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Practice Exam III

- Fin. 429
- Dr. Bruce A. Costa
- Fall 2003

Chapter 11 Capital Budgeting Decision Criteria

- The modified IRR method
- Always leads to the same decision as NPV for

independent projects. - Overcomes the problem of multiple rates of

return. - Compounds cash flows at the cost of capital.
- Overcomes the problem of cash flow timing but not

the problem of project size that leads to

criticism of the regular IRR method. - All of the above statements are true.

Exam 3

- All of the above statements are true.

- Which of the following statements is most

correct? - The MIRR method will always arrive at the same

conclusion as the NPV method. - The MIRR method can overcome the multiple IRR

problem, while the NPV method cannot. - The MIRR method uses a more reasonable assumption

about reinvestment rates than the IRR method. - Statements a and c are correct.
- All of the above statements are correct.

Exam 3

- The MIRR method uses a more reasonable assumption

about reinvestment rates than the IRR method.

- Which of the following is most correct?
- There can never be a conflict between NPV and IRR

decisions if the decision is related to a normal,

independent project, i.e., NPV will never

indicate acceptance if IRR indicates rejection. - To find the MIRR, we first compound CFs at the

regular IRR to find the TV, and then we discount

the TV at the cost of capital to find the PV. - The NPV and IRR methods both assume that cash

flows are reinvested at the cost of capital.

However, the MIRR method assumes reinvestment at

the MIRR itself. - If you are choosing between two projects which

have the same cost, and if their NPV profiles

cross, then the project with the higher IRR

probably has more of its cash flows coming in the

later years. - A change in the cost of capital would normally

change both a projects NPV and its IRR.

Exam 3

- There can never be a conflict between NPV and IRR

decisions if the decision is related to a normal,

independent project, i.e., NPV will never

indicate acceptance if IRR indicates rejection.

- 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 firms

after-tax cash flow will be increased by 100,000

beginning 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 would be the payback period (approx.)? - 2 years
- 4 years
- 6 years
- 8 years
- 10 years

Exam 3

- 6 years

t 0 1 2 3

4 5 6 7

-100 -500 100 110

121 133.10 146.41 161.05

Cumulative Cash Flow

-600 -500 -390 -269

-135.90 10.51

Payback 5 135.90 / 146.41 5.928 6

Years

- As the capital budgeting director for Chapel Hill

Coffins, Inc., you are evaluating construction of

a new plant. The plant has a net cost of 5

million in Year 0, and it will provide net cash

inflows of 1 million in Year 1, 1.5 million in

Year 2, and 2 million in Years 3 through 5. As

a first approximation, you may assume that all

cash flows occur at year-end. Within what range

is the plants IRR? - 14-15
- 15-16
- 16-17
- 17-18
- 18-19

Exam 3

- 18-19

T0 1 2 3

4 5

-5m 1m 1.5m 2m 2m 2m

CF0 -5 CF1 1 CF2 1.5 CF3

2 CF4 2 CF5 2

P/Yr. 1

IRR/Yr. 18.37

- Davis Corporation is faced with two independent

investment opportunities. The corporation has an

investment policy which requires acceptable

projects to recover all costs within 3 years.

The corporation uses the discounted payback

method to assess potential projects and utilizes

a discount rate of 10 percent. The cash flows

for the two projects are

Which investment project(s) does the company

invest in?

6. cont.

Which investment project(s) does the company

invest in?

- Project A only.
- Neither Project A nor Project B.
- Project A and Project B.
- Project B only.

Exam 3

- Project B only.

Project B

Project A

t0 1 2 3

t0 1 2 3

-80 50 20 20

-100 40 40 40

36.36 33.05 30.05 99.46

45.45 16.53 22.54 84.52

Project A doesnt pay

Project B pays back in 3 Yrs.

- Chapter 12
- Capital Budgeting
- Estimating Cash Flow And Analyzing Risk

- When evaluating a new project, the firm should

consider all of the following factors except - Changes in working capital attributable to the

project. - Previous expenditures associated with a market

test to determine the feasibility of the project,

if the expenditures have been expensed for tax

purposes. - The current market value of any equipment to be

replaced. - The resulting difference in depreciation expense

if the project involves replacement. - All of the statements above should be considered.

Exam 3

- Previous expenditures associated with a market

test to determine the feasibility of the project,

if the expenditures have been expensed for tax

purposes.

- Which of the following is not a cash flow that

results from the decision to accept a project? - Changes in working capital.
- Shipping and installation costs.
- Sunk costs.
- Opportunity costs.
- Externalities.

Exam 3

- Sunk costs.

- Project X has an up-front cost of 1 million,

whereas Project Y has an up-front cost of only

200,000. Both projects last five years and

provide positive cash flows in Years 1-5.

