Exam 13: Capital Budgeting

Mid-State Electric Company must clean up the water released from its generating plant.The company's required rate of return is 10 percent for average 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?

Which of the following statements is correct?

The cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky.

As the capital budgeting director for Chapel Hill Coffins Company,you are evaluating construction of a new plant.The plant has a net cost of $5 million in Year 0 (today),and it will provide net cash inflows of $1 million at the end of Year 1,$1.5 million at the end of Year 2,and $2 million at the end of Years 3 through 5.Within what range is the plant's IRR?

Which of the following decision measures should capital budgeting decision makers consider?

The Ace Company is considering investing in a piece of property which costs $105,000.The property will return a constant cash flow forever.If the firm's required rate of return is 9 percent and the corporate tax rate is 40 percent,what is the minimum after-tax cash flow that would make the investment acceptable to Ace?

A decrease in the firm's discount rate (r)will increase NPV,which could change the accept/reject decision for a potential project.However,such a change would have no impact on the project's IRR,hence on the accept/reject decision under the IRR method.

Which of the following statements is correct?

Which of the following statements is correct?

Which of the following rules are essential to successful cash flow estimates,and ultimately,to successful capital budgeting?

Assume you are the director of capital budgeting for an all-equity firm.The firm's current required rate of return is 16 percent;the risk-free rate is 10 percent;and the market risk premium is 5 percent.You are considering a new project that has 50 percent more beta risk than your firm's assets currently have,i.e. ,its beta is 50 percent larger than the firm's existing beta.The expected return (IRR)on the new project is 18 percent.Should the project be accepted if beta risk is the appropriate risk measure? Choose the most correct statement.

Virus Stopper Inc. ,a supplier of computer safeguard systems,uses a required rate of return 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

If a firm invests in a project with a present value less than its cost,the value of the firm will increase.

After getting her degree in marketing and working for 5 years for a large department store,Sally started her own specialty shop in a regional mall.Sally's current lease calls for payments of $1,000 at the end of each month for the next 60 months.Now the landlord offers Sally a new 5-year lease which calls for zero rent for 6 months,then rental payments of $1,050 at the end of each month for the next 54 months.Sally's required rate of return is 11 percent.By what absolute dollar amount would accepting the new lease change Sally's theoretical net worth? (Hint: The required rate of return per month is 11%/12 = 0.9166667%. )

Truck Acquisition You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net 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 firm's marginal tax rate is 40 percent. -Refer to Truck Acquisition.What is the terminal (nonoperating)cash flow at the end of Year 3?

One advantage of the payback period method of evaluating fixed asset investment possibilities is that it provides a rough measure of a project's liquidity and risk.

A key difference between replacement and expansion project analyses is that with replacement,the incremental cash flows are measured as the net difference between projected cash flows from the current productive assets and cash flows of the proposed new productive assets.

Other things held constant,if a firm takes on a project that increases its beta coefficient,unless the increased beta is offset by a higher expected return,the firm's stock price will decline.

____ are decisions about whether to purchase capital assets to take the place of existing assets so as to maintain existing operations.

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 required rate of return.Inflation is zero.What is the project's NPV?