Practice Quiz 3 Chapters 8,9, and 10

 

Mystical Choice

Devine the choice that best completes the statement or answers the question. Assure that you are able to convincingly demonstrate the appropriate justification for the question when and where necessary.

 

____ 1. All else equal, risk averse investors generally require ____ returns to purchase investments with ____ risks.

a.

higher; lower

b.

lower; higher

c.

higher; higher

d.

None of the above is correct.

 

____ 2. According to the following information, which of the stocks would be considered riskiest in a diversified portfolio of investments?

 

Stock

ABC

12.5%

1.0

FGH

  8.0%

0.5

MNO

20.2%

2.4

TUV

15.3%

3.0

 

a.

Stock MNO, because it has the highest standard deviation.

b.

Stock TUV, because it has the highest beta.

c.

Stock FGH, because it has the highest s/b ratio

d.

Stock ABC, because its beta is the same as the market beta (1.0) and the market is always very, very risky.

 

 

____ 3. Which of the following statements is most correct?

a.

The required return on a firm's common stock is determined by the firm's systematic (or market) risk. If its systematic risk is known, and if it is expected to remain constant, the analyst has sufficient information to specify the firm's required return.

b.

A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of most other securities.

c.

If the returns of two firms are negatively correlated, one of them must have a negative beta.

d.

A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only one stock.

e.

Statements b and c are both correct.

 

 

____ 4. Which of the following is not a difficulty concerning beta and its estimation?

a.

Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

b.

Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the "true" or "expected future" beta.

c.

The beta of an "average stock," or "the market," can change over time, sometimes drastically.

d.

Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.

e.

All of the above are potentially serious difficulties.

 

 

____ 5. If a stock has a beta coefficient, , equal to 1.20, the risk premium associated with the market is 9 percent, and the risk-free rate is 5 percent, application of the capital asset pricing model indicates the appropriate return should be ____.

a.

9.8%

b.

14%

c.

5%

d.

15.8%

e.

None of the above is correct.

 

 

____ 6. Sharon Stonewall currently has an investment portfolio that contains 10 stocks that have a total value equal to $160,000. The portfolio has a beta () equal to 1.0. Sharon wants to invest an additional $40,000 in a stock with = 2.0. After Sharon adds the new stock to her portfolio, what will be the portfolio's beta?

a.

1.2

b.

1.5

c.

2.0

d.

Not enough information is given to compute the portfolio's beta ().

e.

None of the above is correct.

 

 

____ 7. Steve Brickson currently has an investment portfolio that contains four stocks with a total value equal to $80,000. The portfolio has a beta () equal to 1.4. Steve wants to invest an additional $20,000 in a stock that has = 2.4. After Steve adds the new stock to his portfolio, what will be the portfolio's beta?

a.

1.6

b.

1.9

c.

2.0

d.

Not enough information is given to compute the portfolio's beta ().

e.

None of the above is correct.

 

 

____ 8. Given the following information, compute the coefficient of variation for Cyber Soda, Inc.:

 

Probability

Return

0.2

  2.0%

0.3

12.0%

0.5

  5.0%

 

Expected return: = 6.5%

 

a.

3.78

b.

0.58

c.

0.00

d.

1.72

e.

None of the above is correct.

 

 

____ 9. HR Corporation has a beta of 2.0, while LR Corporation's beta is 0.5. The risk-free rate is 10%, and the required rate of return on an average stock is 15%. Now the expected rate of inflation built into rRF falls by 3 percentage points, the real risk-free rate remains constant, the required return on the market falls to 11%, and the betas remain constant. When all of these changes are made, what will be the difference in required returns on HR's and LR's stocks?

a.

1.0%

b.

2.5%

c.

4.5%

d.

5.4%

e.

6.0%

 

 

____ 10. Assume that a new law is passed which restricts investors to holding only one asset. A risk-averse investor is considering two possible assets as the asset to be held in isolation. The assets' possible returns and related probabilities (i.e., the probability distributions) are as follows:

 

Asset X

Asset Y

Pr

r

Pr

r

0.10

3%

0.05

3%

0.10

0.10

0.25

0.30

0.25

0.30

0.30

10  

0.25

10  

 

Which asset should be preferred?

a.

Asset X, since its expected return is higher.

b.

Asset Y, since its beta is probably lower.

c.

Either one, since the expected returns are the same.

d.

Asset X, since its standard deviation is lower.

e.

Asset Y, since its coefficient of variation is lower and its expected return is higher.

 

 

____ 11. You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to 1.15. You have decided to sell one of your stocks, a lead mining stock whose = 1.0, for $5,000 net and to use the proceeds to buy $5,000 of stock in a steel company whose = 2.0. What will be the new beta of the portfolio?

a.

1.12

b.

1.20

c.

1.22

d.

1.10

e.

1.15

 

 

____ 12. You are managing a portfolio of 10 stocks which are held in equal amounts. The current beta of the portfolio is 1.64, and the beta of Stock A is 2.0. If Stock A is sold, what would the beta of the replacement stock have to be to produce a new portfolio beta of 1.55?

a.

1.10

b.

1.00

c.

0.90

d.

0.75

e.

0.50

 

 

CAPM Analysis

You have been asked to use a CAPM analysis to choose between stocks R and s, with your choice being the one whose expected rate of return exceeds its required rate of by the widest margin. The risk-free rate is 6%, and the required return on an average stock (or "the market") is 10%. Your security analyst tells you that Stock S's expected rate of return is = 11%, while Stock R's expected rate of return in = 13%. The CAPM is assumed to be a valid method for selecting stocks, but the expected return for any given investor (such as you) can differ from the required rate of return for a given stock. The following past rates of return are to be used to calculate the two stocks' beta coefficients, which are then to be used to determine the stocks' required rates of return.

