Chap 11
Chap 11
Chap 11
CHAPTER AND
11 RISK ANALYSIS
Answer: d Diff: E
A company is considering a new project. The companys CFO plans to calculate the projects NPV
by discounting the relevant cash flows (which include the initial up-front costs, the operating cash
flows, and the terminal cash flows) at the companys cost of capital (WACC). Which of the
following factors should the CFO include when estimating the relevant cash flows?
a.
b.
c.
d.
e.
Any sunk costs that were incurred in the past prior to considering the proposed project.
Any opportunity costs that are incurred if the project is undertaken.
Any externalities (both positive and negative) that are incurred if the project is undertaken.
Statements b and c are correct.
All of the statements above are correct.
Answer: d Diff: E
When evaluating potential projects, which of the following factors should be incorporated as part
of a projects estimated cash flows?
a.
b.
c.
d.
e.
Answer: c Diff: E
Answer: b Diff: E
Chapter 11 - Page 1
Which of the following is not a cash flow that results from the decision to accept a project?
a.
b.
c.
d.
e.
Answer: c Diff: E
Answer: b Diff: E N
When evaluating a new project, the firm should consider all of the following factors except:
a. Changes in net operating working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project,
if the expenditures have been expensed for tax purposes.
c. Current rental income of a building owned by the firm if it is not used for this project.
d. The decline in sales of an existing product directly attributable to this project.
e. All of the statements above should be considered.
Answer: d Diff: E N
Which of the following items should Bevs Beverage Inc. take into account when evaluating a
proposed prune juice project?
a. The company spent $300,000 two years ago to renovate its Cincinnati plant. These renovations
were made in anticipation of another project that the company ultimately did not undertake.
b. If the company did not proceed with the prune juice project, the Cincinnati plant could generate
leasing income of $75,000 a year.
c. If the company proceeds with the prune juice project, it is estimated that sales of the companys
apple juice will fall by 3 percent a year.
d. Statements b and c are correct.
e. All of the statements above are correct.
Answer: d Diff: E N
Which of the following should a company consider in an analysis when evaluating a proposed
project?
a. The new project is expected to reduce sales of the companys existing products by 5 percent a
year.
b. Vacant facilities not currently leased out could instead be leased out for $10 million a year.
c. The company spent $30 million last year to improve the vacant facilities in which the new
project will be housed.
d. Statements a and b are correct.
e. All of the statements above are correct.
Answer: d Diff: E N
Hancock Furniture Inc. is considering new expansion plans for building a new store. In reviewing
the proposed new store, several members of the firms financial staff have made a number of
points regarding the proposed project. Which of the following items should the CFO include in the
analysis when estimating the projects net present value (NPV)?
a. The new store is expected to take away sales from two of the firms existing stores located in
the same town.
Chapter 11 - Page 2
b. The company owns the land that is being considered for use in the proposed project. This land
could instead be leased to a local developer.
c. The company spent $2 million two years ago to put together a national advertising campaign.
This campaign helped generate the demand for some of its past products, which have helped
make it possible for the firm to consider opening a new store.
d. Statements a and b are correct.
e. All of the statements above are correct.
Relevant and incremental cash flows
10
Answer: a Diff: E N
Twin Hills Inc. is considering a proposed project. Given available information, it is currently
estimated that the proposed project is risky but has a positive net present value. Which of the
following factors would make the company less likely to adopt the current project?
a. It is revealed that if the company proceeds with the proposed project, the company will lose
two other accounts, both of which have positive NPVs.
b. It is revealed that the company has an option to back out of the project 2 years from now, if it
is discovered to be unprofitable.
c. It is revealed that if the company proceeds with the project, it will have an option to repeat the
project 4 years from now.
d. Statements a and b are correct.
e. Statements b and c are correct.
Answer: a Diff: E N
A company is considering a proposed expansion to its facilities. Which of the following statements
is most correct?
a. In calculating the project's operating cash flows, the firm should not subtract out financing
costs such as interest expense, since these costs are already included in the WACC, which is
used to discount the projects net cash flows.
b. Since depreciation is a non-cash expense, the firm does not need to know the depreciation rate
when calculating the operating cash flows.
c. When estimating the projects operating cash flows, it is important to include any opportunity
costs and sunk costs, but the firm should ignore cash flows from externalities since they are
accounted for elsewhere.
d. Statements a and c are correct.
e. None of the statements above is correct.
Corporate risk
12
Answer: b Diff: E
Risk analysis
13
Answer: e Diff: E
Which of the following is not discussed in the text as a method for analyzing risk in capital
Chapter 11 - Page 3
budgeting?
a.
b.
c.
d.
e.
Sensitivity analysis.
Beta, or CAPM, analysis.
Monte Carlo simulation.
Scenario analysis.
All of the statements above are discussed in the text as methods for analyzing risk in capital
budgeting.
Chapter 11 - Page 4
Risk analysis
14
Answer: c Diff: E
Lieber Technologies is considering two potential projects, X and Y. In assessing the projects risk,
the company has estimated the beta of each project and has also conducted a simulation analysis.
Their efforts have produced the following numbers:
Expected NPV
Standard deviation (NPV)
Estimated project beta
Estimated correlation of
projects cash flows with
the cash flows of the
companys existing projects.
Project X
$350,000
$100,000
1.4
Cash flows are not
highly correlated with
the cash flows of the
existing projects.
Project Y
$350,000
$150,000
0.8
Cash flows are highly
correlated with the
cash flows of the
existing projects.
Risk analysis
15
Currently, Purcell Products Inc. has a beta of 1.0, and the sales of all of its products tend to be
positively correlated with the overall economy and the overall market. The company estimates that a
proposed new project has a higher standard deviation than the typical project undertaken by the firm.
The company also estimates that the new projects sales will do better when the overall economy is
down and do poorly when the overall economy is strong. On the basis of this information, which of the
following statements is most correct?
a.
b.
c.
d.
e.
The proposed new project has more stand-alone risk than the firms typical project.
If undertaken, the proposed new project will increase the firms corporate risk.
If undertaken, the proposed new project will increase the firms market risk.
Statements a and b are correct.
All of the statements above are correct.
Risk analysis
16
Answer: a Diff: E N
Answer: e Diff: E N
In conducting its risk analysis, Hanratty Inc. estimates that on a stand-alone basis, a proposed
projects estimated returns has more risk than its existing projects. The project is also expected to
be more sensitive to movements in the overall economy and market than are its existing projects.
However, Hanratty estimates that the overall standard deviation of the companys total returns
would fall if the company were to go ahead with this project. On the basis of this information,
which of the following statements is most correct?
a. The proposed projects estimated returns have a higher standard deviation compared to the
average existing project.
b. The proposed project will reduce the companys corporate risk.
c. The proposed project will increase the companys market risk.
d. The proposed projects returns are not perfectly correlated with the returns of its existing
projects.
e. All of the statements above are correct.
Answer: e Diff: E
Chapter 11 - Page 5
17
A firm is considering the purchase of an asset whose risk is greater than the current risk of the
firm, based on any method for assessing risk. In evaluating this asset, the decision maker should
a.
b.
c.
d.
Answer: b Diff: E
Ignoring it.
Adjusting the discount rate upward for increasing risk.
Adjusting the discount rate downward for increasing risk.
Picking a risk factor equal to the average discount rate.
Reducing the NPV by 10 percent for risky projects.
A company estimates that an average-risk project has a WACC of 10 percent, a below-average risk
project has a WACC of 8 percent, and an above-average risk project has a WACC of 12 percent.
Which of the following independent projects should the company accept?
a.
b.
c.
d.
e.
Risk and
20
Answer: b Diff: E
Answer: c Diff: E
Downingtown Industries has an overall (composite) WACC of 10 percent. This cost of capital reflects
the cost of capital for a Downingtown project with average risk; however, there are large risk
differences among its projects. The company estimates that low-risk projects have a cost of capital of 8
percent and high-risk projects have a cost of capital of 12 percent. The company is considering the
following projects:
Project
A
B
C
D
E
Expected Return
15%
12
11
9
6
Risk
High
Average
High
Low
Low
Which of the projects should the company select to maximize shareholder wealth?
a.
b.
c.
d.
e.
A and B.
A, B, and C.
A, B, and D.
A, B, C, and D.
A, B, C, D, and E.
Chapter 11 - Page 6
Answer: c Diff: E
a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into
account diversification effects.
b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into
account the probability of certain effects occurring, whereas scenario analysis does not
consider probabilities.
c. Simulation analysis is a computerized version of scenario analysis that uses continuous probability
distributions of the input variables.
d. Statements a and b are correct.
e. All of the statements above are correct.
Medium:
Cash flows and accounting measures
22
Answer: d Diff: M
Answer: d Diff: M
Adams Audio is considering whether to make an investment in a new type of technology. Which of
the following factors should the company consider when it decides whether to undertake the
investment?
a. The company has already spent $3 million researching the technology.
b. The new technology will affect the cash flows produced by its other operations.
c. If the investment is not made, then the company will be able to sell one of its laboratories for
$2 million.
d. Statements b and c should be considered.
e. All of the statements above should be considered.
Answer: d Diff: M
Laurier Inc. is a household products firm that is considering developing a new detergent. In evaluating
whether to go ahead with the new detergent project, which of the following items should Laurier
explicitly include in its cash flow analysis?
a. The company will produce the detergent in a vacant facility that they renovated five years ago
at a cost of $700,000.
b. The company will need to use some equipment that it could have leased to another company.
This equipment lease could have generated $200,000 per year in after-tax income.
c. The new detergent is likely to significantly reduce the sales of the other detergent products the
company currently sells.
d. Statements b and c are correct.
Chapter 11 - Page 7
Answer: d Diff: M
Sanford & Son Inc. is thinking about expanding their business by opening another shop on
property they purchased 10 years ago. Which of the following items should be included in the
analysis of this endeavor?
a. The property was cleared of trees and brush five years ago at a cost of $5,000.
b. The new shop is expected to affect the profitability of the existing shop since some current
customers will transfer their business to the new shop. The firm estimates that profits at the
existing shop will decrease by 10 percent.
c. Sanford & Son can lease the entire property to another company (that wants to grow flowers on
the lot) for $5,000 per year.
d. Both statements b and c should be included in the analysis.
e. All of the statements above should be included in the analysis.
Answer: d Diff: M
Pickles Corp. is a company that sells bottled iced tea. The company is thinking about expanding its
operations into the bottled lemonade business. Which of the following factors should the company
incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade
business?
a. If the company enters the lemonade business, its iced tea sales are expected to fall 5 percent
as some consumers switch from iced tea to lemonade.
b. Two years ago the company spent $3 million to renovate a building for a proposed project that
was never undertaken. If the project is adopted, the plan is to have the lemonade produced in
this building.
c. If the company doesnt produce lemonade, it can lease the building to another company and
receive after-tax cash flows of $500,000 a year.
d. Statements a and c are correct.
e. All of the statements above are correct.
