Exam 17: Capital Budgeting

Crossover Discount Rates. Sally Rogers is the chief financial officer for Popular Productions, Inc., producers of The Allan Brady Show, a hit comedy series. Rogers is considering the desirability of purchasing one of two alternative forms of post-production equipment used in the tape editing process. Rogers has discovered that a serious problem can arise when using the NPV method of project valuation because projects sometimes differ significantly in terms of the magnitude and timing of cash flows. When the size or pattern of alternative project cash flows differs greatly, each project's NPV can react quite differently to changes in the discount rate. Changes in the appropriate discount rate can sometimes lead to reversals in project rankings. Rogers discovered this problem when considering the following before-tax cash flow data: A. Conceptually describe how ranking reversals can occur at the crossover discount rate. B. Which investment project is preferred at a relevant cost of capital that is below the crossover discount rate? Why? C. Which investment project is preferred at a relevant cost of capital that is above the crossover discount rate? Why?

Rate-of-Return Analysis. New York City licenses taxicabs in two classes: (1) for operation by companies with fleets, and (2) for operation by independent driver-owners who have only one cab. It also fixes the rates that taxis charge. For many years, no new licenses have been issued in either class. In the unofficial market for licenses (medallions), their market value is currently roughly $250,000. A. Does the $250,000 medallion price indicate that operators of New York taxicabs are earning only normal profits? B. What factors would determine whether a change in the fare fixed by the city would raise or lower the value of a license? C. Cab drivers, whether hired by companies or as owners of their own cabs, seem unanimous in opposing any increase in the number of cabs licensed. They argue that an increase in the number of cabs would increase competition for customers, and drive down what they regard as an already unduly low return to drivers. Is their economic analysis correct? Who would benefit and who would lose from an expansion in the number of licenses issued at a nominal fee?

Cash Flow Analysis. The Gulf States Press, Inc., is analyzing the potential profitability of three printing jobs put up for bid by the State Department of Transportation: Assume that: (1) The company's marginal state plus federal tax rate is 40%, (2) each job is expected to have a ten-year life, (3) the firm uses straight-line depreciation, (4) the average cost of capital is 10%, (5) the jobs have the same risks as the firm's other business, and (6) the company has already spent $100,000 on developing the preceding data. This $100,000 has been capitalized and will be amortized over the life of the job chosen, if any. A. What is the expected net cash flow each year? (Hint: Cash flow equals net profit after taxes plus depreciation and amortization charges.) B. What is the net present value of each job? On which job, if any, should Gulf States bid? C. Suppose that Gulf States' primary business is quite cyclical, improving and declining with the economy, which Job B is expected to be counter cyclical. Might this have any bearing on your decision?

NPV Analysis. Travel Services, Inc., is contemplating purchase of a number of seats on regularly scheduled airlines for resale to leisure and business customers. The company projects the following costs and revenues for each type of service: 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?

Acceptance of new investment projects will increase the value of the firm provided that:

Capital budgeting is the process of planning investment expenditures when returns are expected to:

A firm must choose between two projects, X and Y. Project X has the highest net present value, but project Y has the highest profitability index. The firm should choose project Y if:

If the tax rate is 25% and the prevailing interest rate is 12%, the after tax cost of debt is:

Net present value equals:

The crossover discount rate only equates the: