Exam 13: Capital Budgeting: Cash Flows and Risk

Which of the following statements is correct?

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. Produc¬tion Process B also requires an initial invest¬ment 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 dis¬count rate of 12 percent should be used for Process A. If California Mining is to be indifferent between the two processes, what risk-adjusted dis¬count rate must be used to evaluate B?

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?

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 Unlimited's marginal tax rate is 40 percent. What risk-adjusted discount rate will equate the NPV of Project B to that of Project A?

Consider the following project data: (1) A $500 feasibility study will be conducted at t = 0. (2) If the study indicates potential, the firm will spend $1,000 at t = 1 to build a prototype. The best estimate now is that there is an 80 percent chance that the study will indicate potential, and a 20 percent chance that it will not. (3) If reaction to the prototype is good, the firm will spend $10,000 to build a production plant at t = 2. The best estimate now is that there is a 60 percent chance that the reaction to the prototype will be good, and a 40 percent chance that it will be poor. (4) If the plant is built, there is a 50 percent chance of a t = 3 cash inflow of $16,000 and a 50 percent chance of a $13,000 cash inflow.

Pierce Products is deciding whether it makes sense to purchase a new piece of equipment. The equipment costs $100,000 (payable at t = 0)t = 1: 0.33 t = 2: 0.45 T = 3: 0.15 T = 4: 0.07 At the end of four years the company expects to be able to sell the equipment for a salvage value of $10,000 (after-tax). The company is in the 40 percent tax bracket. The company has an after-tax cost of capital of 11 percent. Since 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 of purchasing the equipment?

Changes in net operating working capital do not need to be considered in capital budgeting cash flow analysis as long as the nominal (undiscounted) values of the changes are identical in each time period.

Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables, such as sales. Other things held constant, with the independent variable graphed on the horizontal axis, the steeper the graph of the relationship line, the less risky the project.

With the current techniques available, estimating cash flows has become the easiest step in the analysis of a capital budgeting project.

Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash flows are more risky.

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)• 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)• 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?

Which of the following constitutes an example of a cost which is not incremental, and therefore not relevant in an accept/reject decision?

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?

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, for the duration of a project's life, other things held constant.

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?

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

A project's market risk rises if the correlation of its cash flows with the economy decreases.

The lower the correlation of a project's cash flows with those of the rest of the firm, the greater will be the benefits of the project with regard to reducing within-firm risk.

If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most likely become

Suppose a firm is considering production of a new product whose projected sales include sales that will be taken away from another product the firm also produces. The lost sales on the existing product are a sunk cost and are not a relevant cost to the new product.