Exam 13: Capital Budgeting

A project's market risk rises if the correlation of its cash flows with the economy decreases.

With the current techniques available, estimating cash flows has become the easiest step in the analysis of a capital budgeting project.

Michigan Mattress Company is considering the purchase of land and the construction of a new plant.The land, which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected at the end of the first year (t = 1), would cost $500,000.It is estimated that the firm's after-tax cash flow will be increased by $100,000 starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the next 10 years.What is the approximate payback period?

Many firms use more than one technique to evaluate capital budgeting projects because multiple measures can provide decision makers with somewhat different pieces of relevant information.

Which of the following statements is most correct?

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.

You are considering the purchase of an investment that would pay you $5,000 per year for Years 1−5, $3,000 per year for Years 6−8, and $2,000 per year for Years 9 and 10.If you require a 14 percent rate of return, and the cash flows occur at the end of each year, then how much should you be willing to pay for this investment?

Which of the following statements is most correct?

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

Suppose the firm's required rate of return is stated in nominal terms, but the project's expected cash flows are expressed in real dollars.In this situation, other things held constant, the calculated NPV would

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1) capital budgeting decisions must be based on accounting income, and (2) only incremental cash flows are relevant to accept/reject decisions.

If a project is small relative to the total firm, and if its returns are not highly correlated with the returns on the firm's other assets, then the project may not be very risky in either the within-firm (corporate) or the market risk sense, even if the returns on the project are highly uncertain and thus the project has a high degree of stand-alone risk.

Whitney Crane Inc.has the following independent investment opportunities for the coming year: The IRRs for Project A and C, respectively, are:

Externalities present in projects being considered in capital budgeting are very difficult to quantify and as a result of this, they should be excluded from the financial analyses.

Which of the following constitutes an example of a cost which is not incremental, and therefore not relevant in an accept/reject decision?

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%.)

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects which have different lives are being compared.

An all-equity firm is analyzing a potential project which will require an initial, after-tax cash outlay of $50,000 and after-tax cash inflows of $6,000 per year for 10 years.In addition, this project will have an after-tax salvage value of $10,000 at the end of Year 10.If the risk-free rate is 6 percent, the return on an average stock is 10 percent, and the beta of this project is 1.50, then what is the project's NPV?

New Project NPV 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. [MACRS table required] -Refer to Truck Acquisition.What is the supplemental operating cash flow in Year 1?

The IRR of a project whose cash flows accrue relatively rapidly is more sensitive to changes in the discount rate than is the IRR of a project whose cash flows come in more slowly.