HIGGINS Chapter 7

Which of the following is NOT an important step in the financial evaluation of an investment opportunity? A. Calculate a
figure of merit for the investment.B. Estimate the accounting rate of return for the investment.C. Estimate the relevant
cash flows.D. Compare the figure of merit to an acceptance criterion.E. All of the above are important steps.

B. Estimate the accounting rate of return for the investment.

EAC Nutrition offers a 9.5 percent coupon bond with annual payments, maturing 11 years from today. Your required
return is 11.2 percent. What price are you willing to pay for this bond if the face (or par) value is $1,000? A. $895.43B.
$896.67C. $941.20D. $946.18E. $953.30F. None of the above.

A. $895.43Price = present value of coupons and face valueCoupon payment = 0.095 × 1000 = $95 per year

The accounting rate of return is deficient as a figure of merit because it is insensitive to the timing of cash flows

True

Pro forma free cash flows for a proposed project should:I. exclude the cost of employing existing assets that could be
sold anyway.II. exclude interest expense.III. include the depreciation tax shield related to the project.IV. exclude any
required increase in operating current assets. A. I and II onlyB. II and III onlyC. II and IV onlyD. I, III, and IV onlyE. I, II, III,
and IVF. None of the above.

B. II and III only

When conducting a discounted cash flow analysis of a project, it is important to always include a careful estimate of
financing costs in the project's cash flows.

False
Which of the following figures of merit does not directly take into consideration the time value of money?I. Payback
periodII. Internal rate of returnIII. Net present value (NPV)IV. Accounting rate of return A. IV onlyB. I & III onlyC. II & III
onlyD. I & II onlyE. I & IV onlyF. I, II, III, and IV

E. I & IV only

Your grandmother invested a lump sum 26 years ago at 4.25 percent interest. Today, she gave you the proceeds of that
investment which totaled $51,480.79. How much did she originally invest? A. $15,929.47B. $16,500.00C. $17,444.86D.
$17,500.00E. $17,999.45F. None of the above.

C. $17,444.86Present value = $51,480.79/(1 + 0.0425)26 = $17,444.86

You plan to buy a new Mercedes four years from now. Today, a comparable car costs $82,500. You expect the price of
the car to increase by an average of 4.8 percent per year over the next four years. How much will your dream car cost by
the time you are ready to buy it? A. $98,340.00B. $98,666.67C. $99,517.41D. $99,818.02E. $100,023.16F. None of the
above.

C. $99,517.41Future value = $82,500 × (1 + 0.048)4 = $99,517.41

Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly payments for 5 years at an 8.6
percent annual interest rate, compounded monthly. What is the amount of each payment? A. $287.71B. $296.67C.
$301.12D. $342.76E. $366.05F. None of the above.

E. $366.05The number of monthly periods = 5 × 12 = 60The monthly interest rate = 8.6%/12 = 0.71667%

Which of the following figures of merit might not use all possible cash flows in its calculations?I. Payback periodII.
Internal rate of returnIII. Net present value (NPV)IV. Benefit-cost ratio A. III onlyB. I & III onlyC. II & III onlyD. I onlyE. III &
IV onlyF. I, II, III, and IV

D. I only

What is the benefit-cost ratio for an investment with the following cash flows at a 14.5 percent required return?YEAR
CASH FLOW 0 $(46,500) 1 $12,200 2 $38,400 3 $11,300A. 0.94B. 0.98C. 1.02D. 1.06E. 1.11F. None of the above.

C. 1.02PVinflows = (12,200/1.145) + (38,400/1.1452) + (11,300/1.1453) = $47,472.78BCR = $47,472.78/$46,500 = 1.02

Which of the following statements related to the internal rate of return (IRR) are correct?I. The IRR is the discount rate at
which an investment's NPV equals zero.II. An investment should be undertaken if the discount rate exceeds the IRR.III.
The IRR tends to be used more than net present value simply because its results are easier to comprehend.IV. The IRR is
the best tool available for deciding between mutually exclusive investments. A. I and II onlyB. I and III onlyC. II and III
onlyD. I, II, and IV onlyE. I, II, III, and IVF. None of the above.

B. I and III only

Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent. How much will she have in her
account at the end of 45 years? A. $1,806,429B. $1,838,369C. $2,211,407D. $2,333,572E. $2,508,316F. None of the above.

D. $2,333,572

In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected
Year 1 free cash flow? A. $300B. $600C. $750D. $900

B. $600

Sol's Sporting Goods is expanding, and as a result expects additional operating cash flows of $26,000 a year for 4 years.
This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In
addition, the project requires an additional $3,000 of net working capital throughout the life of the project; Sol expects to
recover this amount at the end of the project. What is the net present value of this expansion project at a 16 percent
required rate of return? A. $18,477.29B. $21,033.33C. $28,288.70D. $29,416.08E. $32,409.57F. None of the above.