Answer: d Diff: M
Which of the following constitutes an example of a cost that is not incremental, and therefore, not
relevant in a capital budgeting decision?
a. A firm has a parcel of land that can be used for a new plant site, or alternatively, can be used
to grow watermelons.
b. A firm can produce a new cleaning product that will generate new sales, but some of the new
sales will be from customers who switch from another product the company currently produces.
c. A firm orders and receives a piece of new equipment that is shipped across the country and
requires $25,000 in installation and set-up costs.
d. Statements a, b, and c are examples of incremental cash flows, and therefore, relevant cash
flows.
e. None of the statements above is an example of an incremental cash flow.
Answer: d Diff: M
Which of the following is not considered a relevant concern in deter- mining incremental cash flows
for a new product?
a. The use of factory floor space that is currently unused but available for production of any
product.
b. Revenues from the existing product that would be lost as a result of some customers switching
to the new product.
Chapter 11 - Page 8
c. Shipping and installation costs associated with preparing the machine to be used to produce
the new product.
d. The cost of a product analysis completed in the previous tax year and specific to the new
product.
e. None of the statements above. (All of the statements above are relevant concerns in
estimating relevant cash flows attributable to a new product.)
Cash flow estimation
29
Which of the following rules are essential to successful cash flow estimates, and ultimately, to
successful capital budgeting analysis?
a.
b.
c.
d.
e.
Answer: b Diff: M
Answer: d Diff: M
Corporate risk
31
In theory, the decision maker should view market risk as being of primary importance.
within-firm, or corporate, risk is relevant to a firms
a.
b.
c.
d.
e.
However,
Well-diversified stockholders, because it may affect debt capacity and operating income.
Management, because it affects job stability.
Creditors, because it affects the firms credit worthiness.
Statements a and c are correct.
All of the statements above are correct.
Answer: e Diff: M
Answer: a Diff: M
d. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to
changes in key variables and the likely range of variable values.
e. Statements c and d are correct.
Monte Carlo simulation
33
Answer: e Diff: M
Chapter 11 - Page 10
Risk adjustment
34
Answer: a Diff: M
The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems.
Since the companys revenue stream will not be affected by the choice of control systems, the
projects are being evaluated by finding the PV of each set of costs. The firms required rate of
return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk
differences. System A is judged to be a high-risk project because it might cost much more to
operate than is expected. System As risk-adjusted cost of capital is
a. 10 percent; this might seem illogical at first but it correctly adjusts for risk, when outflows rather
than inflows are being discounted.
b. 13 percent; the firms cost of capital should not be adjusted when evaluating outflow-only
projects.
c. 16 percent; since A is more risky, its cash flows should be discounted at a higher rate because
this correctly penalizes the project for its high risk.
d. Somewhere between 10 percent and 16 percent, with the answer depending on the riskiness of
the relevant inflows.
e. Indeterminate, or, more accurately, irrelevant, because for such projects we would simply
select the process that meets the requirements with the lowest required investment.
Answer: b Diff: E
St. Johns Paper is considering purchasing equipment today that has a depreciable cost of $1
million. The equipment will be depreciated on a MACRS 5-year basis, which implies the following
depreciation schedule:
Year
1
2
3
4
5
6
MACRS
Depreciation
Rates
0.20
0.32
0.19
0.12
0.11
0.06
Assume that the company sells the equipment after three years for $400,000 and the companys tax
rate is 40 percent. What would be the tax consequences resulting from the sale of the equipment?
a. There are no tax consequences.
b. The company would have to pay $44,000 in taxes.
c. The company would have to pay $160,000 in taxes.
d. The company would receive a tax credit of $124,000.
e. The company would receive a tax credit of $48,000.
Inventory and NPV
36
Answer: d Diff: E N
Rojas Computing is developing a new software system for one of its clients. The system has an upfront cost of $75 million (at t = 0). The client has forecasted its inventory levels for the next five
years as shown below:
Year
Inventory
Chapter 11 - Page 11
1
2
3
4
5
$1.0 billion
1.2 billion
1.6 billion
2.0 billion
2.2 billion
Rojas forecasts that its new software will enable its client to reduce inventory to the following
levels:
Year
1
2
3
4
5
Inventory
$0.8 billion
1.0 billion
1.4 billion
1.7 billion
1.9 billion
After Year 5, the software will become obsolete, so it will have no further impact on the clients
inventory levels. Rojas client is evaluating this software project as it would any other capital
budgeting project. The client estimates that the weighted average cost of capital for the software
system is 10 percent. What is the estimated NPV (in millions of dollars) of the new software
system?
a.
b.
c.
d.
e.
$233.56
$489.98
$625.12
$813.55
$956.43
Answer: c Diff: E
Ellison Products is considering a new project that develops a new laundry detergent, WOW. The
company has estimated that the projects NPV is $3 million, but this does not consider that the new
laundry detergent will reduce the revenues received on its existing laundry detergent products.
Specifically, the company estimates that if it develops WOW the company will lose $500,000 in aftertax cash flows during each of the next 10 years because of the cannibalization of its existing
products. Ellisons WACC is 10 percent. What is the net present value (NPV) of undertaking WOW
after considering externalities?
a.
b.
c.
d.
e.
Medium:
$2,927,716.00
$3,000,000.00
-$ 72,283.55
$2,807,228.00
-$3,072,283.55
Answer: c Diff: M N
For a new project, Armstead Inc. had planned on depreciating new machinery that costs $300
million on a 4-year, straight-line basis. Suppose now, that Armstead decides to depreciate the new
machinery on an accelerated basis according to the following depreciation schedule:
Year
1
2
Chapter 11 - Page 12
MACRS
Depreciation
Rates
20%
32
3
4
5
6
19
12
11
6
The project for which the machinery has been purchased ends in four years, and as a result the
machinery is going to be sold at its salvage value of $50,000,000. Under this accelerated
depreciation method, what is the after-tax cash flow expected to be generated by the sale of the
equipment in Year 4? Assume the firms tax rate is 40 percent.
a.
b.
c.
d.
e.
$31,800,000
$41,600,000
$50,400,000
$51,600,000
$72,200,000
Answer: e Diff: M
Given the following information, calculate the NPV of a proposed project: Cost = $4,000;
estimated life = 3 years; initial decrease in accounts receivable = $1,000, which must be restored
at the end of the projects life; estimated salvage value = $1,000; earnings before taxes and
depreciation = $2,000 per year; tax rate = 40 percent; and cost of capital = 18 percent. The
applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent.
a. $1,137
b. -$ 151
c. $ 137
d. $ 804
e. $ 544
Mars Inc. is considering the purchase of a new machine that will reduce manufacturing costs by
$5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it
expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to
be able to reduce net operating working capital by $15,000 when the machine is installed, but
required net operating working capital will return to its original level when the machine is sold
after 5 years. Mars marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to
evaluate projects of this nature. The applicable depreciation rates are 20 percent, 32 percent, 19
percent, 12 percent, 11 percent, and 6 percent. If the machine costs $60,000, what is the projects
NPV?
a.
b.
c.
d.
e.
-$15,394
-$14,093
-$58,512
-$21,493
-$46,901
Answer: d Diff: M
Answer: b Diff: M
Stanton Inc. is considering the purchase of a new machine that will reduce manufacturing costs by
$5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton
will use the MACRS method to depreciate the machine, and it expects to sell the machine at the
end of its 5-year operating life for $10,000 before taxes. Stantons marginal tax rate is 40 percent,
and it uses a 9 percent cost of capital to evaluate projects of this type. The applicable
Chapter 11 - Page 13
depreciation rates are 20 percent, 32 percent, 19 percent, 12 percent, 11 percent, and 6 percent.
If the machines cost is $40,000, what is the projects NPV?
a.
b.
c.
d.
e.
$1,014
$2,292
$7,550
$ 817
$5,040
Answer: a Diff: M
Maple Media is considering a proposal to enter a new line of business. In reviewing the proposal,
the companys CFO is considering the following facts:
The new business will require the company to purchase additional fixed assets that will cost
$600,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a
straight-line basis over three years. (Annual depreciation will be $200,000 per year at
t = 1, 2, and 3.)
At the end of three years, the company will get out of the business and will sell the fixed
assets at a salvage value of $100,000.
The project will require a $50,000 increase in net operating working capital at t = 0, which
will be recovered at t = 3.
The companys marginal tax rate is 35 percent.
The new business is expected to generate $2 million in sales each year (at t = 1, 2, and 3).
The operating costs excluding deprecia-tion are expected to be $1.4 million per year.
The projects cost of capital is 12 percent.
What is the projects net present value (NPV)?
a.
b.
c.
d.
e.
$536,697
$ 86,885
$ 81,243
$ 56,331
$561,609
Answer: b Diff: M
MacDonald Publishing is considering entering a new line of business. In analyzing the potential
business, their financial staff has accumulated the following information:
The new business will require a capital expenditure of $5 million at t = 0. This expenditure
will be used to purchase new equipment.
This equipment will be depreciated according to the following depreciation schedule:
Year
1
2
3
4
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
The new business is expected to have an economic life of four years. The business is
expected
to
generate
sales
of
$3
million
at
t
=
1,
$4 million at t = 2, $5 million at t = 3, and $2 million at t = 4. Each year, operating costs
excluding depreciation are expected to be 75 percent of sales.
The companys tax rate is 40 percent.
The companys weighted average cost of capital is 10 percent.
The company is very profitable, so any accounting losses on this project can be used to
reduce the companys overall tax burden.
What is the expected net present value (NPV) of the new business?
a.
b.
c.
d.
e.
$ 740,298
-$1,756,929
-$1,833,724
-$1,961,833
$5,919,974
Answer: a Diff: M
Rio Grande Bookstores is considering a major expansion of its business. The details of the
proposed expansion project are summarized below:
The company will have to purchase $500,000 in equipment at t = 0. This is the depreciable
cost.
The project has an economic life of four years.
The cost can be depreciated on a MACRS 3-year basis, which implies the following
depreciation schedule:
Year
1
2
3
4
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
At t = 0, the project requires that inventories increase by $50,000 and accounts payable
increase by $10,000. The change in net operating working capital is expected to be fully
recovered at t = 4.
The projects salvage value at the end of four years is expected to be $0.
The company forecasts that the project will generate $800,000 in sales the first two years (t
= 1 and 2) and $500,000 in sales during the last two years (t = 3 and 4).
Each year the projects operating costs excluding depreciation are expected to be 60
percent of sales revenue.
The companys tax rate is 40 percent.
The projects cost of capital is 10 percent.
What is the net present value (NPV) of the proposed project?
a. $159,145
b. $134,288
c. $162,817
d. $150,776
e. -$257,060
Chapter 11 - Page 15
Your company is considering a machine that will cost $1,000 at Time 0 and 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 per year for 3 years and 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 projects income is negative, and a 10 percent cost of capital. Inflation is zero. What is
the projects NPV?
a.
b.
c.
d.
e.
$ 6.24
$ 7.89
$ 8.87
$ 9.15
$10.41
$ 7,673.71
$12,851.75
$17,436.84
$24,989.67
$32,784.25
Answer: a Diff: M
Your company is considering a machine that will cost $50,000 at Time 0 and that 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 per year for 3 years and 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
projects income is negative, and a 15 percent cost of capital. Inflation is zero. What is the projects
NPV?
a.
b.
c.
d.
e.
47
Answer: b Diff: M
Answer: d Diff: M
Buckeye Books is considering opening a new production facility in Toledo, Ohio. In deciding whether to
proceed with the project, the company has accumulated the following information:
The estimated up-front cost of constructing the facility at t = 0 is $10 million. For tax purposes
the facility will be depreciated on a straight-line basis over 5 years.