 

Year

Stock R

Stock S

Market

1

15% 

0%

5%

2

5   

3

25   

10     

15   

 

Note: The averages of the historical returns are not needed, and they are generally not equal to the expected future returns.

 

____ 13. Refer to CAPM Analysis. Calculate both stocks' betas. What is the difference between the betas, i.e., what is the value of betaR betaS? (Hint: The graphical method of calculating the rise over run, or (Y2 Y1) divided by (X2 X1) may aid you.)

a.

0.0

b.

1.0

c.

1.5

d.

2.0

e.

2.5

 

 

____ 14. Here are the expected returns on two stocks:

 

 

Returns

Probability

X

Y

0.1

20%

10%

0.8

20 

15   

0.1

40 

20   

 

If you form a 50-50 portfolio of the two stocks, what is the portfolio's standard deviation?

a.

8.1%

b.

10.5%

c.

13.4%

d.

16.5%

e.

20.0%

 

 

____ 15. Woodson Inc. has two possible projects, Project A and Project B, with the following cash flows:

 

Year

Project A

Project B

0

150,000

100,000

1

100,000

45,000

2

105,000

65,000

3

40,000

80,000

 

At what required rate of return do the two projects have the same net present value (NPV)? (In other words, what is the "crossover rate" of the projects' NPV profiles?)

a.

10.3%

b.

13.5%

c.

15.8%

d.

21.7%

e.

34.8%

 

 

____ 16. Mid-State Electric Company must clean up the water released from its generating plant. The company's required rate of return is 10 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects. Clean-up Plan A, which is of average risk, has an initial cost of $1,000 at time 0, and its operating cost will be $100 per year for its 10-year life. Plan B, which is a high-risk project, has an initial cost of $300, and its annual operating cost over Years 1 to 10 will be $200. What is the proper PV of costs for the better project?

a.

$1,430.04

b.

$1,525.88

c.

$1,614.46

d.

$1,642.02

e.

$1,728.19

 

 

____ 17. Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of $900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project's income is negative, and a 10 percent required rate of return. Inflation is zero. What is the project's NPV?

a.

$6.24

b.

$7.89

c.

$8.87

d.

$9.15

e.

$10.41

 

 

____ 18. Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3. The facility will produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3 respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent required rate of return. Inflation is zero. What is the project's NPV?

a.

$7,673.71

b.

$12,851.75

c.

$17,436.84

d.

$24,989.67

e.

$32,784.25

 

 

____ 19. A major disadvantage of the payback period method is it

a.

Is useless as a risk indicator.

b.

Ignores cash flows beyond the payback period.

c.

Does not directly account for the time value of money.

d.

All of the above are correct.

e.

Only answers b and c are correct.

 

 

____ 20. Which of the following statements is correct?

a.

The NPV method assumes that cash flows will be reinvested at the required rate of return while the IRR method assumes reinvestment at the IRR.

b.

The NPV method assumes that cash flows will be reinvested at the risk-free rate while the IRR method assumes reinvestment at the IRR.

c.

The NPV method assumes that cash flows will be reinvested at the required rate of return while the IRR method assumes reinvestment at the risk-free rate.

d.

The NPV method does not consider the inflation premium.

e.

The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback period.

 

 

____ 21. Which of the following is not a rationale for using the NPV method in capital budgeting?

a.

An NPV of zero signifies that the project's cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital.

b.

A project whose NPV is positive will increase the value of the firm if that project is accepted.

c.

A project is considered acceptable if it has a positive NPV.

d.

A project is not considered acceptable if it has a negative NPV.

e.

All of the above are true.

 

 

____ 22. The present value of the expected net cash inflows for a project will most likely exceed the present value of the expected net profit after tax for the same project because

a.

Income is reduced by taxes paid, but cash flow is not.

b.

There is a greater probability of realizing the projected cash flow than the forecasted income.

c.

Income is reduced by dividends paid, but cash flow is not.

d.

Income is reduced by depreciation charges, but cash flow is not.

e.

Cash flow reflects any change in net working capital, but sales do not.

 

 

____ 23. Which of the following statements is false?

a.

The NPV will be positive if the IRR is less than the required rate of return.

b.

If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.

c.

When IRR = r (the required rate of return), NPV = 0.

d.

The IRR can be positive even if the NPV is negative.

e.

The NPV method is not affected by the multiple IRR problem.

 

 

____ 24. The internal rate of return of a capital investment

a.

Changes when the required rate of return changes.

b.

Is equal to the annual net cash flows divided by one half of the project's cost when the cash flows are an annuity.

c.

Must exceed the required rate of return in order for the firm to accept the investment.

d.

Is similar to the yield to maturity bond.

e.

Answers c and d are both correct.

 

 

____ 25. The advantage of the payback period over other capital budgeting techniques is that

a.

it is the simplest and oldest formal model to evaluate capital budgeting model.

b.

it directly accounts for the time value of money.

c.

it ignores cash flows beyond the payback period.

d.

it always leads to decisions that maximize the value of the firm.

e.

it incorporates risk into the discount rate used to solve the payback period.

 

 

____ 26. Which of the following statements concerning the internal rate of return is false?

a.

The internal rate of return for a capital budgeting project is the same for all firms regardless of their cost of capital.

b.

A project is acceptable long as the project's internal rate of return is greater than the hurdle rate for the project.

c.

The internal rate of return is dependent on the timing of the cash flows.

d.

A project with a positive internal rate of return will always increase the value of the firm if the project is accepted.

e.

You do not need to know the required rate of return to solve for the internal rate of return.

