EF209 Financial Management Capital Budgeting Decision Tutorial Questions PDF

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Tutorial Questions for Capital Budgeting Decision Chapter for EF209 Financial Management ...

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Chapter 12 The Capital Budgeting Decision Discussion Questions 12-1.

What are the important administrative considerations in the capital budgeting process?

12-2.

Why does capital budgeting rely on analysis of cash flows rather than on net income?

12-3.

What are the weaknesses of the payback method?

12-4.

What is normally used as the discount rate in the net present value method?

12-5.

What does the term mutually exclusive investments mean?

12-6.

How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods?

12-7.

If a corporation has projects that will earn more than the cost of capital, should it ration capital?

12-8.

What is the net present value profile? What three points should be determined to graph the profile? a.

12-9.

How does an asset's ADR (asset depreciation range) relate to its MACRS category?

Chapter 12 Problems 1.

Cash flow (LO2) Assume a corporation has earnings before depreciation and taxes of $100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below.

Earnings before depreciation and taxes Depreciation Earnings before taxes Taxes @ 30% Earnings after taxes Depreciation

2.

_____ _____ _____ _____ _____ _____

Cash flow (LO2) a.

In problem 1, how much would cash flow be if there were only $10,000 in depreciation? All other factors are the same.

b.

How much cash flow is lost due to the reduced depreciation between Problems 1 and 2a?

3.

Cash flow (LO2) Assume a firm has earnings before depreciation and taxes of $500,000 and no depreciation. It is in a 40 percent tax bracket. a. Compute its cash flow. b. Assume it has $500,000 in depreciation. Recompute its cash flow. c. How large a cash flow benefit did the depreciation provide?

4.

Cash flow (LO2) Assume a firm has earnings before depreciation and taxes of $400,000 and depreciation of $100,000. a. If it is in a 35 tax bracket, compute its cash flow. b. If it is in a 20 tax bracket, compute its cash flow.

5.

Cash flow versus earnings (LO2) A1 Quick, the president of a New York Stock Exchange-listed firm, is very short term oriented and interested in the immediate consequences of his decisions. Assume a project that will provide an increase of $2 million in cash flow because of favorable tax consequences, but carries a two-cent decline in earning per share because of a write-off against first quarter earnings. What decision might Mr. Quick make?

6.

Payback method (LO3) Assume a $200,000 investment and the following cash flows for two products: Year 1 2 3 4

Product X $60,000 90,000 50,000 40,000

Product Y $40,000 70,000 80,000 20,000

Which alternatives would you select under the payback method? 7.

Payback method (LO3) Assume a $50,000 investment and the following cash flows for two alternatives. Year 1 ................. 2 ................. 3 ................. 4 ................. 5 .................

Investment A $10,000 11,000 13,000 16,000 30,000

Investment B $20,000 25,000 15,000 — —

Which alternative would you select under the payback method? 8.

Payback method (LO3) Referring back to Problem 7, if the inflow in the fifth year for Investment A were $30,000,000 instead of $30,000, would your answer change under the payback method?

9.

Payback method (LO3) The Short-Line Railroad is considering a $100,000 investment in either of two companies. The cash flows are as follows: Year 1................... 2................... 3................... 4–10............. a. b.

Electric Co. $70,000 15,000 15,000 10,000

Water Works $15,000 15,000 70,000 10,000

Using the payback method, what will the decision be? Explain why the answer in part a can be misleading.

10. Payback and net present value (LO3 & 4) Diaz Camera Company is considering two investments, both of which cost $10,000. The cash flows are as follows: Year 1 ....................... 2 ....................... 3 ....................... a. b. c.

Project A $6,000 4,000 3,000

Project B $5,000 3,000 8,000

Which of the two projects should be chosen based on the payback method? Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent. Should a firm normally have more confidence in answer a or answer b?

11. Internal rate of return (LO4) You buy a new piece of equipment for $11,778, and you receive a cash inflow of $2,000 per year for 10 years. What is the internal rate of return? 12. Internal rate of return (LO4) King’s Department Store is contemplating the purchase of a new machine at a cost of $13,869. The machine will provide $3,000 per year in cash flow for six years. King’s has a cost of capital of 12 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be undertaken.

13. Internal rate of return (LO4) Home Security Systems is analyzing the purchase of manufacturing equipment that will cost $40,000. The annual cash inflows for the next three years will be: Year 1 ......................... 2 ......................... 3 ......................... a. b.

Cash Flow $20,000 18,000 13,000

Determine the internal rate of return using interpolation. With a cost of capital of 12 percent, should the machine be purchased?

14. Net present value method (LO4) Altman Hydraulic Corporation will invest $160,000 in a project that will produce the cash flow shown below. The cost of capital is 11 percent. Should the project be undertaken? Use the net present value method. (Note that the third year’s cash flow is negative.) Year 1 ............ 2 ............ 3 ............ 4 ............ 5 ............

Cash Flow $54,000 66,000 (60,000) 57,000 120,000

15. Net present value method (LO4) Hamilton Control Systems will invest $90,000 in a temporary project that will generate the following cash inflows for the next three years. Year 1 ............ 2 ............ 3 ............

Cash Flow $23,000 38,000 60,000

The firm will be required to spend $15,000 to close down the project at the end of the three years. If the cost of capital is 10 percent, should the investment be undertaken? Use the net present value method.

16. Net present value method (LO4) Cellular Labs will invest $150,000 in a project that will not begin to produce returns until after the third year. From the end of the 3rd year until the end of the 12th year (10 periods), the annual cash flow will be $40,000. If the cost of capital is 12 percent, should this project be undertaken?