The company plans to operate the facility for 4 years. It estimates today that the facilitys
salvage value at t = 4 will be $3 million.
If the facility is opened, Buckeye will have to increase its inventory by $2 million at t = 0. In
addition, its accounts payable will increase by $1 million at t = 0. The companys net
operating working capital will be recovered at t = 4.
If the facility is opened, it will increase the companys sales by $7 million each year for the 4
years that it will be operated (t = 1, 2, 3, and 4).
The operating costs (excluding depreciation) are expected to equal $3 million a year.
The companys tax rate is 40 percent.
The projects cost of capital is 12 percent.
a.
b.
c.
d.
e.
$0.28
$0.50
$0.63
$1.01
$1.26
million
million
million
million
million
Answer: e Diff: M N
Burress Beverages is considering a project where they would open a new facility in Seattle,
Washington. The companys CFO has assembled the following information regarding the proposed
project:
It would cost $500,000 today (at t = 0) to construct the new facility. The cost of the facility will
be depreciated on a straight-line basis over five years.
If the company opens the facility, it will need to increase its inventory by $100,000 at t = 0.
$70,000 of this inventory will be financed with accounts payable.
The CFO has estimated that the project will generate the following amount of revenue over the
next three years:
Year 1
Year 2
Year 3
$ 69,207
$178,946
$286,361
$170,453
$224,451
Answer: c Diff: M R
Mills Mining is considering an expansion project. The proposed project has the following features:
The project has an initial cost of $500,000. This is also the amount that can be depreciated
using the following depreciation schedule:
Year
1
2
3
4
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
Chapter 11 - Page 17
If the project is undertaken, at t = 0 the company will need to increase its inventories by
$50,000, and its accounts payable will rise by $10,000. This net operating working capital will be
recovered at the end of the projects life (t = 4).
If the project is undertaken, the company will realize an additional $600,000 in sales over each of
the next four years (t = 1, 2, 3, and 4). The companys operating costs (not including depreciation)
will equal $400,000 a year.
The companys tax rate is 40 percent.
At t = 4, the projects economic life is complete, but it will have a salvage value (before-tax) of
$50,000.
The projects WACC is 10 percent.
The company is very profitable, so any accounting losses on this project can be used to reduce
the companys overall tax burden.
What is the projects net present value (NPV)?
a.
b.
c.
d.
e.
$11,122.87
$50,330.14
$54,676.59
$68,336.86
$80,035.52
Answer: b Diff: M
As one of its major projects for the year, Steinbeck Depot is considering opening up a new store. The
companys CFO has collected the following information, and is proceeding to evaluate the project.
15.35%
13.94%
10.64%
12.45%
3.60%
Risk-adjusted NPV
51
Answer: c Diff: M N
Chapter 11 - Page 18
basis over 4 years (that is, the companys depreciation expense will be $500,000 in each of the
first four years (t = 1, 2, 3, and 4). The company anticipates that the machine will last for four
years, and that after four years, its salvage value will equal zero.
If the company goes ahead with the proposed product, it will have an effect on the companys
net operating working capital. At the outset, t = 0, inventory will increase by $140,000 and
accounts payable will increase by $40,000. At t = 4, the net operating working capital will be
recovered after the project is completed.
The detergent is expected to generate sales revenue of $1 million the first year (t = 1), $2
million the second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t
= 4). Each year the operating costs (not including depreciation) are expected to equal 50
percent of sales revenue.
The companys interest expense each year will be $100,000.
The new detergent is expected to reduce the after-tax cash flows of the companys existing
products by $250,000 a year (t = 1, 2, 3, and 4).
The companys overall WACC is 10 percent. However, the proposed project is riskier than the
average project for Parker; the projects WACC is estimated to be 12 percent.
The companys tax rate is 40 percent.
-$ 765,903.97
-$1,006,659.58
-$ 824,418.62
-$ 838,997.89
-$ 778,583.43
Risk-adjusted NPV
52
Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent to
evaluate average-risk projects, and it adds or subtracts 2 percentage points to evaluate projects of
more or less risk. Currently, two mutually exclusive projects are under consideration. Both have a cost
of $200,000 and will last 4 years. Project A, a riskier-than-average project, will produce annual end-ofyear cash flows of $71,104. Project B, a less-than-average-risk project, will produce cash flows of
$146,411 at the end of Years 3 and 4 only. Virus Stopper should accept
a.
b.
c.
d.
e.
Risk-adjusted NPV
53
Answer: a Diff: M
Answer: e Diff: M
An all-equity firm is analyzing a potential project that will require an initial, after-tax cash outlay of
$50,000 and after-tax cash inflows of $6,000 per year for 10 years. In addition, this project will
have an after-tax salvage value of $10,000 at the end of Year 10. If the risk-free rate is 6 percent,
the return on an average stock is 10 percent, and the beta of this project is 1.50, what is the
projects NPV?
a. $13,210
b. $ 4,905
c. $ 7,121
d. -$ 6,158
e. -$12,879
Risk-adjusted NPV
Answer: c Diff: M
Chapter 11 - Page 19
54
Real Time Systems Inc. is considering the development of one of two mutually exclusive new computer
models. Each will require a net investment of $5,000. The cash flows for each project are shown
below:
1
2
3
Year
$2,000
2,500
2,250
Project A
$3,000
2,600
2,900
Project B
Model B, which will use a new type of laser disk drive, is considered a high-risk project, while Model
A is an average-risk project. Real Time adds 2 percentage points to arrive at a risk-adjusted cost of
capital when evaluating high-risk projects. The cost of capital used for average-risk projects is 12
percent. Which of the following statements regarding the NPVs for Models A and B is most correct?
a. NPVA = $ 380; NPVB = $1,815
b. NPVA = $ 197; NPVB = $1,590
c. NPVA = $ 380; NPVB = $1,590
d. NPVA = $5,380; NPVB = $6,590
e. NPVA = $ 197; NPVB = $1,815
Risk-adjusted discount rate
55
The Unlimited, a national retailing chain, is considering an investment in one of two mutually exclusive
projects. The discount rate used for Project A is 12 percent. Further, Project A costs $15,000, and it
would be depreciated using MACRS. It is expected to have an after-tax salvage value of $5,000 at the
end of 6 years and to produce after-tax cash flows (including depreciation) of $4,000 for each of the 6
years. Project B costs $14,815 and would also be depreciated using MACRS. B is expected to have a
zero salvage value at the end of its 6-year life and to produce after-tax cash flows (including
depreciation) of $5,100 each year for 6 years. The Unlimiteds marginal tax rate is 40 percent. What
risk-adjusted discount rate will equate the NPV of Project B to that of Project A?
a.
b.
c.
d.
e.
15%
16%
18%
20%
12%
8%
10%
12%
14%
16%
Answer: e Diff: M
California Mining is evaluating the introduction of a new ore production process. Two alter natives 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 riskadjusted discount rate must be used to evaluate B?
a.
b.
c.
d.
e.
57
Answer: b Diff: M
Answer: e Diff: M
Alabama Pulp Company (APC) can control its environmental pollution using either Project Old Tech or
Chapter 11 - Page 20
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
risky. (They are about as uncertain as the cash flows associated with an average project.) APCs cost
of capital for average-risk projects is normally 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.
b.
c.
d.
e.
-$2,521
-$2,399
-$2,457
-$2,543
-$2,422
Mid-State Electric Company must clean up the water released from its generating plant. The
companys cost of capital is 10 percent for average-risk 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.
b.
c.
d.
e.
-$1,430.04
-$1,525.88
-$1,614.46
-$1,642.02
-$1,728.19
Answer: c Diff: M
Answer: c Diff: M
Your company must ensure the safety of its work force. Two plans are being considered for the next 10
years: (1) Install a high electrified fence around the property at a cost of $100,000. Maintenance and
electricity would then cost $5,000 per year over the 10-year life of the fence.
(2) Hire security guards at a cost of $25,000 paid at the end of each year. Because the company plans
to build new headquarters with a state of the art security system in 10 years, the plan will be in
effect only until that time. Your companys cost of capital is 15 percent for average-risk projects, and
that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects. Plan 1
is considered to be of low risk because its costs can be predicted quite accurately. Plan B, on the other
hand, is a high-risk project because of the difficulty of predicting wage rates. What is the proper PV of
costs for the better project?
a.
b.
c.
d.
e.
-$104,266.20
-$116,465.09
-$123,293.02
-$127,131.22
-$135,656.09
Chapter 11 - Page 21
Risky projects
60
Answer: d Diff: M
Cochran Corporation has a weighted average cost of capital of 11 percent for projects of average risk.
Projects of below-average risk have a cost of capital of 9 percent, while projects of above-average risk
have a cost of capital equal to 13 percent. Projects A and B are mutually exclusive, whereas all other
projects are independent. None of the projects will be repeated. The following table summarizes the
cash flows, internal rate of return (IRR), and risk of each of the projects.
Year
0
1
2
3
4
Project A
-$200,000
66,000
66,000
66,000
66,000
Project B
-$100,000
30,000
30,000
40,000
40,000
Project C
-$100,000
30,000
30,000
30,000
40,000
Project D
-$100,000
30,000
30,000
40,000
50,000
Project E
-$100,000
40,000
25,000
30,000
35,000
12.110%
Below
Average
14.038%
Below
Average
10.848%
Average
16.636%
Above
Average
11.630%
Above
Average
IRR
Project
Risk
Projects:
Projects:
Projects:
Projects:
Projects:
A,
B,
B,
A,
B,
B, C, D, E
C, D, E
D
D
C, D
Scenario analysis
61
Answer: c Diff: M
Klott Company encounters significant uncertainty with its sales volume and price in its primary
product. The firm uses scenario analysis in order to determine an expected NPV, 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 Klotts expected NPV (in thousands of dollars), standard deviation of NPV (in
thousands of dollars), and coefficient of variation of NPV?
Probability
of Outcome
Worst case
0.30
Base case
0.50
Best case
0.20
a.
b.
c.
d.
e.
Expected
Expected
Expected
Expected
Expected
NPV
NPV
NPV
NPV
NPV
=
=
=
=
=
Unit Sales
Volume
6,000
10,000
13,000
$35,000;
$35,000;
$10,300;
$13,900;
$10,300;
NPV
NPV
NPV
NPV
NPV
Sales
Price
$3,600
4,200
4,400
=
=
=
=
=
NPV
(In Thousands)
-$6,000
+13,000
+28,000
Answer: a Diff: M N
Chapter 11 - Page 22
Cost
$300,000
150,000
200,000
400,000
Rate of Return
14%
10
13
11
Jacksons target capital structure is 60 percent debt and 40 percent equity. The yield to maturity on the
companys debt is 10 percent. Jackson will incur flotation costs for a new equity issuance of 12 percent.
The growth rate is a constant 6 percent. The stock price is currently $35 per share for each of the 10,000
shares outstanding. Jackson expects to earn net income of $100,000 this coming year and the dividend
payout ratio will be 50 percent. If the companys tax rate is 30 percent, which of the projects will be
accepted?
a.
b.
c.
d.
e.