 

 

____ 27. All of the following factors can complicate the post-audit process except

a.

each element of the cash flow forecast is subject to uncertainty.

b.

projects sometimes fail to meet expectations for reasons beyond the control of operating executives.

c.

it is often difficult to separate the operating results of one investment from those of a larger system.

d.

executives who were responsible for a given decision might have moved on by the time the time the results of the long term project are known.

e.

the most successful firms, on average, are the ones that put the least emphasis on the post-audit.

 

 

____ 28. Benefits of the post-audit include all of the following except

a.

when decision makers are forced to compare their projections to actual outcomes, there is a tendency to improve.

b.

conscious or unconscious biases are removed.

c.

negative NPV projects are identified before they begin.

d.

forecasts are improved.

e.

all of the above are benefits of the post-audit.

 

 

____ 29. Two projects being considered are mutually exclusive and have the following cash flows:

 

Year

Project A

Project B

0

$50,000

$50,000

1

15,625

0

2

15,625

0

3

15,625

0

4

15,625

0

5

15,625

99,500

 

If the required rate of return on these projects is 10 percent, which would be chosen and why?

a.

Project B because of higher NPV.

b.

Project B because of higher IRR.

c.

Project A because of higher NPV.

d.

Project A because of higher IRR.

e.

Neither, because both have IRRs less than the cost of capital.

 

 

____ 30. The Seattle Corporation has been presented with an investment opportunity which will yield end of year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's required rate of return is 10 percent. What is the NPV for this investment?

a.

$135,984

b.

$18,023

c.

$219,045

d.

$51,138

e.

$92,146

 

 

____ 31. Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:

 

Year

Project A

Project B

0

($100,00)

($100,000)

1

39,500

0

2

39,500

0

3

39,500

133,000

 

Based only on the information given, which of the two projects would be preferred, and why?

a.

Project A, because it has a shorter payback period.

b.

Project B, because it has a higher IRR.

c.

Indifferent, because the projects have equal IRRs.

d.

Include both in the capital budget, since the sum of the cash inflows exceeds the initial investment in both cases.

e.

Choose neither, since their NPVs are negative.

 

 

____ 32. Two projects being considered are mutually exclusive and have the following projected cash flows:

 

Year

Project A

Project B

0

$50,000

$ 50,000

1

15,990

0

2

15,990

0

3

15,990

0

4

15,990

0

5

15,990

100,560

 

At what rate (approximately) do the NPV profiles of Projects A and B cross?

a.

6.5%

b.

11.5%

c.

16.5%

d.

20.0%

e.

The NPV profiles of these two projects do not cross.

 

 

____ 33. Which of the following is most correct? The modified IRR (MIRR) method:

a.

Always leads to the same ranking decision as NPV for independent projects.

b.

Overcomes the problem of multiple rates of return.

c.

Compounds cash flows at the required rate of return.

d.

Overcomes the problem of cash flow timing and the problem of project size that leads to criticism of the regular IRR method.

e.

Answers b and c are both correct.

 

 

____ 34. Which of the following statements is correct?

a.

The modified internal rate of return (MIRR) of a project increases as the discount rate increases.

b.

The internal rate of return (IRR) of a project increases as the required rate of return increases.

c.

Both IRR and MIRR can produce the multiple rates of return.

d.

When comparing two projects, the project with the higher IRR will also have the higher MIRR.

e.

Both a and c are correct.

 

 

____ 35. Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years. The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a required rate of return for the firm of 12 percent. What is the project's MIRR?

a.

15.0%

b.

14.0%

c.

12.0%

d.

16.0%

e.

17.0%

 

 

____ 36. Project A has a cost of $1,000, and it will produce end-of-year net cash inflows of $500 per year for 3 years. The project's required rate of return is 10 percent. What is the difference between the project's IRR and its MIRR?

a.

3.88%

b.

4.31%

c.

5.09%

d.

5.75%

e.

6.21%

 

 

____ 37. International Transport Company is considering building a new facility in Seattle. If the company goes ahead with the project, it will spend $2 million immediately (at t = 0) and another $2 million at the end of Year 1(t = 1). It will then receive net cash flows of $1 million at the end of Years 2-5, and it expects to sell the property for $2 million at the end of Year 6. The company's required rate of return is 12 percent, and it uses the modified IRR criterion for capital budgeting decisions. Which of the following statements is most correct?

a.

The project should be rejected because the modified IRR is less than the regular IRR.

b.

The project should be accepted because the modified IRR is greater than the required rate of return.

c.

The regular IRR is less than the required rate of return. Under this condition, the modified IRR will also be less than the regular IRR.

d.

If the regular IRR is less than the required rate of return, then the modified IRR will be greater than the regular IRR.

e.

Given the data in the problem, the NPV is negative. This demonstrates that the modified IRR criterion is not always a valid decision method for projects such as this one.

 

 

____ 38. Which of the following is not a cash flow that results from the decision to accept a project?

a.

Changes in working capital.

b.

Shipping and installation costs.

c.

Sunk costs.

d.

Opportunity costs.

e.

Externalities.

 

 

____ 39. Which of the following statements is correct?

a.

If a firm's stockholders are well diversified, we know from theory and from studies of market behavior that corporate risk is not important.

b.

Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.

c.

Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices.

d.

Market risk is important but does not have a direct effect on stock price because it only affects beta.

 

 

____ 40. Which of the following statements is correct?

a.

An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project.

b.

Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions.

c.

It is unrealistic to expect that increases in net working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project.

d.

Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value.

e.

All of the above are false.

 

 

____ 41. Suppose the firm's required rate of return is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

a.

Be correct.

b.

Be biased downward.

c.

Be biased upward.

d.

Possibly have a bias, but it could be upward or downward.

e.

More information is needed; otherwise, we can make no reasonable statement.

 

 

____ 42. Monte Carlo simulation

a.