E. $32,409.57The initial investment consists of the fixed assets and incremental working capital: $39,000 + $3000 =
$42,000. The working capital amount is recovered at the end of year 4. Solve for the PV of the cash inflows, and then
subtract the initial investment:NPV = 74,409.57 - 42,000 = $32,409.57

You are to receive an annuity of $1,000 per year for 10 years. You will receive the first payment two years from today. At
a discount rate of 10%, what is the present value of this annuity? A. $5,078.15B. $5,585.97C. $6,144.57D. $6,759.03

B. $5,585.97The PV = $6,144.57. But the first payment is received in two years, not one year, so discount the PV by one
more year: 6,144.57/1.1 = $5,585.97

A divisional manager submitted a project proposal to the chief financial officer, complete with a calculated NPV for the
project. The chief financial officer studied the proposal and pointed out that the divisional manager had failed to
account for a one-time increase in net working capital of $60,000 that will be required over the life of the seven-year
project. Assuming the full value of net working capital will be recovered at the end of the project, how will the project's
NPV change after making the chief financial officer's adjustment? Assume a discount rate of 9%. A. The NPV will
decrease by $16,411.B. The NPV will decrease by $32,822.C. The NPV will decrease by $60,000.D. The NPV will not be
affected.E. None of the above.

E. None of the above.In Year 0 there is a $60,000 outflow.In Year 5 there is a $60,000 inflow, which has a present value of
60,000/1.097 = $32,822.The decrease in NPV is 60,000 - 32,822 = $27,178.

When evaluating investments under capital rationing that are independent and can be acquired fractionally, ranking by
the BCR is the appropriate technique.

True

The IRR is the discount rate at which an investment's NPV equals its initial cost.

False

You are the beneficiary of a life insurance policy. The insurance company informs you that you have two options for
receiving the insurance proceeds. You can receive a lump sum of $200,000 today or receive payments of $1,400 a month
for 20 years. You can earn a 6 percent annual rate on your money, compounded monthly. Which option should you take
and why? A. You should accept the monthly payments because they are worth $209,414 to you.B. You should accept the
$200,000 lump sum because the monthly payments are only worth $16,057 to you today.C. You should accept the
monthly payments because they are worth $336,000 to you.D. You should accept the $200,000 lump sum because the
monthly payments are only worth $189,311 to you today.E. You should accept the $200,000 lump sum because the
monthly payments are only worth $195,413 to you today.F. None of the above.

E. You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today.The
number of monthly periods = 20 × 12 = 240The monthly interest rate = 6%/12 = 0.5%

Giant Corp. is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated straight
line to a salvage value of 0 on a 5-year schedule. The project will require a one-time increase in the level of net working
capital of $300. The project will generate an additional $1,600 in revenues and $700 in operating expenses each year.
The project will end at the end of year 2, at which time the machinery is expected to be sold for $800. Giant's tax rate is
50%. In a discounted cash flow analysis of this project, what would be the projected Year 0 free cash flow? A. -$1,200B.
-$1,500C. -$1,800D. -$2,100

C. -$1,800

A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The after-tax salvage value of the
project is expected to be $2,500 in year 5. The project's initial cost is $9,500. What is the net present value of this project
if the required rate of return is 16 percent? A. -$311.02B. $2,168.02C. $4,650.11D. $9,188.98E. $21,168.02F. None of the
above.
B. $2,168.02Solve for the PV of the cash inflows, and then subtract the initial investment:NPV = 11668.02 - 9,500 =
$2,168.02

When making a capital budgeting decision, which of the following is/are NOT relevant?I. The size of a cash flow.II. The
risk of a cash flow.III. The accounting earnings from a cash flow.IV. The timing of a cash flow. A. I onlyB. II onlyC. III
onlyD. II and III onlyE. III and IV onlyF. They are all relevant.

C. III only

In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected
Year 2 free cash flow? A. $1,300B. $1,450C. $1,700D. $1,750

D. $1,750

Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine years from now. Which one of
the following statements is correct if both Ian and Sunny apply a 7 percent discount rate to these amounts? A. The
present values of Ian and Sunny's monies are equal.B. In future dollars, Sunny's money is worth more than Ian's
money.C. In today's dollars, Ian's money is worth more than Sunny's.D. Twenty years from now, the value of Ian's money
will be equal to the value of Sunny's money.E. Sunny's money is worth more than Ian's money given the 7 percent
discount rate.F. None of the above.

C. In today's dollars, Ian's money is worth more than Sunny's.

As a noncash expense, depreciation is irrelevant in the determination of a project's cash flows.

False

The IRR and NPV always yield the same investment recommendations

False

You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year forever. What annual rate of return
will you realize? A. 0.48%B. 2.40%C. 4.80%D. 5.10%E. 20.83%F. None of the above.

C. 4.80%r = A/P = $2.40/$50 = 4.80%

Which of the following should be included in the cash flow projections for a new product?I. Money already spent for
research and development of the new productII. Capital expenditures for equipment to produce the new productIII.
Increase in working capital needed to finance sales of the new productIV. Interest expense on the loan used to finance
the new product launch A. II and III onlyB. II and IV onlyC. I, II, and III onlyD. II, III, and IV onlyE. I, II, III, and IVF. None of
the above.

A. II and III only

What is the difference in the value of a $5,000 annual perpetuity and an annuity of $5,000 for 100 years? Assume that
the discount rate is 8% and that cash flows are received at the end of the year. A. $28B. $656C. $1,656D. $5,000

A. $28The present value of the perpetuity is 5,000/0.08 = $62,500. For the annuity:The difference = 62,500 - 62,472 = $28

Which of the following is NOT a reason why a dollar today is worth more than a dollar in the future? A. Inflation reduces
the purchasing power of future dollars.B. The value of a dollar in the future will be compounded more than the value of a
dollar today.C. There is more uncertainty of receiving dollars further into the future.D. A dollar today can be productively
invested in the time before receiving a dollar in the future.

B. The value of a dollar in the future will be compounded more than the value of a dollar today.