Project A
Projects A and C
Projects A, C, and D
All of the investment projects will be taken.
None of the investment projects will be taken.
Tough:
New project NPV
63
Answer: b Diff: T N
Blair Bookstores is thinking about expanding its facilities. In considering the expansion, Blairs finance
staff has obtained the following information:
The
expansion
will
require
the
company
to
purchase
today
(t
=
0)
$5 million of equipment. The equipment will be depreciated over the following four years at the
following rate:
Year
Year
Year
Year
33%
45
15
7
The expansion will require the company to increase its net operating working capital by $500,000
today (t = 0). This net operating working capital will be recovered at the end of four years (t = 4).
The equipment is not expected to have any salvage value at the end of four years.
The companys operating costs, excluding depreciation, are expected to be 60 percent of the
companys annual sales.
The expansion will increase the companys dollar sales. The projected increases, all relative to
current sales are:
Year
Year
Year
Year
1:
2:
3:
4:
1:
2:
3:
4:
$3.0 million
3.5 million
4.5 million
4.0 million
(For example, in Year 4 sales will be $4 million more than they would have been had the project not
been undertaken.) After the fourth year, the equipment will be obsolete, and will no longer provide
any additional incremental sales.
The companys tax rate is 40 percent and the companys other divisions are expected to have
positive tax liabilities throughout the projects life.
If the company proceeds with the expansion, it will need to use a building that the company already
owns. The building is fully depreciated; however, the building is currently leased out. The company
receives $300,000 before-tax rental income each year (payable at year end). If the company
proceeds with the expansion, the company will no longer receive this rental income.
The projects WACC is 10 percent.
What is the proposed project's NPV?
Chapter 11 - Page 23
a.
b.
c.
d.
e.
New project
64
-$1,034,876
-$1,248,378
-$1,589,885
-$5,410,523
-$ 748,378
NPV
Answer: d Diff: T
Foxglove Corp. is faced with an investment project. The following information is associated with
this project:
Year
1
2
3
4
Net Income*
$50,000
60,000
70,000
60,000
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
$153,840
$159,071
$162,409
$168,604
$182,344
Answer: d Diff: T
Pierce Products is deciding whether it makes sense to purchase a new piece of equipment. The
equipment costs $100,000 (payable at t = 0). The equipment will provide cash inflows before taxes
and depreciation of $45,000 at the end of each of the next four years (t = 1, 2, 3, and 4).
The equipment can be depreciated according to the following schedule:
Year
1
2
3
4
0.33
0.45
0.15
0.07
MACRS
Depreciation
Rates
At the end of four years the company expects to be able to sell the equipment for an after-tax salvage
value of $10,000. The company is in the 40 percent tax bracket. The company has a weighted
average cost of capital of 11 percent. Because there is more uncertainty about the salvage value, the
company has chosen to discount the salvage value at 12 percent. What is the net present value (NPV)
of purchasing the equipment?
a. $ 9,140.78
b. $16,498.72
c. $20,564.23
Chapter 11 - Page 24
d. $22,853.90
e. $28.982.64
Chapter 11 - Page 25
Answer: d Diff: T
Lugar Industries is considering an investment in a proposed project that requires an initial expenditure
of $100,000 at t = 0. This expenditure can be depreciated at the following annual rates:
Year
1
2
3
4
5
6
MACRS
Depreciation
Rates
0.20
0.32
0.19
0.12
0.11
0.06
The project has an economic life of six years. The projects revenues are forecasted to be $90,000 a
year. The projects operating costs (not including depreciation) are forecasted to be $50,000 a year.
After six years, the projects estimated salvage value is $10,000. The companys WACC is 10 percent,
and its corporate tax rate is 40 percent. What is the projects net present value (NPV)?
a.
b.
c.
d.
e.
$31,684
$33,843
$34,667
$38,840
$45,453
After a long drought, the manager of Long Branch Farms is considering the installation of an
irrigation system that will cost $100,000. It is estimated that the irrigation system will increase
revenues by $20,500 annually, although operating expenses other than depreciation will also
increase by $5,000. The system will be depreciated using MACRS over its depreciable life (5
years) to a zero salvage value. The applicable depreciation rates are 20 percent, 32 percent, 19
percent, 12 percent, 11 percent, and 6 percent. If the tax rate is 40 percent, what is the projects
IRR?
a.
b.
c.
d.
e.
12.6%
-1.3%
13.0%
10.2%
-4.8%
Answer: b Diff: T
Answer: e Diff: T
Garcia Paper is deciding whether to build a new plant. The proposed project would have an up-front cost
(at t = 0) of $30 million. The projects cost can be depreciated on a straight-line basis over three years.
Consequently, the depreciation expense will be $10 million in each of the first three years, t = 1, 2, and
3. Even though the project is depreciated over three years, the project has an economic life of five
years.
The project is expected to increase the companys sales by $20 million. Sales will remain at this higher
level for each year of the project (t = 1, 2, 3, 4, and 5). The operating costs, not including
depreciation, equal 60 percent of the increase in annual sales. The projects interest expense is $5
million per year and the companys tax rate is 40 percent. The company is very profitable, so any
accounting losses on this project can be used to reduce the companys overall tax burden. The project
does not require any additions to net operating working capital. The company estimates that the
projects after-tax salvage value at t = 5 will be $1.2 million. The project is of average risk, and,
Chapter 11 - Page 26
therefore, the CFO has decided to discount the operating cash flows at the companys overall WACC of
10 percent. However, the salvage value is more uncertain, so the CFO has decided to discount it at 12
percent. What is the net present value (NPV) of the proposed project?
a. $11.86 million
b. $14.39 million
c. -$26.04 million
d. -$12.55 million
e. -$ 1.18 million
Multiple Part:
(The following information applies to the next four problems.)
The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a new computer. The
computers price is $40,000, and it falls in the MACRS 3-year class. The applicable depreciation rates are 33
percent, 45 percent, 15 percent, and 7 percent. Purchase of the computer would require an increase in net
operating working capital of $2,000. The computer would increase the firms before-tax revenues by $20,000
per year but would also increase operating costs by $5,000 per year. The computer is expected to be used for
three years and then sold for $25,000. The firms marginal tax rate is 40 percent, and the projects cost of
capital is 14 percent.
New project investment
69
a. -$42,000
b. -$40,000
c. -$38,600
d. -$37,600
e. -$36,600
Operating cash flow
70
$ 9,000
$10,240
$11,687
$13,453
$16,200
$18,120
$19,000
$21,000
$25,000
$27,000
Answer: a Diff: M
What is the total value of the terminal year non-operating cash flows at the end of Year 3?
a.
b.
c.
d.
e.
72
Answer: e Diff: M
71
Answer: a Diff: E
Answer: c Diff: M
c. $2,917
d. $5,712
e. $6,438
(The following information applies to the next four problems.)
You have been asked by the president of your company to evaluate the proposed acquisition of a new specialpurpose truck. The trucks basic price is $50,000, and it will cost another $10,000 to modify it for special use
by your firm. The truck falls in the MACRS 3-year class, and it will be sold after three years for $20,000. The
applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent. Use of the truck will
require an increase in net operating 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 firms marginal tax rate is 40 percent.
New project investment
73
What is the net investment in 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
Operating cash flow
74
$17,820
$18,254
$19,920
$20,121
$21,737
$10,000
$12,000
$15,680
$16,000
$18,000
Answer: c Diff: M
What is the total value of the terminal year non-operating cash flows at the end of Year 3?
a.
b.
c.
d.
e.
76
Answer: c Diff: M
75
Answer: d Diff: E
Answer: a Diff: M
Bruener Retail is considering opening a new store. In evaluating the proposed project the companys CFO
has collected the following information:
Chapter 11 - Page 28
It will cost $10 million to construct the new store. These costs will be incurred at t = 0. These costs will be
depreciated on a straight-line basis over the next 10 years.
The company will need an additional $5 million of inventory to stock the new store. $2 million of this
inventory will be financed with accounts payable, the other $3 million will be paid for in cash. The cost of
this net increase in operating working capital will be incurred at t = 0. Assume that this net operating
working capital is fully recovered at t = 4.
The new store will be open for four years. During each of the four years (t = 1, 2, 3, and 4) the store will
produce the following financial projections (in millions of dollars):
t=1
EBITDA
Depreciation
EBIT
7.0
Taxes 2.8
Net income
t=2
$8.0
1.0
7.0
2.8
4.2
t=3
$8.0
1.0
7.0
2.8
4.2
t=4
$8.0
1.0
7.0
2.8
4.2
$8.0
1.0
4.2
Bruener finances its projects with 100 percent equity; thus, there is no interest expense. The company has a
10 percent weighted average cost of capital. The company assigns a 7 percent cost of capital for its low-risk
projects, a 10 percent cost of capital for its average-risk projects, and a 13 percent cost for its above-average
risk projects. Bruener estimates that this new store has average risk, so therefore the proposed projects cost
of capital is 10 percent.
Operating cash flows
77
What are the projects after-tax operating cash flows for each of the four years?
a.
b.
c.
d.
e.
$2.8
$3.6
$4.2
$4.8
$5.2
million
million
million
million
million
$4.5
$6.0
$6.6
$6.9
$7.5
million
million
million
million
million
Answer: d Diff: M N
The CFO estimates that the store can be sold after four years for $7.5 million. Brueners tax rate is
40 percent. What is the stores after-tax salvage value at t = 4?
a.
b.
c.
d.
e.
79
Answer: e Diff: E N
Answer: d Diff: M N
Assuming the store is sold after four years for $7.5 million, what is the projects net present value
(NPV)?
a.
b.
c.
d.
e.
$ 6.87 million
$ 7.49 million
$ 7.99 million
$10.25 million
$10.65 million
Scenario analysis
Answer: e Diff: M N
Chapter 11 - Page 29
80
After taking into account all of the relevant cash flows from the previous question, the companys
CFO has estimated the projects NPV and has also put together the following scenario analysis:
Scenario
County taxes increased
County taxes unchanged
County taxes decreased
Expected NPV
$ 5 million
8 million
10 million
On the basis of the numbers calculated above, the CFO estimates that the standard deviation of
the projects NPV is 2.06. The company typically calculates a projects coefficient of variation (CV)
and uses this information to assess the projects risk. Here is the scale that Bruener uses to
evaluate project risk:
Range for Coefficient
of Variation (CV)
CV > 0.3
0.2 < CV < 0.3
CV < 0.2
Risk
Assessment
High risk
Average risk
Low risk
Projects
WACC
12%
10
8
On the basis of this scenario analysis, which of the following statements is most correct?
a. The projects expected NPV is $7.75 million.
b. The project would be classified as an average-risk project.
c. If the project were classified as a high-risk project, the company should go back and recalculate
the projects NPV using the higher cost of capital estimate.
d. Statements a and b are correct.
e. All of the statements above are correct.
(The following information applies to the next two problems.)
Mitts Beverage Inc. manufactures and distributes fruit juice products.
Mitts is considering the
development of a new prune juice product. Mitts CFO has collected the following information regarding
the proposed project:
The project can be operated at the companys Dayton plant, which is currently vacant.
The project will require that the company spend $1 million today (t = 0) to purchase a new machine. For
tax purposes, the equipment will be depreciated on a straight-line basis. The company plans to use the
machine
for
all
3 years of the project. At t = 3, the equipment is expected to have no salvage value.
