Chapter10 - CHAPTER 10 Cash Flows and Other Capital...

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Unformatted text preview: CHAPTER 10 Cash Flows and Other Capital Budgeting Topics Multiple Choice: Conceptual Relevant cash flows 1. Answer: b Diff: E When evaluating a new project, the firm should consider all of the following factors except: a. Changes in 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. The current market value of any equipment to be replaced. d. The resulting difference in depreciation expense if the project involves replacement. e. All of the statements above should be considered. Relevant cash flows 2. Answer: e Diff: E Which of the following statements is most correct? a. The rate of depreciation will often affect operating cash flows, even though depreciation is not a cash expense. b. Corporations should fully account for sunk costs when making investment decisions. c. Corporations should fully account for opportunity costs when making investment decisions. d. All of the answers above are correct. e. Answers a and c are correct. Relevant cash flows 3. Answer: d Diff: E Which of the following statements is most correct? a. Sunk costs should be incorporated into capital budgeting decisions. b. Opportunity costs should be incorporated into capital budgeting decisions. c. Relevant externalities should be incorporated into capital budgeting decisions. d. Answers b and c are correct. e. Answers a, b, and c are correct. Chapter 11 Page 1 Relevant cash flows 4. Diff: E A company is considering an expansion project. The company’s CFO plans to calculate the project’s 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 company’s 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 associated with the project. Any interest expenses associated with the project. Any opportunity costs associated with the project. Answers b and c are correct. All of the answers above are correct. Relevant cash flows 5. Answer: c Answer: e Diff: E 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. All of the factors above should be considered. e. Factors b and c should be considered. Incremental cash flows 6. Answer: c Diff: E Which of the following is not a cash flow that results from the decision to accept a project? a. b. c. d. e. Changes in working capital. Shipping and installation costs. Sunk costs. Opportunity costs. Externalities. Chapter 11 - Page 2 Relevant and incremental cash flows 7. Answer: a Diff: E 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. Answers a and b are correct. e. Answers b and c are correct. Expansion project cash flows 8. Answer: a A company is considering a proposed expansion to its facilities. of the following statements is most correct? Diff: E Which 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 project’s 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 project’s 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. NPV and depreciation 9. 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 3 years. c. A decrease in the discount rate associated with the project. d. The sale of the old machine in a replacement decision at a capital loss rather than at book value. e. An increase in required working capital. Chapter 11 Page 3 Corporate risk 10. Answer: b Diff: E Which of the following statements is correct? a. Well diversified stockholders do not consider corporate risk when determining required rates of return. b. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk. c. Managers care only about market risk. d. Market risk is important but does not have a direct effect on stock price because it only affects beta. e. All of the statements above are false. Accepting risky projects 11. Answer: e Diff: E 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. Increase the IRR of the asset to reflect the greater risk. b. Increase the NPV of the asset to reflect the greater risk. c. Reject the asset, since its acceptance would increase the risk of the firm. d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm. e. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project. Risk adjustment 12. Diff: E Risk in a revenue-producing project can best be adjusted for by a. b. c. d. 