Can be useful for estimating a project's stand-alone risk.

b.

Is capable of using probability distributions for variables as input data instead of a single numerical estimate for each variable.

c.

Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.

d.

All of the above.

e.

Only answers a and b are correct.

 

 

____ 43. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?

a.

If the beta of the asset is larger than the firm's beta, then the required return on the asset is less than the required return on the firm.

b.

If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm.

c.

If the beta of the asset is greater than the corporate beta prior to the addition of that asset, then the corporate beta after the purchase of the asset will be smaller than the original corporate beta.

d.

If the beta of an asset is larger than the corporate beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.

e.

None of the above is a true statement.

 

 

____ 44. Which of the following statements is correct?

a.

A relatively risky future cash outflow should be evaluated using a relatively low discount rate.

b.

If a firm's managers want to maximize the value of the stock, they should concentrate exclusively on projects' market, or beta, risk.

c.

If a firm evaluates all projects using the same required rate of return to determine NPVs, then the riskiness of the firm as measured by its beta will probably decline over time.

d.

If a firm has a beta which is less than 1.0, say 0.9, this would suggest that its assets' returns are negatively correlated with the returns of most other firms' assets.

e.

The above statements are all false.

 

 

____ 45. Using the Security Market Line concept in capital budgeting, which of the following is correct?

a.

If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project.

b.

If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta.

c.

If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted.

d.

If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted.

 

 

____ 46. Depreciation must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project because

a.

it represents a tax-deductible cash expense.

b.

the firm has a cash outflow equal to the depreciation expense each year.

c.

although it is a non-cash expense, depreciation has an impact on the taxes paid by the firm, which is a cash flow.

d.

depreciation is a sunk cost.

e.

None of the above is correct.

 

 

____ 47. Hill Top Lumber Company is considering building a sawmill in the state of Washington because the company doesn't have such a facility to service its growing customer base that is located on the west coast. Hill Top's executives believe that future growth in west coast customers will make the sawmill project a good investment. When evaluating the acceptability of the project, which of the following would not be considered a relevant cash flow that should be included when determining its initial investment outlay?

a.

Hill Top owns acreage that is large enough and would be an ideal location for the sawmill. The land, which was purchased five years ago, has a current value of $3 million.

b.

It is estimated that the cost of building the sawmill will be $175 million.

c.

It will cost $3 million to clear the land on which Hill Top wants to build the sawmill.

d.

It is estimated that $20 million of business from existing customers will move to the new sawmill.

e.

All of these cash flows should be included in the computation of the sawmill's initial investment outlay.

 

 

____ 48. A firm is evaluating a new machine to replace an existing, older machine. The old (existing) machine is being depreciated at $20,000 per year, whereas the new machine's depreciation will be $18,000. The firm's marginal tax rate is 30 percent. Everything else equal, if the new machine is purchased, what effect will the change in depreciation have on the firm's incremental operating cash flows?

a.

There should be no effect on the firm's cash flows, because depreciation is a noncash expense.

b.

Operating cash flows will increase by $2,000.

c.

Operating cash flows will increase by $1,400.

d.

Operating cash flows will decrease by $600.

e.

None of the above is correct.

 

 

____ 49. Express Press evaluates many different capital budgeting projects each year. The risks of the projects often differ significantly, from very little risk to risks that are substantially greater than the average risk associated with the firm. If Express Press always uses its weighted average cost of capital, or average required rate of return, to evaluate all of these capital budgeting projects, then the company might make an incorrect decision, or a mistake, by

a.

accepting projects that actually should be rejected.

b.

accepting projects with internal rates of return that are too high.

c.

rejecting projects that actually should be rejected.

d.

rejecting projects with internal rates of return that are lower than the appropriate risk-adjusted required rate of return.

e.

accepting project that actually should be accepted.

 

 

____ 50. When determining the marginal cash flows associated with an expansion capital budgeting project, which of the following would be included as an incremental operating cash flow?

a.

depreciation

b.

shipping and installation

c.

increase in working capital

d.

salvage value

e.

decrease in sales

 

 

____ 51. An evaluation of four independent capital budgeting projects by the director of capital budgeting for Ziker Golf Company yielded the following results:

 

 

Internal rate of

 

Project

of return, IRR

Risk level

L

   19.0%

Average

E

15.0

High

M

12.0

Low

Q

11.0

Average

 

The firm's weighted average cost of capital is 12 percent. Ziker Golf generally evaluates projects that are riskier than average by adjusting its required rate of return by 4 percent, whereas projects with less-than-average risk are evaluated by adjusting the required rate of return by 2 percent. Which project(s) should the firm purchase?

a.

Project L

b.

Projects L and E

c.

Projects L and M

d.

Projects L, E, and M

e.

None of the above is a correct answer.

 

 

____ 52. How do most firms deal with the risks of projects when making capital budgeting decisions?

a.

Projects risks are not considered directly because the weighted average cost of capital (WACC) that is used as the required rate of return for capital budgeting decisions is based on the riskiness of the firm. As a result, all projects, no matter their risks, can be evaluated using WACC.

b.

Evaluating risk is important only when the projects are similar to the firm's existing assets.

c.

Most firms adjust the discount rates used to evaluate new projects that have significantly different risks than the risk associated with the firm's existing assets.

d.

Firms generally increase the required rate of return used to evaluate projects that have significantly different risks than the risk associated with the firm's existing assets, regardless of whether the new projects' risks are higher or lower.

e.

None of the above is a correct answer.

 

 

____ 53. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk. Which of the following statements is correct?

a.

The project should be accepted because its IRR (before risk adjustment) is greater than its required return.

b.

The project should be rejected because its IRR (before risk adjustment) is less than its required return.

c.