Project X is riskier its risk-adjusted WACC is

12 percent. Project Y is safer its risk-adjusted

WACC is 8 percent. After discounting each of the

projects cash flows at the projects

risk-adjusted WACC, you find that Project X has a

NPV of 20,000, and Project Y has a NPV of

15,000. The projects are mutually exclusive and

cannot be repeated. The firm is not capital

constrained it can raise as much capital as it

needs, provided it has profitable projects in

which to invest. Given this information, which

of the following statements is most correct? - The firm should select Project Y because it has a

higher return (15,000/200,000) is greater than

(20,000/1,000,000). - The firm should select Project X because it has a

higher NPV. - The firm should select Project Y because it is

less risky. - The firm should reject both projects because

their IRRs are less than the risk-adjusted WACC. - Statements a and c are correct.

Exam 3

- The firm should select Project X because it has a

higher NPV.

- Pickles Corp. is a company which sells bottled

iced tea. The company is thinking about

expanding its operations into the bottled

lemonade business. Which of the following

factors should the company incorporate into its

capital budgeting decision as it decides whether

or not to enter the lemonade business? - If the company enters the lemonade business, its

iced tea sales are expected to fall 5 percent as

some consumers switch from iced tea to lemonade. - Two years ago the company spent 3 million to

renovate a building for a proposed project which

was never undertaken. If the project is adopted,

the plan is to have the lemonade produced in this

building. - If the company doesnt produce lemonade, it can

lease the building to another company and receive

after-tax cash flows of 500,000 a year. - All of the statements above are correct.
- Answers a and c are correct.

Exam 3

- Answers a and c are correct.

- Which of the following statements is correct?
- In a capital budgeting analysis where part of the

funds used to finance the project are raised as

debt, failure to include interest expense as a

cost in the cash flow statement when determining

the project's cash flows will lead to an upward

bias in the NPV. - The preceding statement would be true if "upward"

were replaced with "downward. - The existence of "externalities" reduces the NPV

to a level below the value that would exist in

the absence of externalities. - If one of the assets that would be used by a

potential project is already owned by the firm,

and if that asset could be leased to another firm

if the project is not undertaken, then the net

rent that could be obtained should be charged as

a cost to the project under consideration. - The rent referred to in statement d is a sunk

cost, and as such it should be ignored.

Exam 3

- If one of the assets that would be used by a

potential project is already owned by the firm,

and if that asset could be leased to another firm

if the project is not undertaken, then the net

rent that could be obtained should be charged as

a cost to the project under consideration.

- Virus Stopper Inc., a supplier of computer

safeguard systems, uses a cost of capital of 12

percent to evaluate average-risk projects, and it

adds or subtracts 2 percentage points to evaluate

projects of more or less risk. Currently, two

mutually exclusive projects are under

consideration. Both have a cost of 200,000 and

will last 4 years. Project A, a

riskier-than-average project, will produce annual

end of year cash flows of 71,104. Project B, of

less than average risk, will produce cash flows

of 146,411 at the end of Years 3 and 4 only.

Virus Stopper should accept - B with a NPV of 10,001.
- Both A and B because both have NPVs greater than

zero. - B with a NPV of 8,042.
- A with a NPV of 7,177.
- A with a NPV of 15,968.

Exam 3

- B with a NPV of 10,001.

Project A

0 1 2 3 4

-200,000 71,104 71,104 71,104 71,104

CF0 -200,000 CF1-4 71,104 NPVA

7,176.60 I/Yr 12 2 14

Exam 3

- 12. cont.

Project B

0 1 2 3 4

-200,000 0 0 146,411

146,411

CF0 -200,000 CF1-2 0 CF3-4 146,411 I/Yr

12 2 10

NPVB 10,001.43

- 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 15,000. The new machine,

which falls into the MACRS 5-year class, has an

estimated life of 5 years, it costs 30,000, and

it has a zero estimated salvage value. The new

machine is expected to generate cash savings

(before taxes) of 3,000 per year. What is the

IRR of the proposed project? The companys tax

rate is 40 percent. - 4.1
- 2.2
- 0
- -1.5
- -3.3

Exam 3

- 0

1. Find cash flow at t0

Exam 3

13. cont.

2. Calculate change in depreciation

Exam 3

13. cont.

3. Find cash flows, t1 5 Calculate IRR

0 1 2 3

4 5

(17,000) 3,000(0.60) 3,000(0.60)

3,000(0.60) 3,000(0.60) 3,000(0.60)

4,000(0.40) 7,600(0.40) 3,700(0.40)

1,600(0.40) 1,300(0.40)

1,800(0.40) (17,000) 3,400

4,840 3,280 2,440

3,040

IRR 0.00

- Pierce Products is deciding whether it makes

sense to purchase a new piece of equipment. The

equipment costs 100,000 (payable at t 0). The

equipment will provide before-tax cash inflows of

45,000 a year at the end of each of the next

four years (t 1, 2, 3, 4). The equipment can

be depreciated according to the following

schedule - t 1 0.33 t 3 0.15
- t 2 0.45 t 4 0.07
- At the end of four years the company expects to

be able to sell the equipment for a salvage value

of 10,000 (after-tax). The company is in the

40 tax bracket. The company has an after-tax

cost of capital of 11. Since there is

uncertainty about the salvage value, the company

has chosen to discount the salvage value at 12.