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. Risk and project selection 13. Answer: b Answer: b Diff: E 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. Project A has average risk and an IRR = 9 percent. Project B has below-average risk and an IRR = 8.5 percent. Project C has above-average risk and an IRR = 11 percent. All of the projects above should be accepted. None of the projects above should be accepted. Chapter 11 - Page 4 Risk-adjusted NPV 14. Answer: b Diff: E Project X has an up-front cost of $1 million, whereas Project Y has an up-front cost of only $200,000. Both projects last five years and provide positive cash flows in Years 1-5. Project X is riskier; its risk-adjusted WACC is 12 percent. Project Y is safer; its risk-adjusted WACC is 8 percent. After discounting each of the project’s cash flows at the project’s risk-adjusted WACC, you find that Project X has a NPV of $20,000, and Project Y has a NPV of $15,000. The projects are mutually exclusive and cannot be repeated. The firm is not capital constrained; it can raise as much capital as it needs, provided it has profitable projects in which to invest. Given this information, which of the following statements is most correct? a. The firm should select Project Y because it has a higher return; ($15,000/$200,000) is greater than ($20,000/$1,000,000). b. The firm should select Project X because it has a higher NPV. c. The firm should select Project Y because it is less risky. d. The firm should reject both projects because their IRRs are less than the risk-adjusted WACC. e. Statements a and c are correct. Cash flows and accounting measures 15. Answer: d Diff: M Which of the following statements is correct? a. An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project. b. Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions. c. It is unrealistic to expect that increases in net operating working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project. d. Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value. e. All of the statements above are false. Chapter 11 Page 5 Relevant cash flows 16. Answer: d Diff: M Regarding the net present value of a replacement decision, which of the following statements is false? a. The present value of the after-tax cost reduction benefits resulting from the new investment is treated as an inflow. b. The after-tax market value of the old equipment is treated as an inflow at t = 0. c. The present value of depreciation expenses on the new equipment, multiplied by the tax rate, is treated as an inflow. d. Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0. e. An increase in net operating working capital is treated as an outflow when the project begins and as an inflow when the project ends. Relevant cash flows 17. 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 5 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. Sanford and Son estimate 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. Relevant cash flows 18. Answer: e Diff: M Pickles Corp. is a company which 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 which was never undertaken. If the project is adopted, the plan is to have the lemonade produced in this building. c. If the company doesn’t produce lemonade, it can lease the building to another company and receive after-tax cash flows of $500,000 a year. d. All of the statements above are correct. e. Answers a and c are correct. Chapter 11 - Page 6 Relevant cash flows 19. Answer: b Diff: M Which of the following statements is most correct? a. Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same. b. In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital. c. When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment. d. All of the answers above are correct. e. None of the answers above is correct. Incremental cash flows 20. Answer: e Diff: M Which of the following constitutes an example of a cost which is not incremental, and therefore not relevant in an accept/reject 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 which is shipped across the country and requires $25,000 in installation and set-up costs. d. All of the above are not examples of incremental cash flows. e. Answers a, b, and c are examples of incremental cash flows, and therefore, relevant cash flows. Factors affecting cash flows 21. Answer: d Diff: M Which of the following is not considered a relevant concern in determining incremental cash flows for a new product? a. The use of factory floor space which 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. 