The project will require a $200,000 increase in net operating working capital at t = 0. The cost of the
net operating working capital will be fully recovered at t = 3.
The project is expected to increase the companys sales $1 million a year for three years (t = 1, 2, and
3).
The projects annual operating costs (excluding depreciation) are expected to be 60 percent of sales.
The companys tax rate is 40 percent.
The company is extremely profitable, so any losses incurred from the prune juice project can be used to
partially offset taxes paid on the companys other projects.
The project has a WACC equal to 10 percent.
Chapter 11 - Page 30
Answer: e Diff: M N
c. -$142,035
d. -$135,201
e. -$121,313
After-tax salvage value
82
Answer: c Diff: E N
There is a possibility that the company may be forced to end the project after only the second year. If
forced to end the project, the company will have to sell its equipment. If it sells its equipment after the
second year, Mitts expects to sell it for $400,000. What is the after-tax salvage value that would be
incorporated into the projects cash flow analysis?
a.
b.
c.
d.
e.
$383,333.33
$362,444.50
$373,333.33
$383,333.33
$400,000.00
(The following information applies to the next two problems.)
Bucholz Brands is considering the development of a new ketchup product. The ketchup will be sold in a
variety of different colors and will be marketed to young children. In evaluating the proposed project, the
company has collected the following information:
The company estimates that the project will last for four years.
The company will need to purchase new machinery that has an up-front cost of $300 million (incurred
at t = 0). At t = 4, the machinery has an estimated salvage value of $50 million.
The machinery will be depreciated on a 4-year straight-line basis.
Production on the new ketchup product will take place in a recently vacated facility that the company
owns. The facility is empty and Bucholz does not intend to lease the facility.
The project will require a $60 million increase in inventory at t = 0. The company expects that its
accounts payable will rise by $10 million at t = 0. After t = 0, there will be no changes in net
operating working capital, until t = 4 when the project is completed, and the net operating working
capital is completely recovered.
The company estimates that sales of the new ketchup will be $200 million each of the next four years.
The operating costs, excluding depreciation, are expected to be $100 million each year.
The companys tax rate is 40 percent.
The projects WACC is 10 percent.
What is the projects after-tax operating cash flow the first year (t = 1)?
a.
b.
c.
d.
e.
$22.5
$45.0
$60.0
$72.5
$90.0
million
million
million
million
million
Answer: e Diff: M N
Answer: a Diff: M N
-$10.07
-$25.92
-$46.41
-$60.07
million
million
million
million
Chapter 11 - Page 31
e. +$ 5.78 million
Web Appendix 11A
Multiple Choice: Conceptual
Easy:
NPV and depreciation
85
11A- .
Answer: c Diff: E
Other things held constant, which of the following would increase the NPV of a
project being considered?
a. A shift from MACRS to straight-line depreciation.
b. Making the initial investment in the first year rather than spreading it over the
first three years.
c. A decrease in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. All of the statements above will increase the projects NPV.
Medium:
Depreciation cash flows
11A-86.
Answer: c Diff: M
11B- .
Answer: d Diff: M
Given the following information, what is the required cash outflow associated with
the acquisition of a new machine; that is, in a project analysis, what is the cash
outflow at t = 0?
Purchase price of new machine
$8,000
Installation charge
2,000
Market value of old machine
2,000
Book value of old machine
1,000
Inventory decrease if new machine
is installed
1,000
Accounts payable increase if new
machine is installed
500
Tax rate
35%
Cost of capital
15%
a.
b.
c.
d.
Chapter 11 - Page 32
-$
-$
-$
-$
8,980
6,460
5,200
6,850
e. -$12,020
Tough:
Replacement decision
88
11B- .
Answer: b Diff: T
Replacement decision
11B-89.
Answer: a Diff: T
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 fifth
year. The applicable depreciation rates are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06.
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 cost of capital is 10 percent and its tax rate is 35 percent, what is the NPV of
the broilers?
a. -$60,644
b. $17,972
c. $28,451
d. -$44,553
e. $ 5,021
Replacement decision
11B-90.
Answer: c Diff: T
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 toward
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 cost of capital is
10 percent. The applicable depreciation rates are 0.20, 0.32, 0.19, 0.12, 0.11, and
Chapter 11 - Page 33
0.06. Assume a 40 percent tax rate. What is the net present value of the new
oven?
a. -$2,418
b. -$1,731
c. $2,635
d. $ 163
e. $1,731
Replacement project IRR
91
11B- .
Answer: c Diff: T
a. 4.1%
b. 2.2%
c. 0.0%
d. -1.5%
e. -3.3%
Replacement project
11B-92.
Answer: d Diff: T
a. $2,112.05
b. $ 318.27
c. -$5,887.95
d. $ 552.62
e. $1,497.91
New project NPV
11B-93.
Answer: d Diff: T
Year
1
2
Chapter 11 - Page 34
Net Income*
$50,000
60,000
MACRS
Depreciation
Rates
0.33
0.45
3
4
70,000
60,000
0.15
0.07
$153,840
$159,071
$162,409
$168,604
$182,344
Chapter 11 - Page 35
ANSWERS
CHAPTER
AND SOLUTIONS
11
1.
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.
2.
Answer: c
Diff: E
The correct answer is c. Sunk costs should be excluded from the analysis,
and interest expense is incorporated in the WACC so it should not be
incorporated in the projects cash flows.
3.
Answer: d
Diff: E
Sunk costs should be ignored, but externalities and opportunity costs should
be included in the project evaluation.
Therefore, the correct choice is
statement d.
4.
Answer: b
Diff: E
Sunk costs are never included in project cash flows, so statement a is false.
Externalities
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 project cash flows, interest
expense should not be included in project cash flows. Therefore, statement c
is false.
5
.
6.
Answer: b
Diff: E
7.
Answer: d
Diff: E
Answer: c
Diff: E
The 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 externality and should be included. Therefore, statement d
is the correct choice.
8
Relevant
Answer: d
9.
cash
Diff: E
flows
N
10.
Answer: a
Diff: E
Statement a is true; the other statements are false. If the company lost two
other accounts with positive NPVs, this would obviously be a huge negative when
considering the proposed project.
If the firm has an option to abandon a
project if it is unprofitable, this would make the company more likely to
accept the project. An option to repeat a project is a plus not a negative.
11.
Answer: a
Diff: E
Corporate risk
Answer: b
Diff: E
13.
Risk analysis
Answer: e
Diff: E
14.
Risk analysis
Answer: c
Diff: E
Statement a is false.
Stand-alone risk is measured by standard deviation.
Therefore, since Ys standard deviation is higher than Xs, Y has higher standalone risk than X. Statement b is false. Corporate risk is measured by the
correlation of project cash flows with other company cash flows. Therefore,
since Ys cash flows are highly correlated with the cash flows of existing
projects, while Xs are not, Y has higher corporate risk than X. Market risk
is measured by beta. Therefore, since Xs beta is greater than Ys, statement
c is true.
15.
Risk analysis
Answer: a
Diff: E
The correct answer is statement a. Since the proposed new project has a higher
standard deviation than the firms typical project, it has more stand-alone risk
than the firms typical project.
Statement b is incorrect; it will actually
lower corporate risk. Statement c is incorrect; we do not know what effect the
project will have on the firms market risk.
16.
Risk analysis
Answer: e
Diff: E
17.
The 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.
Accepting risky projects
Answer: e Diff: E
18.
Risk adjustment
Answer: b
Diff: E
19.
Answer: b
Diff: E
20.
Answer: c
Diff: E
Determine the required rate of return on each project. High-risk projects must
have a higher required rate of return than low-risk projects. The following
table shows the required return for each project on the basis of its risk
level.
Project
A
Expected Return
15%
Risk
High
B
C
D
E
12
11
9
6
Average
High
Low
Low
10
12
8
8
The company will accept all projects whose expected return exceeds
required return. Therefore, it will accept Projects A, B, and D.
21.
Answer: c
its
Diff: E
Answer: d
Diff: M
23.
Answer: d
Diff: M
Statements b and c are true; therefore, statement d is the correct choice. The
$3 million spent on researching the technology is a sunk cost and should not be
considered in the investment decision.
24.
Answer: d
Diff: M
Statement a is a sunk cost and sunk costs are never included in the capital
budgeting analysis. Therefore, statement a is not included. Statement b is
an opportunity cost and should be included in the capital budgeting analysis.
Statement c is the cannibalization of existing products, which will cause the
company to forgo cash flows and profits in another division. Therefore, it
is included in the capital budgeting analysis. Therefore, the correct answer
is statement d.
25.
Answer: d
Diff: M
Statements b and c are true; therefore, statement d is the correct choice. The
cost of clearing the land is a sunk cost and should not be considered in the
analysis. The expected impact of the new store on the existing store should be
considered.
In addition, the opportunity to lease the land represents an
opportunity cost of opening the new store on the land and should be considered.
26
.
Answer: d
Diff: M
Answer: d
Diff: M
28.
Answer: d
Diff: M
29.
Answer: b
Diff: M
30.
Answer: d
Diff: M
Corporate risk
Answer: e
Diff: M
32.
Answer: a
Diff: M
33.
Answer: e
Diff: M
34.
Risk adjustment
Answer: a
Diff: M
kA = 13% - 3% = 10%.
If the cash flows are cost-only outflows, and the
analyst wants to correctly reflect their risk, the discount rate should be
adjusted downward (in this case by subtracting 3 percentage points) to make
the discounted flows comparatively larger.
35
Taxes
on
gain
Answer: b
on
sale
Diff: E
When the machine is sold the total accumulated depreciation on it is: (0.20 +
0.32 + 0.19) $1,000,000 = $710,000. The book value of the equipment is:
$1,000,000 - $710,000 = $290,000. The machine is sold for $400,000, so the
gain is $400,000 - $290,000 = $110,000. Taxes are calculated as $110,000
0.4 = $44,000.
36.
Answer: d
Diff: E
We are given the up-front cost. The new software systems cash flows are the
annual cash amounts freed up by not having to invest in inventory.
0
1
2
3
4
5 Years
10%
|
|
|
|
|
|
-75,000,000
+200,000,000 +200,000,000 +200,000,000 +300,000,000 +300,000,000
$200,000,000
$200,000,000
$200,000,000
+
+
2
(1.1)
(1.1)
(1.1)3
$300,000,000
$300,000,000
+
+
4
(1.1)
(1.1)5
NPV = -$75,000,000 + $181,818,000 + $165,289,000 + $150,263,000 +
$204,904,000 + $186,276,000
NPV = $813,550,000.
NPV = -$75,000,000 +
37.
Answer: c
Diff: E
Step 1:
Step 2:
38
After-tax
Answer: c
salvage
Diff: M
value
N
The book value of the machinery at the end of Year 4 is 0.17 $300,000,000 =
$51,000,000.
The salvage value of the machinery is $50,000,000, so the
company has a loss of $50,000,000 - $51,000,000 = $1,000,000. However, the
firm will receive a tax credit on the sale of the machinery of 0.4
$1,000,000 = $400,000. So, the after-tax cash flow received from the sale of
the machinery is $50,000,000 + $400,000 = $50,400,000.