17. Net present value and internal rate of return methods (LO4) The Hudson Corporation makes an investment of $14,400 that provides the following cash flow: Year 1 ................. 2 ................. 3 .................

Cash Flow $ 7,000 7,000 4,000

a.

What is the net present value at an 11 percent discount rate?

b.

What is the internal rate of return? Use the interpolation procedure shown in this chapter.

c.

In this problem would you make the same decision under both parts a and b?

18. Net present value and internal rate of return methods (LO4) The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of bottling and save money. The net cost of this machine is $45,000. The annual cash flows have the following projections. Year 1 ........... 2 ........... 3 ........... 4 ........... 5 ...........

Cash Flow $15,000 20,000 25,000 10,000 5,000

b.

If the cost of capital is 10 percent, what is the net present value of selecting a new machine? What is the internal rate of return?

c.

Should the project be accepted? Why?

a.

19. Use of profitability index (LO4) You are asked to evaluate the following two projects for the Norton Corporation. Using the net present value method combined with the profitability index approach described in footnote 2 of this chapter, which project would you select? Use a discount rate of 10 percent.

Project X (Videotapes of the Weather Report) ($10,000 Investment) Year 1 .........................

Project Y (Slow-Motion Replays of Commercials) ($30,000 investment)

Cash Flow $5,000

Year 1...................................

Cash Flow $15,000

2 .........................

3,000

2...................................

8,000

3 .........................

4,000

3...................................

9,000

4 .........................

3,600

4...................................

11,000

20. Reinvestment rate assumption in capital budgeting (LO4) Turner Video will invest $48,500 in a project. The firm’s cost of capital is 9 percent. The investment will provide the following inflows. Year 1 ................. 2 ................. 3 ................. 4 ................. 5 .................

Inflow $10,000 12,000 16,000 20,000 24,000

The internal rate of return is 14 percent. a.

b. c.

If the reinvestment assumption of the net present value method is used, what will be the total value of the inflows after five years? (Assume the inflows come at the end of each year.) If the reinvestment assumption of the internal rate of return method is used, what will be the total value of the inflows after five years? Generally is one investment assumption likely to be better than another?

21. Modified internal rate of return (LO4) The Caffeine Coffee Company uses the modified internal rate of return. The firm has a cost of capital of 12 percent. The project being analyzed is as follows ($27,000 investment): Year 1 ............ 2 ............ 3 ............ a. b.

Cash Flow $15,000 12,000 9,000

What is the modified internal rate of return? An approximation from Appendix B is adequate. (You do not need to interpolate.) Assume the traditional internal rate of return on the investment is 17.5 percent. Explain why your answer in part a would be lower.

22. Capital rationing and mutually exclusive investments (LO4) The Suboptimal Glass Company uses a process of capital rationing in its decision making. The firm’s cost of capital is 13 percent. It will only invest only $60,000 this year. It has determined the internal rate of return for each of the following projects.

Project A ..................... B ..................... C ..................... D ..................... E ..................... F ...................... G ..................... a. b.

Project Size $10,000 30,000 25,000 10,000 10,000 20,000 15,000

Internal Rate of Return 15% 14 16.5 17 23 11 16

Pick out the projects that the firm should accept. If Projects D and E are mutually exclusive, how would that affect your overall answer? That is, which projects would you accept in spending the $60,000?

23. Net present value profile (LO4) Keller Construction is considering two new investments. Project E calls for the purchase of earthmoving equipment. Project H represents an investment in a hydraulic lift. Keller wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project E

Project H

($20,000 Investment)

($20,000 investment)

Year 1 ........................... 2 ........................... 3 ........................... 4 ........................... a. b.

Cash Flow $ 5,000 6,000 7.000 10,000

Year 1 .................................. 2 .................................. 3 ..................................

Cash Flow $16,000 5,000 4,000

Determine the net present value of the projects based on a zero discount rate. Determine the net present value of the projects based on a 9 percent discount rate.

The internal rate of return on Project E is 13.25 percent, and the internal rate of return on Project H is 16.30 percent. Graph a net present value profile for the two investments similar to Figure 12-3. (Use a scale up to $8,000 on the vertical axis, with $2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.) d. If the two projects are not mutually exclusive, what would your acceptance or rejection decision be if the cost of capital (discount rate) is 8 percent? (Use the net present value profile for your decision; no actual numbers are necessary.) e. If the two projects are mutually exclusive (the selection of one precludes the selection of the other), what would be your decision if the cost of capital is (1) 6 percent, (2) 13 percent, (3) 18 percent? Once again, use the net present value profile for your answer. 24. Net present value profile (LO4) Davis Chili Company is considering an investment of $15,000, which produces the following inflows: c.

Year 1 ................. 2 ................. 3 .................

Cash Flow $8,000 7,000 4,000

You are going to use the net present value profile to approximate the value for the internal rate of return. Please follow these steps:

a.

Determine the net present value of the project based on a zero discount rate.

b. c.

Determine the net present value of the project based on a 10 percent discount rate. Determine the net present value of the project based on a 20 percent discount rate (it will be negative). Draw a net present value profile for the investment and observe the discount rate at which the net present value is zero. This is an approximation of the internal rate of return based on the interpolation procedure presented in this chapter. Compare your answer in parts d and e. Actually compute the internal rate of return based on the interpolation procedure presented in this chapter. Compare your answers in parts d and e.

d.

e....