What is the net present value of purchasing the

equipment? - 9,140.78
- 16,498.72
- 20,564.23
- 22,853.90
- 28.982.64

Exam 3

- 22,853.90

1. Find project NPV Cash Flows

t0 -100,000 t1 (45,000 33,000)(1 .04)

33,000 40,200 t2 (45,000 45,000)(1

.04) 45,000 45,000 t3 (45,000 15,000)(1

.04) 15,000 33,000 t4 (45,000

7,000)(1 .04) 7,000 29,800

I/Yr 11

NPV 16,498.72

Exam 3

- 14. cont.

2. Find PV of salvage value

N 4 I 12 PMT 0 FV -10,000

PV 6,355.18

16,498.72 6,355.18 22,853.90

- Problems

- Problem 1
- Your firm is considering the following two

mutually exclusive investments, A and B. - Your firms cost of capital is 12 percent.

Compute the NPV, IRR, and modified internal rate

of return (MIRR) on the two investments and

compare the projects.

Problem 1 Exam 3

- Mutually exclusive projects
- Project A
- NPV -14,000 4,500(PVIFA12,5)
- -14,000 4,500(3.6048) 2,221.60.
- 14,000 4,500(PVIFA) 3.1111 PVIFAk,5.
- IRR is approximately equal to 18. (Calculator

solution18.23) - PVOutflows 14,000.
- TVInflows 4,500(FVIFA12,5) 4,500(6.3528)

28,587.60. - 14,000 28,587.60(PVIFk,5) 0.4897

PVIFk,5. - MIRR is approximately equal to 15. (Calculator

solution15.35)

Problem 1 Exam 3

- Project B
- NPV -14,000 30,000(0.5674) 3,022.
- 14,000 30,000(PVIFk,5) 0.4667 PVIFk,5.
- IRR is approximately equal to 16 percent.

(Calculator solution is 16.47.) - PVOutflows 14,000. TVInflows 30,000.
- 14,000 30,000(PVIFk,5) 0.4667

PVIFk,5. - MIRR is approximately equal to 16 percent.

(Calculator solution is 16.47.)

Problem 1 Exam 3

- There is a conflict between the choice indicated

by NPV and that indicated by IRR. By the NPV

criterion, B should be chosen however, the IRR

method chooses A. By the MIRR criterion, B

should be chosen. Note that there is no conflict

between the NPV and MIRR methods in this

instance the MIRR method assumes reinvestment at

the cost of capital (as does the NPV method). - MIRR is superior to the regular IRR as an

indicator of a projects true rate of return or

expected long-term rate of return, but the NPV

method is still best, especially for choosing

among competing projects that differ in size,

because it provides a better indicator of how

much each project will cause the value of the

firm to increase.

Problem 2

- The Harris Company has a choice between two

mutually exclusive projects, S, which costs

200,000 and will provide cash flows of 100,000

per year at the end of each of the next 3 years,

or L, which costs 425,000 and will provide cash

flows of 200,000 per year for 3 years. Harriss

cost of capital is 10 percent. - Calculate the NPV, IRR, and modified internal

rate of return (MIRR) for each project. - Which project should Harris choose? Explain your

answer. - Since these two projects have the same time

pattern of returns, would Project L be preferred

to S regardless of Harriss cost of capital?

Explain.

Problem 2 Exam 3

Problem 2a Exam 3

- A.
- NPV CF(PVIFAk,n) - Outlay.
- NPVS 100,000(2.4869) - 200,000 48,690.
- NPVL 200,000(2.4869) - 425,000 72,380.
- IRRS 23.38. IRRL 19.44.

Problem 2a Exam 3

- MIRRS
- PVOutflows 200,000.
- TVInflows 100,000(FVIFA10,3)

100,000(3.3100) 331,000. - 200,000 331,000(PVIFk,3) 0.6042 PVIFk,3.
- MIRR is approximately 18
- (Calculator solution is 18.29.)

Problem 2a Exam 3

- MIRRL
- PVOutflows 425,000.
- TVInflows 200,000(FVIFA10,3)
- 200,000(3.3100) 662,000.
- 425,000 662,000(PVIFk,3) 0.6420 PVIFk,3.
- MIRR is approximately 16
- (Calculator solution is 15.92.)

Problem 2b Exam 3

- If capital is readily available at a cost of 10

percent, then Project L should be selected

because selecting L adds the most to the value of

the firm. The problem can also be viewed this

way

NPV? 100,000(2.4869) - 225,000

23,690 IRR? 15.9.

Problem 2b Exam 3

The NPV of Project? gt 0 and IRR? gt k. If we

take the smaller project, we lose the opportunity

of taking Project?, and thereby give up 23,690

of increased value to the firm. Note that the

modified internal rate of return method selects

Project S, and thus, conflicts with the NPV

method. The reason for the conflict is because

the 2 projects differ in size. The NPV method

always chooses the correct project and thus is

superior to the MIRR method.

Problem 2c Exam 3

- Look at the graph above, which shows that the

statement is false--at any cost of capital above

15.9, Project S would be preferred to Project L.

The difference in the sizes of the two projects

causes their NPV profiles to cross.

End of Practice Exam III

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