The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's policy were to reduce a riskier-than-average project's IRR by 1 percentage point, then the project should be accepted.

d.

Riskier-than-average projects should have their IRRs increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.

e.

Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision.

 

 

____ 54. Whitney Crane Inc. has the following independent investment opportunities for the coming year:

 

 

 

Annual Cash

 

 

Project

Cost

Inflows

Life (years)

IRR

A

$10,000

$11,800

1

 

B

5,000

3,075

2

15

C

12,000

5,696

3

 

D

3,000

1,009

4

13

 

The IRRs for Project A and C, respectively, are:

a.

16% and 14%

b.

18% and 10%

c.

18% and 20%

d.

18% and 13%

e.

16% and 13%

 

 

____ 55. Alabama Pulp Company (APC) can control its environmental pollution using either "Project Old Tech" or "Project New Tech." Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the expected cost levels. The cash outflows associated with Project Old Tech, which uses standard proven technology, are less riskythey are about as uncertain as the cash flows associated with an average project. APC's required rate of return for average risk projects normally is set at 12 percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk projects. The two projects in question meet the criteria for high and average risk, but the financial manager is concerned about applying the normal rule to such cost-only projects. You must decide which project to recommend, and you should recommend the one with the lower PV of costs. What is the PV of costs of the better project?

 

Cash Outflows

Years

0

1

2

3

4

Project New Tech

1,500

315

315

315

315

Project Old Tech

   600

600

600

600

600

 

a.

2,521

b.

2,399

c.

2,457

d.

2,543

e.

2,422

 

 

____ 56. Meals on Wings Inc. supplies prepared meals for corporate aircraft (as opposed to public commercial airlines), and it needs to purchase new broilers. If the broilers are purchased, they will replace old broilers purchased 10 years ago for $105,000 and which are being depreciated on a straight line basis to a zero salvage value (15-year depreciable life). The old broilers can be sold for $60,000. The new broilers will cost $200,000 installed and will be depreciated using MACRS over their 5-year class life; they will be sold at their book value at the end of the 5th year. The firm expects to increase its revenues by $18,000 per year if the new broilers are purchased, but cash expenses will also increase by $2,500 per year. If the firm's required rate of return is 10 percent and its tax rate is 34 percent, what is the NPV of the broilers?

a.

$61,019

b.

$17,972

c.

$28,451

d.

$44,553

e.

$5,021

 

 

____ 57. Mom's Cookies Inc. is considering the purchase of a new cookie oven. The original cost of the old oven was $30,000; it is now 5 years old, and it has a current market value of $13,333.33. The old oven is being depreciated over a 10-year life towards a zero estimated salvage value on a straight line basis, resulting in a current book value of $15,000 and an annual depreciation expense of $3,000. The old oven can be used for 6 more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is $25,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new oven are $4,000 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the required rate of return is 10 percent. Assume a 40 percent tax rate. What is the net present value of the new oven?

a.

$2,418

b.

$1,731

c.

$1,568

d.

$163

e.

$1,731

 

 

____ 58. California Mining is evaluating the introduction of a new ore production process. Two alternatives are available. Production Process A has an initial cost of $25,000, a 4-year life, and a $5,000 net salvage value, and the use of Process A will increase net cash flow by $13,000 per year for each of the 4 years that the equipment is in use. Production Process B also requires an initial investment of $25,000, will also last 4 years, and its expected net salvage value is zero, but Process B will increase net cash flow by $15,247 per year. Management believes that a risk-adjusted discount rate of 12 percent should be used for Process A. If California Mining is to be indifferent between the two processes, what risk-adjusted discount rate must be used to evaluate B?

a.

8%

b.

10%

c.

12%

d.

14%

e.

16%

 

 

Exhibit 10-1

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent.

 

[MACRS table required]

 

____ 59. Refer to Exhibit 10-1. What is the initial investment outlay for the truck? (That is, what is the Year 0 net cash flow?)

a.

$50,000

b.

$52,600

c.

$55,800

d.

$62,000

e.

$65,000

 

 

____ 60. Refer to Exhibit 10-1. What is the terminal (nonoperating) cash flow at the end of Year 3?

a.

$10,000

b.

$12,000

c.

$15,680

d.

$16,000

e.

$18,000


Practice Quiz 3 - 8910

Answer Section

 

MULTIPLE CHOICE

 

1. ANS: C PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: Risk and return

 

2. ANS: B PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: Portfolio risk

 

3. ANS: E PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Risk analysis

 

4. ANS: C PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Beta coefficient

 

5. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: CAPM

 

6. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Beta coefficient

 

7. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Beta coefficient

 

8. ANS: B PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Coefficient of variation

 

9. ANS: E

HR = 2.0; LR = 0.5. No changes occur.

rRF = 10%. Decreases by 3% to 7%.

rM = 15%. Falls to 11%.

Now SML: ri = rRF + (rM rRF)I

 

rHR = 7% + (11% 7%)2 = 7% + 4%(2)

=

15%

rLR = 7% + (11% 7%)0.5 = 7% + 4%(0.5)

=

  9

Difference

 

  6%

 

 

PTS: 1 DIF: Easy OBJ: TYPE: Problem

TOP: CAPM and required return

 

10. ANS: E

= 0.10 (3%) + 0.10 (2%) + 0.25 (5%) + 0.25 (8%) + 0.30 (10%) = 6.15%

= 0.05 (3%) + 0.10 (2%) + 0.30 (5%) + 0.30 (8%) + 0.25 (10%) = 6.45%

 

 

= 0.10 (3% 6.15%)2 + 0.10 (2% 6.15%)2 + 0.25 (5% 6.15%)2

 

+ 0.25 (8% 6.15%)2 + 0.30 (10% 6.15%)2

 

=15.73; x= 3.97.

 

 

CVx

= 3.97/6.15 = 0.645.

 

 

= 0.05 (3 6.45%)2 + 0.10 (2% 6.45%)2 + 0.30 (5% 6.45%)2

 

+ 0.30 (8% 6.45)2 + 0.25 (10% 6.45%)2

 

= 10.95; y = 3.31.

 

 

CVy

= 3.31/6.45 = 0.513.

 

Therefore, Asset Y has a higher expected return and lower coefficient of variation and hence it would be preferred.

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: Expected return

 

11. ANS: B

Before:

1.15 = 0.95(R) + 0.05(1.0)

0.95(R) = 1.10

R = 1.158

 

After:

P = 0.95(R) + 0.05(2.0) = 1.10 + 0.10 = 1.20.

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: Portfolio beta

 

12. ANS: A

Before:

p

= 1.64 = 0.9 (R) + 0.1 (2.0)

R

= Average beta of the other 9 stocks in the portfolio

 

= 1.44/0.9 = 1.60

 

After:

New

= 1.55 m= 0.9(R) + 0.1() = 1.44 + 0.1()

= 1.01(0.11) = 1.10.

 

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: Portfolio beta

 

13. ANS: C

a.

Plot the returns of Stocks R & S and the market.

 

 

 

 

 

b.

Calculate beta using rise over run method or calculator regression method.

 

=

 

R =

 

S =

 

 

c.

The difference in betas is: R S = 2.0 0.5 = 1.5

 

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: Beta Calculation

 

14. ANS: A

Fill in the columns for "XY" and "product," and then use the formula to calculate the standard deviation. We did each P calculation with a calculator, stored the value, did the next calculation and added it to the first one, and so forth. When all three calculations had been done, we recalled the stored memory value, took its square root, and had .

 

Probability

Portfolio X Y

Product

0.1

5.0%

   0.5%

0.8

17.5   

14.0

0.1

30.0   

  3.0

 

 

=   16.5%

 

Covariance:

 

PTS: 1 DIF: Medium OBJ: TYPE: Financial Calculator

TOP: Portfolio standard deviation

 

15. ANS: D

To determine the crossover rate, find the differential cash flows between the 2 projects and then calculate the IRR of those differential cash flows.

 

 

Project ,

 

A B

0

50,000

1

55,000

2

40,000

3

40,000

 

IRR = 21.7%

 

Alternatively, you could draw the NPV profiles of the 2 projects. We can obtain the Y- and X- axis intercept points to draw the NPV profiles.

 

 

A

B

Y-intercept, r = 0

$95,000

$90,000

X-intercept, IRR

33.8%

36.0%

 

 

The intersection point or crossover rate occurs between 20% and 25% so the correct choice must be d.

 

PTS: 1 DIF: Medium OBJ: TYPE: Financial Calculator

TOP: NPV profiles

 

16. ANS: C

The first thing to note is that risky cash outflows should be discounted at a lower discount rate, so in this case we would discount the riskier Project B's cash flows at 10% 2% = 8%. Project A's cash flows would be discounted at 10%.

 

Now we would find the PV of the costs as follows:

Project A

= 1,000

= 100

I = 10.0%

Solve for NPV = $1,614.46.

 

Project B

= 300

= 200

I = 8.0%

Solve for NPV = $1,642.02.

 

Project A has the lower PV of costs. If Project B had been evaluated with a 12% cost of capital, its PV of costs would have been $1,430.04, but that would have been wrong.

 

PTS: 1 DIF: Medium OBJ: TYPE: Financial Calculator

TOP: Discounting risky outflows

 

17. ANS: B

 

0

1

2

3

Sales

 

$900 

$900 

$900 

Costs

 

(450)

(450)

(450)

Deprn

 

(500)

(300)

(200)

EBT

 

($ 50)

$150 

$250 

Taxes (40%)

 

20 

(60)

(100)

Net income

 

($ 30)

$ 90 

$150 

Add deprn

 

500 

300 

200 

 

 

$470

$390 

$350 

Cost

(1,000)

 

 

 

Inventory

(200)

 

 

 

Salvage value

 

 

 

100 

Tax on SV

 

 

 

(40)

Ret. of inv.

_____ 

____ 

____ 

200 

 

(1,200)

$470 

$390 

$610 

 

NPV = $7.89; IRR = 10.36%

 

PTS: 1 DIF: Medium OBJ: TYPE: Financial Calculator

TOP: New project NPV

 

18. ANS: A

Purchase

(50,000)

 

 

 

Sales

 

50,000 

50,000 

50,000 

VC

 

(20,000)

(20,000)

(20,000)

Deprec.

 

(40,000)

(5,000)

(5,000)

EBT

 

(10,000)

25,000 

25,000 

Taxes

 

4,000 

(10,000)

(10,000)

Net income

 

(6,000)

15,000 

15,000 

+Depreciation

 

40,000 

5,000 

5,000 

 

 

34,000 

20,000 

20,000 

NWC

(12,000)

 

 

12,000 

RV(AT)

______ 

______ 

______ 

6,000 

NCF

(62,000)

34,000 

20,000 

38,000 

 

NPV15% = $7,673.71.

