
@022 )2 22 D@ 2E D2E D@ (2E 22 @)-2
@022 )2 (22 @12 2 @ 02 (22 @(02
@)-2
@(02
N'(
(
@022 )2 22 @2 122 @12 22 @(2 122 D)2E 22 @12
Diff: #
+
2 k = 12> 1 G G 71,22 )-2
N45 = 7@1,22
+
@)-2 1.12
+
@(02
D1.12E
+
G (02
( 8ears G 12
@12 (
D1.12E
= @-.0. ).
New project N'(
Answer: a 2 k = 1> G 72,222
%ost
Sales 5% 6epreciation per. inc. before ta"es !a"es D)2>E per. inc. after ta"es 6epreciation perating %Hs N#% D1,222E $! Salvage JJJJJJJ N%Hs D@,222E N45 = 7@,222 )-
+
@(),222 1.1+
+
1 G
G
@2,222 2,222 )2,222 D@12,222E D),222E D@ ,222E )2,222 @(),222
@2,222 2,222 ,222 @,222 12,222 @1,222 ,222 @2,222
JJJJJJJ @(),222
JJJJJJJ @2,222
@2,222
D1.1+E
+
@(,222 (
D1.1+E
( G
@2,222 2,222 ,222 @,222 12,222 @1,222 ,222 @2,222 1,222 ,222 @(,222
= @-,-(.-1.
Diff: #
8ears
.
New project N'(
Answer: d
Diff: #
!he euipment is purchased for @12,222,222 and is depreciated over years. !he depreciation table looks like thisF 8ear 1 ( )
Straight7?ine 6epreciation ate 1O 1O 1O 1O 1O
6epreciation @,222,222 ,222,222 ,222,222 ,222,222 ,222,222
/ook 5alue @,222,222 ,222,222 ),222,222 ,222,222 2
Notice that the pro&ect has a life of only ) years, while the euipment is depreciated over years. $t the end of 8ear ), the company sells the euipment for @( million, but its book value is only @ million. !he euipment is sold for @1 million more than its book value; therefore, the firm will be ta"ed on this @1 million. %onseuently, at the end of the pro&ect, it receives @( million for the sale, but it has to pay @)22,222 in ta"es D)2> of @1 millionE. Net operating working capital reuired at t = 2 will be @1 million. D3nventories are a use of working capital, so they increase operating working capital by @ million. $ccounts payable are a source of operating working capital, so they decrease operating working capital by @1 million. Net operating working capital increases by @1 millionE. emember that the firm gets this back at t = ). 8ear 2 Sales p. costs 6ep'n per. inc. before ta"es !a"es D)2>E per. inc. after ta"es 6ep'n per. cash flow *uipment cost D@12,222,222E !a"es on sale %hange in N#% D1,222,222E Net cash flow D@11,222,222E
1 @ -,222,222 (,222,222 ,222,222 @ ,222,222 22,222 @ 1,22,222 ,222,222 @ (,22,222
@ -,222,222 (,222,222 ,222,222 @ ,222,222 22,222 @ 1,22,222 ,222,222 @ (,22,222
( @ -,222,222 (,222,222 ,222,222 @ ,222,222 22,222 @ 1,22,222 ,222,222 @ (,22,222
@ (,22,222
@ (,22,222
@ (,22,222
) @ -,222,222 (,222,222 ,222,222 @ ,222,222 22,222 @ 1,22,222 ,222,222 @ (,22,222 (,222,222 D)22,222E 1,222,222 @ ,22,222
Now, enter the net cash flows into the cash flow register and enter the discount rate, 3O8 = 1, and solve for the pro&ect's N45 = @1,22-,(( ≈ @1.21 million.
).
New project N'(
Answer: e
2 7@22,222 7(2,222
*uipment outlay %hange in N#% Sales p. costs e"cl.deprec. D-2>E 6epreciation per. inc. before ta"es !a"es D)2>E per. inc. after ta"es $dd backF 6epreciation per. cash flows $! salvage value ecovery of N#% Net cash flows 7@(2,222
Diff: #
1
(
@1,222,222 -22,222 122,222 @ 22,222 2,222 @ 12,222 122,222 @ 2,222
@1,22,222 )2,222 122,222 @ 2,222 12),222 @ 1,222 122,222 @ ,222
@
@
@1,22,222 1,22,222 122,222 @ (2,222 1)2,222 @ 12,222 122,222 @ (12,222 22,222 (2,222 @ )2,222
2,222
,222
N
%H2 = 7(2222; %H 1 = 2222; %H = 222; %H ( = )2222; 3O8 = 1); and then solve for N45 = @),)2.- ≈ @),)1. )0.
New project N'(
Answer: c
Qet the depreciation using the :$%S table provided 2 1 %ost D@22,222E N#% D)2,222E Sales @22,222 @22,222 perating %ost )22,222 )22,222 6epreciation 1,222 ,222 per. inc. before ta"es @ (,222 D@ ,222E !a"es D)2>E 1),222 D12,222E per. inc. after ta"es @ 1,222 D@ 1,222E $fter7ta" salvage value eturn of N#% + 6epreciation JJJJJJJJ 1,222 ,222 Net %Hs D@)2,222E @1,222 @12,222
Diff: #
R
in the uestion. ( )
@22,222 )22,222 -,222 @1,222 2,222 @ -,222
@22,222 )22,222 (,222 @1,222 ,222 @ 00,222 (2,222 )2,222 (,222 @2),222
-,222 @12,222
Note in year ) your @)2,222 of net operating working capital is recovered plus the after ta" salvage value of @(2,222. *nter the cash flows into the cash flow register and solve for the N45 using the #$%% of 12>. N45 = @),-.0. 2
.