39.
Answer: e
2
|
1,920
Diff: M
3 Years
|
1,152
Year
1
2
3
4
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
Depreciable
Basis
$4,000
4,000
4,000
4,000
Annual
Depreciation
$1,320
1,800
600
280
$4,000
II
Initial outlay
1) Cost
2) Decrease in NOWC
3) Total net investment
Operating flows:
4) EBT and depreciation
5) Oper. income after taxes
(line 4 0.6)
6) Depreciation (from table)
7) Tax savings from
($4,000)
1,000
($3,000)
$2,000
$2,000
$2,000
1,200
1,320
1,200
1,800
1,200
600
528
720
240
$1,728
$1,920
$1,440
$1,000
______
$1,728
(288)
(1,000)
($ 288)
______
$1,152
______
$1,920
Numerical solution:
$1,728
$1,920
$1,152
= $544.46 $544.
2
1.18
(1.18)
(1.18)3
NPV = -$3,000
40.
Answer: d
Time line:
0
1
| k = 12% |
-45,000
7,800
NPV = ?
2
|
10,680
3
|
7,560
4
|
5,880
Diff: M
5 Years
|
-1,920
MACRS
Depreciation
Rates
0.20
0.32
0.19
0.12
0.11
0.06
Depreciable
Basis
$60,000
60,000
60,000
60,000
60,000
60,000
Annual
Depreciation
$12,000
19,200
11,400
7,200
6,600
3,600
$60,000
5,000 $ 5,000
3,000
3,000
7,200
6,600
2,880
2,640
5,880 $ 5,640
$10,000
(2,560)
11)
12)
IV Net
13)
Return of NOWC
(15,000)
Total termination CFs
(7,560)
CFs
_______ _______ _______ _______ _______ _______
Net CFs
($45,000) $ 7,800 $10,680 $ 7,560 $ 5,880($ 1,920)
Numerical solution:
NPV = -$45,000
$7,800
$10,680
$7,560
$5,880
$1,920
2
3
4
1.12
(1.12)
(1.12)
(1.12)
(1.12)5
= -$21,493.24 -$21,493.
Financial calculator solution:
Inputs:
CF0 = -45000; CF1 = 7800; CF2 = 10680; CF3 = 7560; CF4 = 5880;
CF5 = -1920; I = 12.
Output: NPV = -$21,493.24 -$21,493.
41.
Answer: b
Time line:
0 k = 9%
1
2
|
|
|
-40,000
9,800
11,720
NPV = ?
Depreciation cash flows:
MACRS
Depreciation
Year
Rates
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
Project analysis worksheet:
0
Initial outlay
1) Machine cost
($40,000)
2) NOWC
-3) Total net inv. ($40,000)
II Operating cash flows
4) Inc. in earnings
before deprec. & taxes $
5) After-tax increase in
earnings (line 4 0.6)
6) Before tax reduction
in cost
7) After tax reduction
in cost (line 6 0.4)
8) Deprec. (from table)
9) Deprec. tax savings
(line 8 0.4)
10) Net operating CFs
(lines 5 + 7 + 9)
$
III Terminal year CFs
11) Estimated salvage value
12) Tax on salvage value
[($10,000 - $2,400)(0.4)]
13) Return of NOWC
14) Total termination CFs
I
3
|
9,640
4
|
8,520
Depreciable
Basis
$40,000
40,000
40,000
40,000
40,000
40,000
Diff: M
5 Years
|
15,320
Annual
Depreciation
$ 8,000
12,800
7,600
4,800
4,400
2,400
$40,000
3
3,600
3,600
3,600
3,600
5,000
5,000
5,000
5,000
5,000
3,000
8,000
3,000
12,800
3,000
7,600
3,000
4,800
3,000
4,400
3,200
5,120
3,040
1,920
1,760
IV
Net CFs
15) Net CFs
Numerical solution:
NPV = -$40,000
$9,800
$11,720
$9,640
$8,520
$15,320
2
3
4
1.09
(1.09)
(1.09)
(1.09)
(1.09)5
= $2,291.90 $2,292.
42.
-$
0
600,000
-50,000
Sales increase
Operating costs
Depreciation
Oper. inc. before taxes
Taxes (35%)
Oper. inc. after taxes
+Depreciation
Operating cash flow
Recovery of NOWC
Equipment sale
Taxes on sale
___________
Net CFs
-$ 650,000
43
.
Diff: M
$2,000,000
1,400,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
$2,000,000
1,400,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
__________
$ 460,000
__________
$ 460,000
$2,000,000
1,400,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
50,000
+100,000
-35,000
$ 575,000
Answer: b
Diff: M
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
0
-$5,000,000
-300,000
Depreciable
Basis
$5,000,000
$5,000,000
$5,000,000
$5,000,000
2
Sales
$3,000,000 $4,000,000
Operating costs (75%)
2,250,000
3,000,000
Depreciation
1,650,000
2,250,000
Oper. inc. before taxes
-$ 900,000 -$1,250,000
Taxes (40%)
-360,000
-500,000
Oper. inc. after taxes
-$ 540,000 -$ 750,000
Plus: Depreciation
1,650,000
2,250,000
Operating CF
$1,110,000 $1,500,000
Recovery of NOWC
Net CFs
-$5,300,000 $1,110,000 $1,500,000
Annual
Depreciation
$1,650,000
2,250,000
750,000
350,000
$5,000,000
3
$5,000,000
3,750,000
750,000
$ 500,000
200,000
$ 300,000
750,000
$1,050,000
$1,050,000
$2,000,000
1,500,000
350,000
$ 150,000
60,000
$
90,000
350,000
$ 440,000
300,000
$ 740,000
*An 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.
Thus, the change in net
operating working capital will be $200,000 - $500,000 = -$300,000 at time 0.
44
NPV
Diff: M
Project cost
NOWC
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
0
($500,000)
(40,000)
Sales
Operating costs
Depreciation
Oper. costs bef. taxes
Taxes (40%)
Oper. costs after taxes
Plus: Depreciation
Recovery of NOWC
Net CFs
($540,000)
NPV
45.
Depreciable
Basis
$500,000
500,000
500,000
500,000
$800,000
480,000
165,000
$155,000
62,000
$ 93,000
165,000
________
$258,000
Annual
Depreciation
$165,000
225,000
75,000
35,000
$500,000
$800,000
480,000
225,000
$ 95,000
38,000
$ 57,000
225,000
________
$282,000
$500,000
300,000
75,000
$125,000
50,000
$ 75,000
75,000
________
$150,000
$500,000
300,000
35,000
$165,000
66,000
$ 99,000
35,000
40,000
$174,000
Answer: b
0
($1,000)
(200)
Sales
Costs
Depreciation
Oper. inc. before taxes
Taxes (40%)
Oper. inc. after taxes
Add Depreciation
Operating CFs
Salvage value
Tax on SV
Recovery of NOWC
Net CFs
($1,200)
$900
450
500
($ 50)
(20)
($ 30)
500
$470
$900
450
300
$150
60
$ 90
300
$390
$470
$390
$900
450
200
$250
100
$150
200
$350
100
(40)
200
$610
Diff: M
0 k = 10% 1
|
|
-1,200
470
NPV = -$1,200
46.
3 Years
|
610
$470
$390
$610
2
1.10 (1.10)
(1.10)3
= $7.89.
New project NPV
Answer: a
0
k = 15% 1
|
|
Cost
-50,000
Sales
$50,000
VC
20,000
Depreciation
40,000
Oper. inc. before taxes
($10,000)
Taxes (40%)
(4,000)
Oper. inc. after taxes
($ 6,000)
Depreciation
40,000
Operating CFs
$34,000
NOWC
(12,000)
AT Salvage
_______
_______
NCFs
($62,000)
$34,000
NPV = -$62,000
47
2
|
390
2
|
$50,000
20,000
5,000
$25,000
10,000
$15,000
5,000
$20,000
_______
$20,000
3
|
$50,000
20,000
5,000
$25,000
10,000
$15,000
5,000
$20,000
12,000
6,000
$38,000
$34,000
$20,000
$38,000
= $7,673.71.
2
1.15
(1.15)
(1.15)3
Diff: M
Years
Answer: d
Diff: M
The equipment is purchased for $10,000,000 and is depreciated over 5 years. The
depreciation table looks like this:
Year
1
2
3
4
5
Straight-Line
Depreciation Rate
1/5
1/5
1/5
1/5
1/5
Depreciation
$2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
Book Value
$8,000,000
6,000,000
4,000,000
2,000,000
0
Notice that the project has a life of only 4 years, while the equipment is
depreciated over 5 years.
At the end of Year 4, the company sells the
equipment for $3 million, but its book value is only $2 million. The equipment
is sold for $1 million more than its book value; therefore, the firm will be
taxed on this $1 million. Consequently, at the end of the project, it receives
$3 million for the sale, but it has to pay $400,000 in taxes (40% of $1
million).
Net operating working capital required at t = 0 will be $1 million.
(Inventories are a use of working capital, so they increase operating working
capital by $2 million.
Accounts payable are a source of operating working
capital, so they decrease operating working capital by $1 million. Net
operating working capital increases by $1 million). Remember that the firm gets
this back at t = 4.
Year
0
Sales
Op. costs
Depn
Oper. inc. before taxes
Taxes (40%)
Oper. inc. after taxes
Depn
Oper. cash flow
Equipment cost
($10,000,000)
Taxes on sale
Change in NOWC
(1,000,000)
Net cash flow
($11,000,000)
1
$ 7,000,000
3,000,000
2,000,000
$ 2,000,000
800,000
$ 1,200,000
2,000,000
$ 3,200,000
2
$ 7,000,000
3,000,000
2,000,000
$ 2,000,000
800,000
$ 1,200,000
2,000,000
$ 3,200,000
3
$ 7,000,000
3,000,000
2,000,000
$ 2,000,000
800,000
$ 1,200,000
2,000,000
$ 3,200,000
$ 3,200,000
$ 3,200,000
$ 3,200,000
4
$ 7,000,000
3,000,000
2,000,000
$ 2,000,000
800,000
$ 1,200,000
2,000,000
$ 3,200,000
3,000,000
(400,000)
1,000,000
$ 6,800,000
Now, enter the net cash flows into the cash flow register and enter the
discount rate, I/YR = 12, and solve for the projects NPV = $1,007,383 $1.01
million.
48.
Answer: e
0
Equipment outlay
-$500,000
Change in NOWC
-30,000
Sales
Op. costs excl.deprec. (70%)
Depreciation
Oper. inc. before taxes
Taxes (40%)
Oper. inc. after taxes
Add back: Depreciation
Oper. cash flows
AT salvage value
Recovery of NOWC
Net cash flows
-$530,000
Diff: M
$1,000,000
700,000
100,000
$ 200,000
80,000
$ 120,000
100,000
$ 220,000
$1,200,000
840,000
100,000
$ 260,000
104,000
$ 156,000
100,000
$ 256,000
$1,500,000
1,050,000
100,000
$ 350,000
140,000
$ 210,000
100,000
$ 310,000
200,000
30,000
$ 540,000
220,000
256,000
CF0 = -530000; CF1 = 220000; CF2 = 256000; CF3 = 540000; I/YR = 14; and then
solve for NPV = $224,450.76 $224,451.