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 above. (All are relevant concerns in estimating relevant cash flows attributable to a new-product project.) Chapter 11 Page 7 Cash flow estimation 22. Answer: d Diff: M Which of the following statements is correct? a. In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost in the cash flow statement when determining the project's cash flows will lead to an upward bias in the NPV. b. The preceding statement would be true if "upward" were replaced with "downward." c. The existence of "externalities" reduces the NPV to a level below the value that would exist in the absence of externalities. d. If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration. e. The rent referred to in statement d is a sunk cost, and as such it should be ignored. Depreciation cash flows 23. Answer: c Diff: M Which of the following statement completions is incorrect? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce a. Higher depreciation charges in the early years of an asset's life. b. Larger cash flows in the earlier years of an asset's life. c. Larger total undiscounted profits from the project over the project's life. d. Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes. e. None of the above. (All of the above are correct.) Corporate risk 24. Answer: d Diff: M In theory, the decision maker should view market risk as being of primary importance. However, within-firm, or corporate, risk is relevant to a firm's a. Well-diversified stockholders, because it may affect debt capacity and operating income. b. Management, because it affects job stability. c. Creditors, because it affects the firm's credit worthiness. d. All of the answers above are correct. e. Only answers a and c are correct. Chapter 11 - Page 8 Methods of analysis 25. Answer: a Diff: M Which of the following statements is correct? a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions. b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's NPV. c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done using a PC with a spreadsheet program or even a calculator. 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. Answers c and d are correct. Risk-adjusted discount rate 26. Diff: M If a company uses the same discount rate for evaluating all projects, which of the following results is likely? a. b. c. d. e. Accepting Rejecting Accepting Accepting Answers a poor, high-risk projects. good, low-risk projects. only good, low-risk projects. no projects. and b are correct. Risk-adjusted discount rate 27. Answer: e Answer: a Diff: M If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most likely become a. b. c. d. e. Riskier over time, and its value will decline. Riskier over time, and its value will rise. Less risky over time, and its value will rise. Less risky over time, and its value will decline. There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate. Chapter 11 Page 9 Multiple Choice: Problems (Note: MACRS accelerated depreciation rates should be used for many of these problems.) Investment outlay 28. Diff: E The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of expected life remaining and a current book value of $30,000 versus a current market value of $24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value, what is the initial after-tax outlay for the new printing machine? a. b. c. d. e. -$22,180 -$30,000 -$33,600 -$36,000 -$40,000 Risk-adjusted discount rate 29. Answer: c Answer: c Diff: E Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than average, its fresh produce division has average risk, and its institutional foods division has below-average risk. Dandy adjusts for both divisional and project risk by adding or subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is the risk-adjusted required rate of return for a low-risk project in the yogurt division? a. 6% b. 8% c. 10% d. 12% e. 14% Chapter 11 - Page 10 [MACRS table required] New project NPV 30. Answer: d Diff: M Mars Inc. is considering the purchase of a new machine which 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 working capital will return to the original level when the machine is sold after 5 years. Mars's marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to evaluate projects of this nature. If the machine costs $60,000, what is the project’s NPV? a. b. c. d. e. -$15,394 -$14,093 -$58,512 -$21,493 -$46,901 [MACRS table required] New project NPV 31. Answer: b Diff: M Stanton Inc. is considering the purchase of a new machine which 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. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's cost is $40,000, what is the project's NPV? a. b. c. d. e. $1,014 $2,292 $7,550 $ 817 $5,040 Chapter 11 Page 11 New project NPV 32. Answer: c Diff: M Parker Products manufactures a variety of household products. The company is considering introducing a new detergent. The company’s CFO has collected the following information about the proposed product. (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 to produce the detergent. The machine has an up-front cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4 years (that is, the company’s 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 company’s 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 company’s interest expense each year will be $100,000. The new detergent is expected to reduce the after-tax cash flows of the company’s existing products by $250,000 a year (t = 1, 2 , 3, and 4). The company’s overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project’s WACC is estimated to be 12 percent. The company’s tax rate is 40 percent. What is the net present value of the proposed project? a. b. c. d. e. -$ 765,903.97 -$1,006,659.58 -$ 824,418.62 -$ 838,997.89 -$ 778,583.43 Chapter 11 - Page 12 Risk-adjusted NPV 33. Diff: M 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 of year cash flows of $71,104. Project B, of less than average risk, 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. B with Both A B with A with A with New project NPV 34. Answer: a a NPV and B a NPV a NPV a NPV of $10,001. because both have NPVs greater than zero. of $8,042. of $7,177. of $15,968. Answer: b Diff: M Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of $900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project's income is negative, and a 10 percent cost of capital. Inflation is zero. What is the project's NPV? a. b. c. d. e. $ 6.24 $ 7.89 $ 8.87 $ 9.15 $10.41 Chapter 11 Page 13 New project NPV 35. Answer: a Diff: M Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3. The facility will produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3 respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent cost of capital. Inflation is zero. What is the project's NPV? a. b. c. d. e. $ 7,673.71 $12,851.75 $17,436.84 $24,989.67 $32,784.25 Chapter 11 - Page 14 CHAPTER 11 Answers and Solutions 1. Relevant cash flows Answer: b Diff: E 2. Relevant cash flows Answer: e Diff: E Statements a and c are correct; therefore, statement e 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. 3. Relevant cash flows Answer: d Diff: E 4. Relevant cash flows 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 and not the cash flows. 5. Relevant cash flows Answer: e Diff: E Statements b and c are correct; therefore, statement e is the correct answer. The $3 million spent on researching the technology is a sunk cost and should be excluded from the analysis. 6. Incremental cash flows 7. Answer: c Diff: E Relevant and incremental cash flows Answer: Statement a is correct; 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 adopt it. An option to repeat a project is a plus not a negative. 8. Expansion project cash flows Statement a is correct; the others are false. Depreciation cash flows must be considered when calculating operating cash flows. In addition, externality cash flows should be considered; however, sunk costs are not included in the analysis. 9. NPV and depreciation Answer: c Diff: E 10. Corporate risk Answer: b Diff: E 11. Accepting risky projects Answer: e Diff: E 12. Risk adjustment Answer: b Diff: E 13. Risk and project selection Answer: b Diff: E Chapter 11 Page 15 Answer: 14. Risk-adjusted NPV Statement a is false because the firm is not capital constrained; therefore, it should consider only NPV when evaluating projects. The return measure in statement a is irrelevant. Statement c is false because a risk-adjusted cost of capital has been used to evaluate the projects and arrive at the NPV. Statement d is false; we do not know what the projects' IRRs are. Statement b is the correct answer. 