 

PTS: 1 DIF: Medium OBJ: TYPE: Financial Calculator

TOP: New project NPV

 

19. ANS: E PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: Payback period

 

20. ANS: A PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: Ranking conflicts

 

21. ANS: E PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: NPV

 

22. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: PV of cash flows

 

23. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: NPV and IRR

 

24. ANS: E PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: IRR

 

25. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Payback period

 

26. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: IRR

 

27. ANS: E PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Post-audit

 

28. ANS: C PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Post-audit

 

29. ANS: A

Financial calculator solution:

Project A

Inputs: N = 5; I = 10; PMT = 15,625

Output: PV = 59,231.04

NPVA = $59,231.04 $50,000 = $9,231.04

 

Project B

Inputs: N = 5; I = 10; FV = 99,500

Output: PV = 61,781.67

NPVB = $61.781.67 $50,000 = $11,781.67

 

Alternate method by cash flows

Project A:

Inputs: = 50,000; = 15,625; Nj = 5; I =10

Output: NPV = $9,231.04

 

Project B:

Inputs: = 50,000; = 0; Nj = 4; = 99,500; I = 10

Output: NPV = $11,781.67

 

PTS: 1 DIF: Easy OBJ: TYPE: Problem

TOP: NPV analysis

 

30. ANS: D

Financial calculator solution: (In thousands)

Inputs: = 150; = 30; Nj = 4; = 35; Nj = 5; = 40; I =10

Output: NPV = $51.13824 = $51,138.24 $51,138

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: NPV analysis

 

31. ANS: B

Cash flow time line:

 

Financial calculator solution:

Project A:

Inputs: = 100,000; = 39,500; Nj = 3

Output: IRRA = 8.992% 9.0%

 

Project B:

Inputs: = 10,000; = 0; Nj = 2; = 133,000

Output: IRRB = 9.972% 10.0%

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: IRR

 

32. ANS: B

Cash flow time line:

 

 

Financial calculator solution:

Solve for IRRA

Inputs: = 50,000; = 15,990; Nj = 5

Output: IRR = 18.0%

 

Solve for IRRB

Inputs: = 50,000; = 0; Nj = 5; = 100,560

Output: IRR = 15.0%

 

Solve for crossover rate using the differential project CFs, CFA-B

Inputs: = 0; = 15,990; Nj =4; = 84,570

Output: IRR = 11.49% The crossover rate is 11.49%.

 

PTS: 1 DIF: Tough OBJ: TYPE: Problem

TOP: NPV profiles

 

33. ANS: E PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Modified IRR

 

34. ANS: A

Statement a is correct. The MIRR is dependent on the required rate of return. As the required rate of return increases, so does the terminal value. Because the MIRR is the rate which equates the PV with the terminal value, the MIRR increases as the terminal value increases. All the other statements are false.

 

PTS: 1 DIF: Tough OBJ: TYPE: Conceptual

TOP: MIRR and IRR

 

35. ANS: D

Numerical Solution:

3.278691/8 = 1 + MIRR

MIRR = 16%.

 

Financial calculator solution:

TV Inputs: N = 8; I = 12; PMT = 73,306.

Output: FV = 901,641.31.

 

MIRR Inputs: N = 8; PV = 275,000; FV = 901,641.31.

Output: I = 16.0%.

 

Alternate method

Inputs: = 0; = 73,306; Nj = 8; I =12

Output: NFV = $901,641.31.

 

Inputs: = 275,000; = 0; Nj = 7; = 901,641.31.

Output: IRR = 16.0% = MIRR.

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: MIRR

 

36. ANS: C

Cash flow time line:

 

IRRA = 23.38%.

 

Calculate MIRR: Find PV of CFs at 10%:

N = 3; I = 10; PMT = 500; FV = 0. Solve for PV = $1,243.43.

 

Find FV of this PV:

N = 3; I = 10; PV = 1,243.43; PMT = 0.

Solve for FV = TV = $1,655.00.

 

Find MIRR = 18.29%:

N = 3; PV = 1,000; PMT = 0; FV = 1,655.

Solve for I = MIRR = 18.29%.

 

Difference = 23.38% 18.29% = 5.09%.

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: IRR and MIRR

 

37. ANS: D

1 + MIRR = [7,352,816/3,785,714]1/6

MIRR = 11.7%.

 

Since the MIRR is less than the required rate of return, the IRR is less than the MIRR. Thus, Answer d is correct.

 

Financial calculator solution:

Calculate TV of inflows

Inputs: = 0; = 1,000,000; Nj = 4; = 2,000,000; I = 12.

Output: NFV = $7,352,847.36.

 

Calculate MIRR

Inputs: N = 6; PV = 3,785,714; FV = 7,352,847.

Output: I = 11.70%.

 

Calculate IRR

Inputs: = 2,000,000; = 2,000,000; = 1,000,000; Nj = 4; = 2,000,000.

Output: IRR = 11.50%.

r > MIRR > IRR.

12.0% > 11.7% > 11.50%.

 

PTS: 1 DIF: Tough OBJ: TYPE: Problem

TOP: Modified IRR

 

38. ANS: C PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: Determining incremental cash flows

 

39. ANS: B PTS: 1 DIF: Easy OBJ: TYPE: Conceptual

TOP: Corporate risk

 

40. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Cash flows and accounting measures

 

41. ANS: B PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Inflation effects

 

42. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Monte Carlo simulation

 

43. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Risk and project betas

 

44. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Beta and project risk

 

45. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: SML and capital budgeting

 

46. ANS: C PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Relevant cash flows

 

47. ANS: E PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Relevant cash flows

 

48. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Determining incremental cash flows

 

49. ANS: A PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Risk-adjusted discount rate

 

50. ANS: D PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Incremental cash flows

 

51. ANS: C PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Risk adjustment

 

52. ANS: C PTS: 1 DIF: Medium OBJ: TYPE: Conceptual

TOP: Risk adjustment

 

53. ANS: C

rs = 10% + (16% 10%)1.5 = 10% + 9% = 19%.

Original IRR = 21%. 21% Risk adjustment 1% = 20%.

Risk adjusted IRR = 20% > rs = 19%.

 

PTS: 1 DIF: Easy OBJ: TYPE: Problem

TOP: Risk adjustment

 

54. ANS: C

Financial calculator solution:

Project A

Inputs: N = 1; PV = 10,000; FV = 11,800.

