Exam 13: Capital Budgeting

The primary function of the capital budget is to forecast the funds required for future investments that must be raised through external funding, that is, by selling stock or bonds.

Risk in a revenue producing project can best be adjusted for by

Which of the following statements is correct?

Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large projects are forecast with great accuracy, but revenues are more uncertain and large errors are not uncommon.

Which of the following statements is correct?

The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year.If the firm's required rate of return is 14 percent and its tax rate is 40 percent, what is the project's IRR?

If a project's NPV exceeds the project's IRR, then the project should be accepted.

California Mining is evaluating the introduction of a new ore production process.Two alternatives 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.Production Process B also requires an initial investment 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 discount rate of 12 percent should be used for Process A.If California Mining is to be indifferent between the two processes, what risk-adjusted discount rate must be used to evaluate B?

If a particular project would increase a firm's beta coefficient if it is accepted, then we can conclude that the firm's required rate of return also would increase, other things held constant.

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.

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR is greater than the firm's average required rate of return.

Lloyd Enterprises has a project which has the following cash flows: The required rate of return is 10 percent.What is the project's discounted payback?

Only the incremental after-tax cash flows associated with a capital project are relevant in capital budgeting.

Risk-Adjusted Discount Rate Real Time Inc. The president of Real Time Inc.has asked you to evaluate the proposed acquisition of a new computer.The computer's price is $40,000, and it falls into the MACRS 3-year class.Purchase of the computer would require an increase in net working capital of $2,000.The computer would increase the firm's before-tax revenues by $20,000 per year but would also increase operating costs by $5,000 per year.The computer is expected to be used for 3 years and then be sold for $25,000.The firm's marginal tax rate is 40 percent, and the project's required rate of return is 14 percent. [MACRS table required] -Refer to Real Time Inc.What is the initial investment outlay required at t = 0?

Risk-Adjusted Discount Rate Real Time Inc. The president of Real Time Inc.has asked you to evaluate the proposed acquisition of a new computer.The computer's price is $40,000, and it falls into the MACRS 3-year class.Purchase of the computer would require an increase in net working capital of $2,000.The computer would increase the firm's before-tax revenues by $20,000 per year but would also increase operating costs by $5,000 per year.The computer is expected to be used for 3 years and then be sold for $25,000.The firm's marginal tax rate is 40 percent, and the project's required rate of return is 14 percent. [MACRS table required] -Refer to Real Time Inc.What is the supplemental operating cash flow in Year 2?

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?

The NPV and IRR methods, when used to evaluate an independent project, will lead to different accept/reject decisions unless the IRR is greater than the required rate of return.

Genuine Products Inc.requires a new machine.Two companies have submitted bids, and you have been assigned the task of choosing one of the machines.Cash flow analysis indicates the following: What is the internal rate of return for each machine?

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

Arizona Rock, an all-equity firm, currently has a beta of 1.25, and r_RF = 7 percent and r_M = 14 percent.Suppose the firm sells 10 percent of its assets (beta = 1.25) and purchases the same proportion of new assets with a beta of 1.1.What will be the firm's new overall required rate of return, and what rate of return must the new assets produce in order to leave the stock price unchanged?