Exam 13: Capital Budgeting

Which of the following statements is correct?

____ projects are projects whose cash flows are not affected by the acceptance or non-acceptance of other projects.

Alabama Pulp Company (APC) can control its environmental pollution using either "Project Old Tech" or "Project New Tech." Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the expected cost levels.The cash outflows associated with Project Old Tech, which uses standard proven technology, are less risky⎯they are about as uncertain as the cash flows associated with an average project.APC's required rate of return for average risk projects normally is set at 12 percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk projects.The two projects in question meet the criteria for high and average risk, but the financial manager is concerned about applying the normal rule to such cost-only projects.You must decide which project to recommend, and you should recommend the one with the lower PV of costs.What is the PV of costs of the better project?

A firm should never undertake an investment if accepting the project would cause an increase in the firm's required rate of return.

Two projects being considered are mutually exclusive and have the following projected cash flows: If the required rate of return on these projects is 10 percent, which would be chosen and why?

Tech Engineering Company is considering the purchase of a new machine to replace an existing one.The old machine was purchased 5 years ago at a cost of $20,000, and it is being depreciated on a straight line basis to a zero salvage value over a 10-year life.The current market value of the old machine is $14,000.The new machine, which falls into the MACRS 5-year class, has an estimated life of 5 years, it costs $30,000, and Tech plans to sell the machine at the end of the 5th year for $1,000.The new machine is expected to generate before-tax cash savings of $3,000 per year.The company's tax rate is 40 percent.What is the IRR of the proposed project?

The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

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.The truck's required rate of return is 10 percent.What is its NPV?

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

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.

If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm will select X rather than Y if X has a NPV > 0.

The net present value of a replacement item of equipment will decrease if the current market value of the equipment to be replaced is increased, other things held constant.

As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows: If Denver's required rate of return is 15 percent, you would choose?

Which of the following statements is correct?

Mid-State Electric Company must clean up the water released from its generating plant.The company's required rate of return is 10 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects.Clean up Plan A, which is of average risk, has an initial cost of −$1,000 at time 0, and its operating cost will be −$100 per year for its 10-year life.Plan B, which is a high-risk project, has an initial cost of −$300, and its annual operating cost over Years 1 to 10 will be −$200.What is the proper PV of costs for the better project?

Net present value and internal rate of return will always give the same accept or reject decision for mutually exclusive projects, but they might give different rankings for independent projects.

If a firm invests in a project with a present value less than its cost, the value of the firm will increase.

The underlying cause of ranking conflicts between the NPV and IRR methods is differing

Changes in net working capital do not need to be considered in capital budgeting cash flow analysis as long as the nominal (undiscounted) values of the changes are identical in each time period.

If a firm faces capital rationing, it should select that set of investments which has the highest total net present value, subject to the constraint that it does not require more capital than is available.