Output: I = 18% = IRRA.

 

Project B

Inputs: N = 3; PV = 12,000; PMT = 5,696.

Output: I = 19.99% 20% = IRRB.

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: IRRs

 

55. ANS: E

Recognize that (1) risk outflows must be discounted at lower rates, and (2) since Project New Tech is risky, it must be discounted at a rate of 12% 3% = 9%. Project Old Tech must be discounted at 12%.

 

PVOld Tech is a smaller outflow than NPVNew Tech, thus, Project Old Tech is the better project.

 

Financial calculator solution:

Project New Tech

Inputs: = 1,500; = 315; Nj = 4; I = 9.

Output: NPV = $2,520.51.

 

Project Old Tech

Inputs: = 600; = 600; Nj = 4; I = 12.

Output: NPV = $2,422.41.

 

PTS: 1 DIF: Medium OBJ: TYPE: Problem

TOP: Discounting risky outflows

 

56. ANS: A

[MACRS table required]

Depreciation cash flows*:

 

 

MACRS

New Asset

Old Asset

Change in

Year

Percent

Depreciation

Depreciation

Depreciation

1

0.20

$40,000

$7,000

$33,000

2

0.32

64,000

7,000

57,000

3

0.19

38,000

7,000

31,000

4

0.12

24,000

7,000

17,000

5

0.11

22,000

7,000

15,000

6

0.06

12,000

--

12,000

 

*Depreciation old equipment: 105,000/15 = 7,000 per year 10 years = 70,000 in accumulated depreciation.

 

Book value =

$105,000

 

70,000

 

$ 35,000

 

Replacement analysis worksheet:

 

I

Initial investment outlay

 

1) New equipment cost

($200,000)  

 

2) Market value old equip.

60,000   

 

3) Taxes on sale of old equip.

(8,500)*

 

4) Increase in NWC

--   

 

5) Total net investment

($148,500)  

 

 

 

 

*(Market value Book value)(Tax rate)

 

 

(60,000 35,000) (0.34)

 

 

 

II

Incremental operating cash flows

 

Year:

0

1

2

3

4

5

 

6) Increase in revenues

 

$18,000

$18,000

$18,000

$18,000

$18,000

 

7) Increase in expenses

 

(2,500)

(2,500)

(2,500)

(2,500)

(2,500)

 

8) AT change in earnings

 

10,230

10,230

10,230

10,230

10,230

 

((line 6 + 7) 0.66)

 

 

 

 

 

 

 

9) Deprec. on new machine

40,000

64,000

38,000

24,000

22,000

 

10) Deprec. on old machine

7,000

7,000

7,000

7,000

7,000

 

11) Change in deprec.

 

33,000

57,000

31,000

17,000

15,000

 

(line 9 10)

 

 

 

 

 

 

 

12) Tax savings from deprec.

11,220

19,380

10,540

5,780

5,100

 

(line 11 0.34)

 

 

 

 

 

 

 

13) Net operating CFs

 

$21,450

$29,610

$20,770

$16,010

$15,330

 

(line 8 + 12)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

III

Terminal CF

 

14) Estimated salvage value

 

 

 

 

$12,000

 

15) Tax on salvage value

 

 

 

 

 

--

 

16) Return of NWC

 

 

 

 

 

--

 

17) Net CF

 

 

 

 

 

12,000

 

 

 

 

 

 

 

 

IV

Net CFs

 

18) Total Net CFs

($148,500)

$21,450

$29,610

$20,770

$16,010

$27,330

 

Financial calculator solution:

Inputs: = 148,500; = 21,450; = 29,610; = 20,770; = 16,010; = 27,330; I = 10.

Output: NPV = $61,019.29 $61,019.

 

Note: Tabular solution differs from calculator solution due to interest factor rounding.

 

PTS: 1 DIF: Tough OBJ: TYPE: Problem

TOP: Replacement decision

 

57. ANS: C

[MACRS table required]

Depreciation cash flows:

 

 

MACRS

New Asset

Old Asset

Change In 

Year

Percent

Depreciation

Depreciation

Depreciation 

1

0.20

$ 5,000

$ 3,000

$ 2,000 

2

0.32

8,000

3,000

5,000 

3

0.19

4,750

3,000

1,750 

4

0.12

3,000

3,000

5

0.11

2,750

3,000

(250)

6

0.06

1,500

______

1,500 

 

 

$25,000

$15,000

$10,000 

 

Project analysis worksheet:

 

I

Initial investment outlay

 

1) New equipment cost

($25,000.00) 

 

2) Market value old equip.

13,333.33  

 

3) Tax savings sale of old equip.

666.67*

 

4) Increase in NWC

--  

 

5) Total net investment

($11,000.00

 

 

 

 

*(Market value - Book value)(Tax rate)

 

 

($13,333.33 $15,000) (0.4) = 666.67

 

 

 

II

Incremental operating cash flows

 

Year:

0

1

2

3

4

5

6

 

6) Before-tax savings new equip.

$4,000

$4,000

$4,000

$4,000

$4,000

$4,000

 

7) After-tax savings new equip.

2,400

2,400

2,400

2,400

2,400

2,400

 

(line 6 0.6)

 

 

 

 

 

 

 

8) Dep. new machine

5,000

8,000

4,750

3,000

2,750

1,500

 

9) Dep. old machine

3,000

3,000

3,000

3,000

3,000

0

 

10) Change in deprec.

2,000

5,000

1,750

0

(250)

1,500

 

(line 8 9)

 

 

 

 

 

 

 

11) Tax savings from deprec.

800

2,000

700

0

(100)

600

 

(line 10 0.4)