15. Cash flows and accounting measures Answer: d Diff: M 16. Relevant cash flows Answer: d Diff: M 17. Relevant cash flows Answer: d Diff: M Statements b and c are correct; therefore, statement d is the correct answer. 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 a new store on the land and should be considered. 18. Relevant cash flows Answer: e Diff: M Statements a and c are correct; therefore, statement e is the correct answer. Externalities and opportunity costs should be considered, while sunk costs should not be included in the analysis. 19. Relevant cash flows Answer: b Diff: M 20. Incremental cash flows Answer: e Diff: M 21. Factors affecting cash flows Answer: d Diff: M 22. Cash flow estimation Answer: d Diff: M Statement d is true--the foregone rent is an "opportunity cost" which should be charged to the project under consideration. Note that Statements a and b are both false--the cash flows should not take account of interest, because financial costs are dealt with by discounting at the WACC. If interest were deducted to find cash flows, then this cost would be "double counted," and the NPV would be downward biased. Ignoring interest when determining cash flows produces no bias in the NPV whatever. Note also that externalities can be either positive or negative--they tend to be negative if the new project is a substitute for existing products, but positive if the new project is complementary to the firm's other products. 23. Depreciation cash flows Answer: c Diff: M 24. Corporate risk Answer: d Diff: M 25. Methods of analysis Answer: a Diff: M 26. Risk-adjusted discount rate Answer: e Diff: M Chapter 11 - Page 16 Answer: 27. Risk-adjusted discount rate Answer: a Diff: M 28. Investment outlay Answer: c Diff: E Answer: c Diff: E Initial outlay Cost of new machine Salvage value (old) Tax effect of sale = $6,000(0.4) = After-tax outlay = 29. Risk-adjusted discount rate -$60,000 + 24,000 + 2,400 -$33,600 kYD = 10% + 2% = 12%. However, for a low-risk project, Dandy Product subtracts 2 percentage points. Therefore, the required rate of return is 10 percent. kYD,Low-risk project = 10% + 2% - 2% = 10%. 30. New project NPV Answer: d Diff: M Chapter 11 Page 17 Time line: 0 k = 12% 1 2 -45,000 7,800 10,680 NPV = ? Depreciation cash flows: MACRS Year Percent 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06 3 7,560 4 5,880 Depreciable Basis $60,000 60,000 60,000 60,000 60,000 60,000 5 Years -1,920 Annual Depreciation $12,000 19,200 11,400 7,200 6,600 3,600 $60,000 Project analysis worksheet: Year: 0 1 2 3 4 5 I Initial outlay 1) Machine cost ($60,000) 2) Decrease in NWC 15,000 3) Total net inv. ($45,000 ) II Operating cash flows 4) Reduction in cost $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 5) After-tax dec. in cost 3,000 3,000 3,000 3,000 3,000 6) Deprec. (from table) 12,000 19,200 11,400 7,200 6,600 7) Tax savings deprec. (line 6 × 0.4) 4,800 7,680 4,560 2,880 2,640 8) Net operating CFs (line 5 + 7) $ 7,800 $10,680 $ 7,560 $ 5,880 $ 5,640 III Terminal year CFs 9) Estimated salvage value $10,000 10) Tax on salvage value ($10,000 - $3,600)(0.4) (2,560) 11) Return of NWC (15,000 ) 12) Total termination CFs (7,560) IV Net CFs ) $ 13) Total Net CFs ($45,000 $ 7,800 $10,680 $ 7,560 $ 5,880 ( 1,920) Numerical solution: NPV = -$45,000 + $7,800(1/1.12) + $10,680(1/1.12 2) + $7,560(1/1.12 3) + $5,880(1/1.12 4) - $1,920(1/1.12 5) = -$45,000 + $7,800(0.8929) + $10,680(0.7972) + $7,560(0.7118) + $5,880(0.6355) - $1,920(0.5674) = -$21,492.74 ≈ -$21,493. Financial calculator solution: Inputs: CF0 = -45,000; CF 1 = 7,800; CF2 = 10,680; CF 3 = 7,560; CF4 = 5,880; CF5 = -1,920; I = 12. Output: NPV = -$21,493.24 ≈ -$21,493. 