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Title: Practice Exam III


1
Practice Exam III
  • Fin. 429
  • Dr. Bruce A. Costa
  • Fall 2003

2
Chapter 11 Capital Budgeting Decision Criteria
3
  • 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.

4
Exam 3
  • All of the above statements are true.

5
  • 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.

6
Exam 3
  • The MIRR method uses a more reasonable assumption
    about reinvestment rates than the IRR method.

7
  • 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.

8
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.

9
  • 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

10
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
11
  • 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

12
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
13
  • 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?
14
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.

15
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.
16
  • Chapter 12
  • Capital Budgeting
  • Estimating Cash Flow And Analyzing Risk

17
  • 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.

18
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.

19
  • 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.

20
Exam 3
  • Sunk costs.

21
  • 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.

22
Exam 3
  • The firm should select Project X because it has a
    higher NPV.

23
  • 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.

24
Exam 3
  • Answers a and c are correct.

25
  • 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.

26
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.

27
  • 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.

28
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
29
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
30
  • 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

31
Exam 3
  • 0

1. Find cash flow at t0
32
Exam 3
13. cont.
2. Calculate change in depreciation
33
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
34
  • 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

35
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
36
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
37
  • Problems

38
  • 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.

39
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)

40
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.)

41
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.

42
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.

43
Problem 2 Exam 3
44
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.

45
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.)

46
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.)

47
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.
48
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.
49
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.

50
End of Practice Exam III
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