Old Exam Questions - Capital Budgeting
Page 36 of 55 Pages
Assume that you are given the following cash flows for a project. These are real
dollars and have not been adjusted for inflation. The firm intends to analyze this
project using infinite replication. The price of the project is expected to increase at a
constant annual inflation rate of 6% (that is, the price will be $8,000 in Year 0,
$10,099.82 in Year 4, $12,750.78 in Year 8, etc.). The cash inflows for this project are
expected to increase at a constant annual inflation rate of 5% (that is, the cash inflow
will be $3,150.00 in Year 1, $3,307.50 in Year 2, etc.). Using the method
demonstrated in class, and assuming that the correct risk-adjusted discount rate to use
for all cash flows is 10 percent per year, determine the net present value for this
infinitely replicated project. (Hint: you have to look at your inflows and outflows, and
the time period for these flows, separately.)
Assume that your company is considering a new project and has collected the
following information about the project. (Note: You may or may not need to use all of
this information, use only the information that is relevant.)
The project has an anticipated economic life of 4 years.
The company will have to purchase a new machine. The machine will have an up-
front cost of $2 million at Year 0. The machine will be depreciated on a straight-line
basis over 4 years (that is, depreciation expense will be $500,000 in each of Years
1-4). 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
company’s net operating working capital. At the outset, Year 0, inventory will
increase by $140,000 and accounts payable will increase by $40,000. At Year 4,
the net operating working capital will be recovered after the project is completed.
The project is expected to generate sales revenue of $2 million in Year 1, $3
million in Years 2 and 3, and $2 million in Year 4. Each year the operating costs
(not including depreciation) are expected to equal 50 percent of sales revenue.
The company’s interest expense each year will be $100,000.