31. New project NPV Chapter 11 - Page 18 Answer: b Diff: M Time line: 0 k = 9% 1 2 -40,000 9,800 11,720 NPV = ? Depreciation cash flows: MACRS Year Percent 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06 3 4 9,640 5 Years 8,520 Depreciable Basis $40,000 40,000 40,000 40,000 40,000 40,000 15,320 Project analysis worksheet: Year: 0 1 I Initial outlay 1) Machine cost ($40,000) 2) Decrease in NWC -3) Total net inv. ($40,000 ) II Operating cash flows 4) Inc. in earnings before deprec. & tax $ 6,000 5) After-tax increase in earnings (line 4 × 0.6) 3,600 6) Before tax reduction in cost 5,000 7) After tax reduction in cost (line 6 × 0.4) 3,000 8) Deprec. (from table) 8,000 9) Deprec. tax savings (line 8 × 0.4) 3,200 _______ 10) Net operating CFs (line 5 + 7 + 9) $ 9,800 III Terminal year CFs 11) Estimated salvage value 12) Tax on salvage value ($10,000 - $2,400)(0.4) 13) Return of NWC 14) Total termination CFs IV Net CFs 15) Total Net CFs ($40,000 ) $ 9,800 2 Annual Depreciation $ 8,000 12,800 7,600 4,800 4,400 2,400 $40,000 3 4 5 $ 6,000 $ 6,000 $ 6,000 $ 6,000 3,600 3,600 3,600 3,600 5,000 5,000 5,000 5,000 3,000 12,800 3,000 7,600 3,000 4,800 3,000 4,400 5,120 3,040 1,920 1,760 _______ _______ _______ _______ $11,720 $ 9,640 $ 8,520 $ 8,360 $10,000 (3,040) -6,960 $11,720 $ 9,640 $ 8,520 $15,320 Numerical solution: NPV = -$40,000 + $9,800(1/1.09) + $11,720(1/1.09 2) + $9,640(1/1.09 3) + $8,520(1/1.09 4) + $15,320(1/1.09 5) = -$40,000 + $9,800(0.9174) + $11,720(0.8417) + $9,640(0.7722) + $8,520(0.7084) + $15,320(0.6499) = $2,291.29 ≈ $2,292. Financial calculator solution: Inputs: CF0 = -40,000; CF 1 = 9,800; CF2 = 11,720; CF 3 = 9,640; CF4 = 8,520; CF5 = 15,320; I = 9. Output: NPV = $2,291.90 ≈ $2,292. Chapter 11 Page 19 32. New project NPV Answer: c Diff: M (In Thousands of Dollars) Initial cost Change in NWC Initial outlay Sales Op. Costs Depr. Op. Inc. bef. taxes Taxes (40%) Oper. Inc. from project Depr. Change in other products Return of NWC Net cash flow (NCF) t=0 -2,000 -100 -2,100 ______ -2,100 t=1 t=2 t=3 t=4 $1,000 500 500 $ 0 0 $ 0 500 - 250 ______ $ 250 $2,000 1,000 500 $ 500 200 $ 300 500 - 250 ______ $ 550 $2,000 1,000 500 $ 500 200 $ 300 500 - 250 ______ $ 550 $1,000 500 500 $ 0 0 $ 0 500 - 250 + 100 $ 350 Entering the NCF amounts into the cash flow register (at 12%) gives you a NPV of -$824,418.62. 33. Risk-adjusted NPV Time lines: Project A 0 k = 14% 1 2 3 | | | | CFsA -200,000 71,104 71,104 71,104 NPVA = ? Project B 0 k = 10% 1 2 3 | | | | CFsB -200,000 0 0 146,411 NPVB = ? Calculate required returns on A and B: Project A High risk k Risk adjusted = 12% + 2% = 14%. Project B Low risk k Risk adjusted = 12% - 2% = 10%. Answer: a Diff: M 4 Years | 71,104 4 Years | 146,411 Tabular solution: NPVA = $71,104 [(1/0.14)-(1/(0.14 (1.14 4)))] - $200,000 = $71,104(2.9137) - $200,000 = $7,175.72. NPVB = $146,411(1/1.14 3) + $146,411(1/1.14 4) - $200,000 = $146,411(0.7513) + $146,411(0.6830) - $200,000 = $9,997.30. Project B has the higher NPV. Since they are mutually exclusive, select Project B. Financial calculator solution: A Inputs: CF 0 = -200,000; CF 1 = 71,104; Nj = 4; I = 14. Output: NPV A = $7,176.60 ≈ $7,177. B Inputs: CF 0 = -200,000;CF 1 = 0;Nj = 2;CF2 = 146,411;Nj = 2;I = 10. Output: NPV B = $10,001.43 ≈ $10,001. Note: The difference in the NPV B between the numerical solution and financial calculator cash flow solution of $4.13 is due to rounding. Greater precision in the PVIF factors produces identical answers. Chapter 11 - Page 20 34. New project NPV Answer: b 0 1 $900 450 500 ($ 50) (20) ($ 30) 500 $470 Sales Costs Deprn EBT Taxes (40%) Net income Add deprn Cost Inventory Salvage value Tax on SV Ret. of inv. 2 $900 450 300 $150 60 $ 90 300 $390 3 $900 450 200 $250 100 $150 200 $350 $390 Diff: M 100 (40) 200 $610 (1,000) (200) (1,200 ) 0 k $470 1 -1,200 2 3 470 = 10% 390 610 NPV = $7.89. IRR = 10.36%. 35. New project NPV Answer: a 0 Purchase Sales - VC - Deprec. EBT - Taxes Net income + Depreciation k = 15% 1 2 Diff: M 3 -50,000 NWC -12,000 RV(AT) _______ NCF -62,000 NPV15% = $7,673.71. 50,000 -20,000 -40,000 -10,000 +4,000 -6,000 +40,000 34,000 50,000 -20,000 -5,000 25,000 -10,000 15,000 +5,000 20,000 _______ 34,000 _______ 20,000 50,000 -20,000 -5,000 25,000 -10,000 15,000 +5,000 20,000 +12,000 +6,000 38,000 Chapter 11 Page 21 ...
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This note was uploaded on 02/16/2012 for the course BUSINESS 331 taught by Professor Rhee during the Spring '12 term at Strayer.

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