Exam 13: Capital Budgeting

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.

A major disadvantage of the payback period method is that it

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?

____ are decisions about whether to purchase capital projects and add them to existing assets so as to increase existing operations.

The present value of the expected net cash inflows for a project will most likely exceed the present value of the expected net profit after tax for the same project because

Topsider Inc.is considering the purchase of a new leather-cutting machine to replace an existing machine that has a book value of $3,000 and can be sold for $1,500.The old machine is being depreciated on a straight-line basis,and its estimated salvage value 3 years from now is zero.The new machine will reduce costs (before taxes)by $7,000 per year.The new machine has a 3-year life,it costs $14,000,and it can be sold for an expected $2,000 at the end of the third year.The new machine would be depreciated over its 3-year life using the MACRS method.Assuming a 40 percent tax rate and a required rate of return of 16 percent,find the new machine's NPV.

Estimating project cash flows is considered the most important and the most difficult step in the capital budgeting process.Both the number of variables and the interdepartmental nature of the process contribute to the difficulty of estimating cash flows.

Assuming that the total cash flows are equal,the NPV of a project whose cash flows accrue relatively rapidly is more sensitive to changes in the discount rate than is the NPV of a project whose cash flows come in more slowly.

In capital budgeting analyses,it is possible that NPV and IRR will both involve assuming reinvestment of the project's cash flows at the same rate.

Klott Company encounters significant uncertainty with its sales volume and price in its primary product.The firm uses scenario analysis in order to determine an expected NPV,which it then uses in its budget.The base case,best case,and worse case scenarios and probabilities are provided in the table below.What is Klott's expected NPV,standard deviation of NPV,and coefficient of variation of NPV? Probability Of Outcome Unit Sales Volume Sales Price NPV (In Thousands) Worst case 0)30 6,000 $3,600 −$ 6,000 Base case 0)50 10,000 4,200 + 13,000 Best case 0)20 13,000 4,400 + 28,000

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4,$35,000 per year in Years 5 through 9,and $40,000 in Year 10.This investment will cost the firm $150,000 today,and the firm's required rate of return is 10 percent.Assume cash flows occur evenly during the year,1/365th each day.What is the payback period for this investment?

Other things held constant,an increase in the required rate of return will result in a decrease of a project's IRR.

The Seattle Corporation has been presented with an investment opportunity which will yield end of year cash flows of $30,000 per year in Years 1 through 4,$35,000 per year in Years 5 through 9,and $40,000 in Year 10.This investment will cost the firm $150,000 today,and the firm's required rate of return is 10 percent.What is the NPV for this investment?

Two projects being considered by a firm are mutually exclusive and have the following projected cash flows: Based only on the information given,which of the two projects would be preferred,and why?

Woodson Inc.has two possible projects,Project A and Project B with the following cash flows: Year Project A Project B 0 −150,000 −100,000 1 100,000 45,000 2 105,000 65,000 3 40,000 80,000 At what required rate of return do the two projects have the same net present value (NPV)? (In other words,what is the "crossover rate" of the projects' NPV profiles? )

Capital budgeting decisions must be based on net income to determine if the investment is to create value for the firm.

Assume that you are comparing two mutually exclusive projects.Which of the following statements is most correct?

Louisiana Enterprises,an all-equity firm,is considering a new capital investment.Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7 percent.The firm currently has a required return of 10.75 percent and a beta of 1.25.The investment,if undertaken,will double the firm's total assets.If r_RF = 7 percent and the market return is 10 percent,should the firm undertake the investment? (Choose the best answer. )

Your company is planning to open a new gold mine which will cost $3.0 million to build,with the expenditure occurring at the end of the year three years from today.The mine will bring year-end after-tax cash inflows of $2.0 million at the end of the two succeeding years,and then it will cost $0.5 million to close down the mine at the end of the third year of operation.What is this project's IRR?

The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems.Since the company's revenue stream will not be affected by the choice of control systems,the projects are being evaluated by finding the PV of each set of costs.The firm's required rate of return is 13 percent,and it adds or subtracts 3 percentage points to adjust for project risk differences.System A is judged to be a high-risk project (it might end up costing much more to operate than is expected).The appropriate risk-adjusted discount rate that should be used to evaluate System A is