Exam 17: Capital Budgeting

When NPV is positive, the IRR:

Cash flows include depreciation:

Cost of Capital. Determine whether each of the following would increase or decrease the firm's cost of capital for investment project evaluation. Explain. A. The company's stock price suffers a sharp decline, but no decline in the company's earnings potential is perceived. B. A merger with a leading competitor increases the company's stock price substantially. C. The company's home state increases the corporate state income tax. D. In an effort to spur business activity, Congress cuts corporate income taxes.

NPV Analysis. QED Exploration, Ltd., is contemplating on-shore and off-shore oil and gas exploration projects. Financial analysis resulted in the following projections for a ten-year planning horizon: A. Calculate the net present value for each investment. Which is more desirable according to the NPV criterion? B. Calculate the profitability index for each investment. Which is more desirable according to the PI criterion? C. Under what conditions would either or both investments be undertaken?

Cost of Capital. Dartmouth Systems, Inc., is a leading supplier of sorters and collators to the copier and computer printer market. A security analyst's report issued by a national brokerage firm indicates that debt yielding 8%, comprises 50% of Dartmouth's overall capital structure. Furthermore, both earnings and dividends are not expected to grow during coming years. Currently, common stock in the company is priced at $75, and it should pay $7.50 per share in dividends during the coming year. This yield compares favorably with the 7% return currently available on risk-free securities and the 13% average for all common stocks, given the company's estimated beta of 0.5. A. Calculate Dartmouth's component cost of equity using both the capital asset pricing model and the dividend yields plus expected growth model. B. Assuming a 40% marginal federal plus state income tax rate, calculate Dartmouth's weighted average cost of capital.

Cost of Capital. Marine Transport, Ltd., operates a fleet of oil and chemical tankers. A security analyst's report issued by a national brokerage firm indicates that debt yielding 13%, comprises 50% of Marine's overall capital structure. Furthermore, both earnings and dividends are expected to grow at a rate of 10% per year. Currently, common stock in the company is priced at $40, and it should pay $2 per share in dividends during the coming year. This yield compares favorably with the 10% return currently available on risk-free securities and the 15% average for all common stocks, given the company's estimated beta of 1. A. Calculate Marine's component cost of equity using both the capital asset pricing model and the dividend yield plus expected growth model. B. Assuming a 50% marginal federal plus state income tax rate, calculate Marine's weighted average cost of capital.

The cost of capital is the:

Generally, a firm's estimated component cost of debt:

NPV Analysis. Paralegal Services, Inc., is contemplating purchase of additional computer hardware equipment and software programming. Financial analysis resulted in the following projections for a three-year planning horizon: A. Calculate the net present value for each. Which is more desirable according to the NPV criterion? B. Calculate the profitability index for each. Which is more desirable according to the PI criterion? C. Under what conditions would either or both investments be undertaken?

NPV Analysis. The Santa Catalina Passenger Ferry Company is contemplating leasing an additional ferryboat to expand service to Santa Monica or Newport Beach. Financial analysis resulted in the following projections for a 5-year planning horizon: A. Calculate the net present value for each service. Which is more desirable according to the NPV criterion? B. Calculate the profitability index for each service. Which is more desirable according to the PI criterion? C. Under what conditions would either or both of the services be undertaken?

The risk-free rate of return is the investor reward for:

An estimate of the firm's cost of equity capital is:

Incremental Analysis. Cunningham's Drug Store, a medium-sized drug store located in Milwaukee, Wisconsin, is owned and operated by Richard Cunningham. Cunningham's sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Cunningham's most recent annual net income statement is as follows: Cunningham's sales and expenses have remained relatively constant in the past few years and are expected to continue unchanged in the near future. To increase sales, Cunningham is considering using some floor space for a small soda fountain. Cunningham would operate the soda fountain for an initial five-year period, and then reevaluate its profitability. The soda fountain requires an incremental investment of $25,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the initial five-year period. At the end of that time, additional capital would be required to continue operating the soda fountain and no capital would be recovered if it were dropped. The soda fountain is expected to have sales of $125,000 and food and materials expenses of $30,000 per year. The soda fountain is also expected to increase wage and salary expenses by 8% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of nonsoda fountain items are expected to decline by 10%. A. Calculate net incremental cash flows for the soda fountain. B. Assume that Cunningham has the capital necessary to install the soda fountain and places a 12% before-tax opportunity cost on those funds. Should the soda fountain be installed? Why or why not?

The discount rate that equates present value of cash inflows and outflows is called the:

Firms should finance a project if its:

NPV Analysis. Nocando Retailing, Ltd. is contemplating leasing additional retail space to expand its distribution network in northeastern markets. Financial analysis resulted in the following projections for a five-year planning horizon: A. Calculate the net present value for each type of retail space. Which is more desirable according to the NPV criterion? B. Calculate the profitability index for each. Which is more desirable according to the PI criterion? C. Under what conditions would either or both of the leasing options be undertaken?

NPV Analysis. The net present value (NPV), profitability index (PI), and internal rate of return (IRR) methods are often employed in project valuation. Indicate whether each of the following statements is true or false and explain why. A. A PI < 1 describes a project with IRR < k. B. Selection solely according to the PI criterion will tend to favor smaller as opposed to larger investment projects. C. Use of the NPV criterion is especially appropriate for larger firms with easy access to capital markets. D. The IRR method can tend to overstate the relative attractiveness of investment projects when the opportunity cost of cash flows is below the IRR. E. When NPV > 0, the IRR exceeds the cost of capital.

The change in net cash flows due to an investment project is called:

When net present value is positive:

Expected Return. Dr. Kevin Lenahan & Associates is a local optometrist considering two alternative capital budgeting projects. Project A is an investment of $800,000 in a new office addition to showcase an expanded selection of designer frames and contact lenses. Project B is an investment of $750,000 to upgrade existing testing facilities. Relevant annual cash flow data for the two projects over their expected seven-year lives are as follows: A. Calculate the expected value, standard deviation, and coefficient of variation of cash flows for each project. B. Calculate the risk-adjusted NPV for each project, using a 20% cost of capital for the more risky project and 15% for the less risky one. Which project is preferred using the NPV criterion? C. Calculate the PI for each project, and rank them according to their PIs. D. Calculate the IRR for each project, and rank them according to their IRRs. E. Compare your answers to parts B, C, and D, and discuss any differences.