49.
Answer: c
Diff: M
in the question.
3
4
$600,000
400,000
75,000
$125,000
50,000
$ 75,000
$600,000
400,000
35,000
$165,000
66,000
$ 99,000
30,000
40,000
35,000
$204,000
75,000
$150,000
Answer: b
Diff: M
Set up a time line in an income statement format to lay out the cash
flows:
0
Building
NOWC
-$14.0
-5.0
Revenues
Oper. costs
Depreciation
Oper. inc. before taxes
Taxes (40%)
Oper. inc. after taxes
Plus Depreciation
Oper. CFs
Sale of building
Taxes on sale
Recovery of NOWC
Net cash flows
-$19.0
$15.0
10.0
2.0
$ 3.0
1.2
$ 1.8
2.0
$ 3.8
$15.0
10.0
2.0
$ 3.0
1.2
$ 1.8
2.0
$ 3.8
$15.0
10.0
2.0
$ 3.0
1.2
$ 1.8
2.0
$ 3.8
$15.0
10.0
2.0
$ 3.0
1.2
$ 1.8
2.0
$ 3.8
$ 3.8
$ 3.8
$ 3.8
$ 3.8
$15.0
10.0
2.0
$ 3.0
1.2
$ 1.8
2.0
$ 3.8
8.0
-1.6*
5.0
$15.2
Step 2:
51.
Risk-adjusted NPV
Answer: c
Diff: M
2
3
4
Initial cost-$2,000Change in NOWC
-100Initial outlay
-2,100Sales$1,000$2,000$2,000$1,000Operating costs
500 1,000 1,000
500Depreciation
500
500
500
500Operating income$
0 $ 500$ 500$
0Taxes (40%)
0
200
200
0Operating income$
0$ 300$ 300$
0Depreciation
500
500
500
500Externalities -250 -250 -250 -250Return of
NOWC ________________________+ 100Net cash flow (NCF)-$2,100$ 250$ 550$ 550$
350
Entering the NCF amounts into the cash flow register (at 12%) gives you a NPV
of -$824,418.62.
52.
Risk-adjusted NPV
Answer: a
Time lines:
Project A:
0 k = 14% 1
|
|
CFsA -200,000
71,104
2
|
71,104
3
|
71,104
4 Years
|
71,104
2
|
0
3
|
146,411
4 Years
|
146,411
NPVA = ?
Project B:
0 k = 10%
|
CFsB -200,000
1
|
0
NPVB = ?
Calculate required returns on A and B:
Project A High risk kRisk adjusted = 12% + 2% = 14%.
Diff: M
Project B
Low risk
Risk-adjusted NPV
Time line:
0
1
k = 12%
|
|
-50,000
6,000
NPV = ?
Answer: e
2
|
6,000
Salvage value
Diff: M
10 Years
|
6,000
10,000
16,000
Risk-adjusted NPV
Answer: c
Diff: M
A: Inputs: CF0 = -5000; CF1 = 2000; CF2 = 2500; CF3 = 2250; I = 12.
Output: NPV = $380.20 $380.
B: Inputs: CF0 = -5000; CF1 = 3000; CF2 = 2600; CF3 = 2900; I = 14.
Output: NPV = $1,589.61 $1,590.
Risk-adjusted discount rate
Answer: b
Diff: M
Time lines:
0 k = 12% 1
|
|
CFsA -5,000
2,000
NPVA = ?
0 k = 14% 1
|
|
CFsB -5,000
3,000
NPVB = ?
Project A:
Project B:
55.
2
|
2,500
3 Years
|
2,250
2
|
2,600
3 Years
|
2,900
Time lines:
Project A
0 k = 12% 1
2
|
|
|
CFsA -15,000 4,000 4,000
NPVA = ? = 3,978.78
Project B
0 k = ? 1
2
|
|
|
CFsB -14,815 5,100 5,100
NPVB = NPVA = 3,978.78
3
|
4,000
4
|
4,000
5
|
4,000
6 Years
|
4,000
5,000 Salvage value
Terminal CF = 9,000
6 Years
|
5,100
0 Salvage value
Terminal CF = 5,100
Inputs:
Output:
Answer: e
2
|
13,000
2
|
15,247
Diff: M
3
|
13,000
4 Years
|
13,000
5,000 Salvage Value
Terminal CF = 18,000
3
|
15,247
4 Years
|
15,247
0 Salvage Value
Terminal CF = = 15,247
A:
Inputs:
Output:
B:
Inputs:
Output:
57
.
0
|
CFsNew Tech -1,500
NPVNew Tech = ?
CFsOld Tech
-600
NPVOld Tech = ?
Answer: e
1
|
-315
2
|
-315
3
|
-315
4
|
-315
-600
-600
-600
-600
Diff: M
Recognize that (1) risky 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%.
Project New Tech:
Project Old Tech:
58.
Inputs:
Output:
Inputs:
Output:
CF0
NPV
CF0
NPV
=
=
=
=
Diff: M
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
Bs cash flows at 10% - 2% = 8%. Project As cash flows would be discounted
at 10%.
Now we would find the PV of the costs as follows:
Project A: CF0 = -1000; CF1-10 = -100; I = 10.0; and then solve for NPV = -
$1,614.46.
Project B: CF0 = -300; CF1-10 = -200; I = 8.0; and then 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.
59
Plan 2:
Answer: c
(Low Risk)
0 i = 17% 1
10 Years
|
|
|
-100,000
-5,000
-5,000
With a financial calculator input the following:
CF0 = -100000; CF1-10 = -5000; I = 17; and then
NPV1 = -$123,293.02.
(High Risk)
0 i = 13% 1
|
|
0
-25,000
Diff: M
solve
for
10 Years
|
-25,000
for
NPV2
Note that because we are dealing with cash outflows, the higher-risk projects
discount rate must be lowered, while the lower-risk projects discount rate
must be increased. Thus, Plan 1 has the lower costs and should be accepted.
60.
Risky projects
Answer: d
Diff: M
Look at the NPV, IRR, and hurdle rate for each project:
Project
A
B
C
D
E
Hurdle rate
9.00%
9.00%
11.00%
13.00%
13.00%
NPV
$13,822
$11,998
IRR
12.11%
14.04%
10.85%
16.64%
11.63%
NPVA = -$200,000
$66,000
$66,000
$66,000
$66,000
= $13,821.51 $13,822.
2
3
1.09
(1.09)
(1.09)
(1.09)4
NPVB = -$100,000
$30,000
$30,000
$40,000
$40,000
= $11,997.68 $11,998.
2
3
1.09
(1.09)
(1.09)
(1.09)4
Projects A and B are mutually exclusive, so we cannot use the IRR method, so
their NPVs must be calculated. We pick project A because it has the largest
NPV. Projects C, D, and E are independent so we pick the ones whose IRR exceeds
the cost of capital, in this case, just D. Therefore, the projects undertaken
are A and D.
61
Scenario analysis
Answer: c
Diff: M
Pi(x)
0.3(-6,000)
0.5(13,000)
0.2(28,000)
Expected NPV
____________________________________________________
Worst case
Base case
Best case
0.3(-6,000 10,300)2
0.5(13,000 10,300)2
0.2(28,000 10,300)2
= -1,800
=
6,500
=
5,600
= $10,300
Pi(x - x )2
265,690,000
79,707,000
7,290,000
3,645,000
313,290,000
62,658,000
2 = 146,010,000
___________________________
___________________________
Answer: a
Diff: M
Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the
company has earnings of $100,000 and pays out 50% or $50,000 in dividends, then
it will retain earnings of $50,000.
The retained earnings breakpoint is
$50,000/0.4 = $125,000. Since it will require financing in excess of $125,000
to undertake any of the alternatives, we can conclude the firm must issue new
equity. Therefore, the pertinent component cost of equity is the cost of new
equity.
Calculate the expected dividend per share (note this is D 1) as
$50,000/10,000 = $5. Thus, the cost of new equity is $5/[($35(1 - 0.12)] + 6% =
22.23%. Jacksons WACC is 7%(0.6) + 22.23%(0.4) = 13.09%. Only the return on
Project A exceeds the WACC, so only Project A will be undertaken.
63.
Answer: b
Depreciation Schedule
Depreciable Basis:
$5,000,000
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
Year
1
2
3
4
Diff: T
Annual
Depreciation
$1,650,000
2,250,000
750,000
350,000
1,800,000
2,100,000
2,700,000
450,000)($
2,400,000Depreciation
1,650,000
2,250,000__________
850,000)$1,050,000$1,250,000Taxes (40%)
270,000)($
510,000)$
630,000$
750,000Plus:
750,000__________
(180,000)
(340,000)
420,000
Depreciation
1,650,000
2,250,000
500,000
Enter the NCF amounts into the cash flow register (at 10%) and obtain the NPV
of the cash flows is -$1,248,378.
64.
Step 2:
Step 3:
Calculate depreciation:
Dep1 = $100,000(0.33) =
Dep2 = $100,000(0.45) =
Dep3 = $100,000(0.15) =
Dep4 = $100,000(0.07) =
Answer: d
Diff: T
$33,000.
$45,000.
$15,000.
$ 7,000.
= -$105,000.
= $ 83,000.
= $105,000.
= $ 85,000.
+ $5,000 + $15,000 = $87,000.
65.
Answer: d
Diff: T
Answer: d
Diff: T
[90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 (10,000)(1 - 0.4)
(100,000)(0.20)](1
(100,000)(0.32)](1
(100,000)(0.19)](1
(100,000)(0.12)](1
(100,000)(0.11)](1
(100,000)(0.06)](1
0.4)
0.4)
0.4)
0.4)
0.4)
0.4)
+
+
+
+
+
+
(100,000)(0.20)
(100,000)(0.32)
(100,000)(0.19)
(100,000)(0.12)
(100,000)(0.11)
(100,000)(0.06) +
=
=
=
=
=
-100,000
32,000
36,800
31,600
28,800
28,400
32,400
Enter the cash flows into the cash flow register (at 10%) and solve for the NPV
= $38,839.59 $38,840.
67.
Answer: b
Diff: T
Time line:
IRR = ?
0
1
k = 12%
|
|
-100,000
17,300
NPV = ?
Year
1
2
3
4
5
6
2
|
22,100
3
|
16,900
MACRS
Depreciation
Rates
0.20
0.32
0.19
0.12
0.11
0.06
4
|
14,100
Depreciable
Basis
$100,000
100,000
100,000
100,000
100,000
100,000
5
|
13,700
6 Years
|
11,700
Annual
Depreciation
$20,000
32,000
19,000
12,000
11,000
6,000
$100,000
68.
Answer: e
Diff: T
0
-$30.0
$20.0
12.0
10.0
$20.0
12.0
10.0
$20.0
12.0
10.0
$20.0
12.0
0.0
$20.0
12.0
0.0
-$30.0
-$ 2.0
-0.8
-$ 1.2
10.0
$ 8.8
-$ 2.0
-0.8
-$ 1.2
10.0
$ 8.8
-$ 2.0
-0.8
-$ 1.2
10.0
$ 8.8
$ 8.0
3.2
$ 4.8
0.0
$ 4.8
$ 8.0
3.2
$ 4.8
0.0
$ 4.8
Numerical solution:
Step 1: Determine the NPV of net operating cash flows:
NPV = -$30 + $8.8/1.10 + $8.8(1.10)2 + $8.8/(1.10)3
+ $4.8/(1.10)4 + $4.8/(1.10)5
= -$30 + $8 + $7.2727 + $6.6116 + $3.2785 + $2.9804
= -$1.8568 million.