New project $RR
Step 1F
Answer: b
Diff: #
Set up a time line in an income statement format to lay out the cash flowsF 2
1
(
)
/uilding N#%
7@1).2 7.2
evenues per. costs 6epreciation per. inc. before ta"es !a"es D)2>E per. inc. after ta"es 4lus 6epreciation per. %Hs Sale of building !a"es on sale ecovery of N#% Net cash flows
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@1.2 12.2 .2 @ (.2 1. @ 1. .2 @ (.
@1.2 12.2 .2 @ (.2 1. @ 1. .2 @ (.
@1.2 12.2 .2 @ (.2 1. @ 1. .2 @ (.
@1.2 12.2 .2 @ (.2 1. @ 1. .2 @ (.
@ (.
@ (.
@ (.
@ (.
@1.2 12.2 .2 @ (.2 1. @ 1. .2 @ (. .2 71.P .2 @1.
P$t the end of years, the /5 of the building will be @1),222,222 7 D × @,222,222E = @),222,222. !he company sells it for @ million; however, the /5 is only @) million. So, the company will have a BprofitC of @) million, on which it will owe ta"es. !he ta"es owed are calculated asF !a"es = 2.) × @) million = @1. million.
Step F
1.
Solve for the pro&ect's 3F *nter the following data in the calculatorF %H2 = 710; %H17) = (.; %H = 1.; and then solve for 3 = 1(.0)>.
Risk)adjsted N'(
Answer: c
Diff: #
N
D3n thousands of dollarsE 2
( ) 3nitial cost7@,222%hange in N#% 71223nitial outlay 7,122Sales@1,222@,222@,222@1,222perating costs 22 1,222 1,222 226epreciation 22 22 22 22perating income@ 2 @ 22@ 22@ 2!a"es D)2>E 2 22 22 2perating income@ 2@ (22@ (22@ 26epreciation 22 22 22 22*"ternalities 72 72 72 72eturn of N#% JJJJJJJJJJJJJJJJJJJJJJJJ+ 122Net cash flow DN%HE7@,122@ 2@ 2@ 2@ (2 *ntering the N%H amounts into the cash flow register Dat 1>E gives you a N45 of 7@),)1..
.
1
Risk)adjsted N'(
Answer: a
!ime linesF 4ro&ect $F 2 k = 1)> 1 G G %Hs$ 722,222 -1,12)
G -1,12)
( G -1,12)
) 8ears G -1,12)
G 2
( G 1),)11
) 8ears G 1),)11
N45$ = I 4ro&ect /F 2 k = 12> G %Hs/ 722,222
1 G 2
N45/ = I %alculate reuired returns on $ and /F 4ro&ect $
+ > = 1)>.
Diff: #
4ro&ect /
?ow risk
k isk ad&usted = 1> 7 > = 12>.
$ 3nputsF %H2 = 722222; %H 1 = -112); N & = ); 3 = 1). utputF N45 $ = @-,1-.2 ≈ @-,1--. / 3nputsF %H2 = 722222; %H1 = 2; N& = ; %H = 1))11; N & = ; 3 = 12. utputF N45 / = @12,221.)( ≈ @12,221. (.
Risk)adjsted N'( !ime lineF 2 1 k = 1> G G 72,222 ,222 N45 = I
Answer: e G ,222
•
•
•
Salvage value
Diff: #
12 8ears G ,222 12,222 1,222
k4ro&ect = > + )>D1.E = 1>. 3nputsF %H 2 = 72222; %H 1 = 222; N & = 0; %H 12 = 1222; 3 = 1>. utputF N45 = 7@1,-.0( ≈ 7@1,-0. ).
Risk)adjsted N'(
!ime linesF 2 1 k = 1> G G %Hs $ 7+,222 ,222 N45 $ = I 2 1 k = 1)> G G %Hs / 7+,222 (,222 N45 / = I
4ro&ect $F 4ro&ect /F $F 3nputsF utputF /F 3nputsF utputF .
Answer: c
G ,+22
( 8ears G ,+2
G ,22
( 8ears G ,022
Diff: #
k $verage risk = 1>. k + > = 1)>. %H 2 = N45 = %H 2 = N45 =
7222; %H 1 = 222; %H = 22; %H ( = 2; 3 = 1. @(2.2 ≈ @(2. 7222; %H 1 = (222; %H = 22; %H ( = 022; 3 = 1). @1,0.1 ≈ @1,02.
Risk)adjsted discont rate
!ime linesF 4ro&ect $ 2 k = 1> 1 G G G %Hs $ 71+,222 ),222 ),222 N45 $ = I = (,0-.- 4ro&ect / 2 1 k = I G G G %Hs/ 71),1 ,122 ,122 N45/ = N45$ = (,0-.-
Answer: b
( G ),222
) G ),222
Diff: #
8ears G ),222 +,222 Salvage value !erminal %H = 0,222
•
+ G ),222
8ears G ,122 2 Salvage value !erminal %H = ,122 •
•
%alculate 4ro&ect $'s N45F 3nputsF %H 2 = 71222; %H 1 = )222; N & = ; %H = 0222; 3 = 1. utputF N45 = @(,0-.-. !o calculate the discount rate at which 4ro&ect /'s N45 is eual to 4ro&ect $'s, calculate 4ro&ect /'s 3 with an initial cash flow D%H 2E that is @(,0-.- greater than its current %H 2. %H2 = 7@1),1 + D7@(,0-.-E = 7@1,-0(.-. Now calculate 4ro&ect /'s 3F