Step 2:
Step 3:
69.
Step 2:
Step 3:
70
.
Answer: a
Diff: E
Answer: e
Diff: M
($40,000)
(2,000)
($42,000)
Year
MACRS
Depreciation
Rates
Depreciable
Basis
Annual
Depreciation
1
2
3
4
0.33
0.45
0.15
0.07
$40,000
40,000
40,000
40,000
$13,200
18,000
6,000
2,800
$40,000
Increase in revenues
Increase in costs
Before-tax change in earnings
After-tax change in
earnings (line 3 0.60)
5) Depreciation
6) Deprec. tax savings
(line 5 0.40)
7) Net operating CFs
(lines 4 + 6)
71.
1
$20,000
(5,000)
$15,000
2
$20,000
(5,000)
$15,000
3
$20,000
(5,000)
$15,000
$ 9,000
13,200
$ 9,000
18,000
$ 9,000
6,000
5,280
7,200
2,400
$14,280
$16,200
$11,400
Answer: a
Diff: M
3
$25,000
(8,880)*
2,000
$18,120
72.
Answer: c
Time line:
0 k = 14% 1
|
|
-42,000
14,280
2
|
16,200
3 Years
|
11,400
TV = 18,120
29,520
Numerical solution:
NPV = -$42,000
= $2,916.85 $2,917.
1.14
(1.14)2
(1.14)3
Diff: M
73.
Answer: d
Initial investment:
Cost
Modification
Change in NOWC
Total net investment
74
.
Diff: E
($50,000)
(10,000)
(2,000)
($62,000)
Answer: c
Diff: M
Depreciation schedule:
Year
1
2
3
4
75
MACRS
Depreciation
Rates
0.33
0.45
0.15
0.07
Depreciable
Basis
$60,000
60,000
60,000
60,000
Annual
Depreciation
$19,800
27,000
9,000
4,200
$60,000
1
$20,000
2
$20,000
3
$20,000
12,000
19,800
12,000
27,000
12,000
9,000
7,920
$19,920
10,800
$22,800
3,600
$15,600
Answer: c
Diff: M
3
$20,000
(6,320)*
2,000
$15,680
Numerical solution:
Answer: a
2
|
22,800
3 Years
|
15,600
TV = 15,680
31,280
Diff: M
NPV = -$62,000
= -$1,546.81 -$1,547.
1.10
(1.10)2
(1.10)3
Answer: e
Diff: E
Depreciation
Net income
Oper. CFs
78.
t = 2
$1.0
4.2
$5.2
t = 3
$1.0
4.2
$5.2
t = 4
$1.0
4.2
$5.2
Answer: d
Diff: M
The original cost of the store is $10 million and the annual depreciation
expense is $1 million (since the store is being depreciated on a straightline basis over 10 years). So after 4 years the remaining BV = $10 - $4 = $6
million. If the store is sold for $7.5 million, the gain on the sale is $7.5
- $6.0 = $1.5 million. The tax on the gain is 0.4($1.5) = $0.6 million. The
after-tax salvage value is $7.5 - $0.6 = $6.9 million.
79.
Answer: d
Diff: M
t = 0
-$10.0
-3.0
-$13.0
t = 1
t = 2
t = 3
$5.2
$5.2
$5.2
$5.2
$5.2
$5.2
t = 4
$3.0
5.2
6.9
$15.1
Numerical solution:
NPV = -$13.0 +
$5.2
$5.2
$5.2
$15.1
2
3
1.10 (1.10)
(1.10)
(1.10)4
Scenario analysis
Answer: e
Diff: M
The correct answer is statement e. The expected NPV for the project = 0.25
$5 + 0.5 $8 + 0.25 $10 = $7.75 million. Therefore, statement a is correct.
The standard deviation of the project is given as 2.06. So, the coefficient of
Answer: e
t = 0
Equipment
-$1,000,000
Net oper. working capital
-200,000
Sales
Oper. costs (60%)
Depreciation
EBIT
Taxes (40%)
EBIT(1 - T)
Depreciation
AT Oper. CF
Recovery of NOWC
Net cash flows
82.
___________
-$1,200,000
Diff: M
t = 1
t = 2
t = 3
$1,000,000
600,000
333,333
$
66,667
26,667
$
40,000
333,333
$ 373,333
__________
$ 373,333
$1,000,000
600,000
333,333
$
66,667
26,667
$
40,000
333,333
$ 373,333
__________
$ 373,333
$1,000,000
600,000
333,333
$
66,667
26,667
$
40,000
333,333
$ 373,333
200,000
$ 573,333
Enter the cash flows into the cash flow register (at 10%) and solve for the NPV
= -$121,313.
After-tax salvage value
Answer: c Diff: E N
The tax due on the sale of equipment would be:
($400,000 - $333,333.33) 40% = $26,666.67.
Then, subtracting this tax from the sale price, ($400,000 - $26,666.67) you
get $373,333.33.
83.
Answer: e
Diff: M
Answer: a
Diff: M
The project cash flows are shown below (in millions of dollars):
Up-front costs
Increase in NOWC
Sales
0
-300
-50
200
200
200
200
Operating costs
Depreciation
EBIT
Taxes (40%)
EBIT(1 - T)
Depreciation
Operating CF
AT(SV)
NOWC recovery
Net CF
-350
-100
-75
25
-10
15
75
90
-100
-75
25
-10
15
75
90
-100
-75
25
-10
15
75
90
90
90
90
-100
-75
25
-10
15
75
90
30
50
170
Answer: c
Diff: E
Answer: c
Diff: M
Answer: d
Diff: M
87
88
($10,000)
2,000
(350)
1,500
($ 6,850)
11B-.
Replacement decision
Time line:
0
1
k = 16%
|
|
-11,900
5,648
NPV = ?
Depreciation cash flows:
MACRS
Depreciation
Year
Rates
1
0.33
2
0.45
3
0.15
4
0.07
Answer: b
2
Diff: T
3 Years
|
6,320
|
6,232
New Asset
Depreciation
$4,620
6,300
2,100
980
Old Asset
Depreciation
$1,000
1,000
1,000
--
Change in
Depreciation
$3,620
5,300
1,100
980
3
$7,000
4,200
2,100
1,000
1,100
440
$4,640
$2,000
(408)
-1,592
IV
Net CFs
16) Total Net Cfs
($11,900) $5,648
$6,320
$6,232
Answer: a
Diff: T
Time line:
0
1
2
3
4
5 Years
k = 10%
|
|
|
|
|
|
-148,750
21,625
30,025
20,925
16,025
27,325
NPV = ?
Depreciation cash flows*:
MACRS
Depreciation
New Asset
Old Asset
Change in
Year
Rates
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
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
((line 6 + 7) 0.65)
10,075 10,075 10,075 10,075 10,075
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.
(line 9 - 10)
33,000 57,000 31,000 17,000 15,000
12) Tax savings from deprec.
(line 11 0.35)
11,550 19,950 10,850
5,950
5,250
13) Net operating CFs
(line 8 + 12)
$21,625 $30,025 $20,925 $16,025 $15,325
III Terminal year CFs
14) Estimated salvage value
$12,000
15) Tax on salvage value
-16) Return of NWC
-17) Total termination CFs
12,000
IV Net CFs
18) Total Net CFs($148,750) $21,625 $30,025 $20,925 $16,025 $27,325
Financial calculator solution:
Inputs: CF0 = -148750; CF1 = 21625; CF2 = 30025; CF3 = 20925;
Answer: c
Diff: T
Time line:
0
1
2
3
4
5
6 Years
k = 10%
|
|
|
|
|
|
|
-11,000
3,200
4,400
3,100
2,400
2,300
3,000
NPV = ?
Depreciation cash flows:
MACRS
Depreciation
New Asset
Old Asset
Change in
Year
Rates
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
0
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 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 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.(line 6 0.6)
2,400 2,400 2,400 2,400 2,400 2,400
8) Deprec. new machine
5,000 8,000 4,750 3,000 2,750 1,500
9) Deprec. old machine
3,000 3,000 3,000 3,000 3,000
0
10) Change in deprec.
(line 8 - 9)
2,000 5,000 1,750
0
(250) 1,500
11) Tax savings from deprec.
(line 10 0.4)
800 2,000
700
0
(100)
600
12) Net operating CFs
(line 7 + 11)
$3,200 $4,400 $3,100 $2,400 $2,300 $3,000
III Terminal year CFs
13) Estimated salvage value
0
14) Total terminal yr CF
0
IV Net CFs
15) Total Net
CFs
($11,000)$3,200 $4,400 $3,100 $2,400 $2,300 $3,000
11B-.
Diff: T
Time line:
0
1
IRR = ?
|
|
-17,600
3,400
NPV = ?
Depreciation cash flows:
MACRS
Depreciation
Year
Rates
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
2
|
4,840
3
|
3,280
New Asset
Depreciation
$ 6,000
9,600
5,700
3,600
3,300
1,800
$30,000
|
2,440
Old Asset
Depreciation
$ 2,000
2,000
2,000
2,000
2,000
$10,000
|
3,640
Change in
Depreciation
$ 4,000
7,600
3,700
1,600
1,300
1,800
$20,000
$3,000
1,800
3,300
2,000
1,300
520
2,320
$1,000
320
-$1,320
$3,640
Answer: d
Diff: T
First calculate CF0: The old equipment can be sold for $8,000, but the book
value (BV) of the old equipment is $10,000 - $1,800 = $8,200. Thus, the
company will realize a loss on the sale of $200. The loss reduces taxes by
$200(0.40) = $80. CF0 includes the cost of the new equipment, net of the sale
proceeds
and
the
tax
effect
of
the
sale
equipment,
or
11B-.
Dep. New
$15,000(0.33)
$15,000(0.45)
$15,000(0.15)
$15,000(0.07)
= $4,950
= 6,750
= 2,250
= 1,050
Increased
Op Inc. =
CF
$1,800
$3,060
1,800
3,780
1,800
1,980
1,800
1,500
The old machine could have been sold for its BV or $1,000 at t = 4. This
represents an opportunity cost of replacement. Thus, CF4 = $1,500 - $1,000 =
$500.
The relevant cash flows are then CF0 = -$6,920, CF1 = $3,060, CF2 =
$3,780, CF3 = $1,980, and CF4 = $1,500. Discounting at 12 percent yields an
NPV of $552.62.
93
New project NPV
Answer: d Diff: T
Step 1:
Calculate depreciation:
Dep 1 = 100,000(0.33) = 33,000.
Dep 2 = 100,000(0.45) = 45,000.
Dep 3 = 100,000(0.15) = 15,000.
Dep 4 = 100,000(0.07) = 7,000.
Step 2:
Step 3:
= -105,000.
=
83,000.
= 105,000.
=
85,000.
5,000 + 15,000 = 87,000.
Calculate NPV:
Use CF key on calculator.
Enter cash flows shown above. Enter
I/YR = 12%. Solve for NPV = $168,604.
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