Fina exam 3 study guide - review for the exam PDF

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CHAPTER 9 9.1 QUIZ - CAPITAL BUDGETING PROJECTS Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function Mutually Exclusive The primary purpose of capital budgeting is to: maximize the shareholders' wealth. 9.2 QUIZ - NPV The "gold standard" of investment criteria refers to: NPV What is the NPV of a project that costs $100,000.00 and returns $50,000.00 annually for three years if the opportunity cost of capital is 6.98%? On the financial calculator: CFo = -100,000 C01 = 50,000 C02 = 50,000 C03 = 50,000 CLICK NPV I = 6.98 CLICK DOWN ARROW CPT = 31,263.76

9.3 QUIZ - THE INTERNAL RATE OF RETURN What is the internal rate of return for a project with an initial outlay of $10,000 that is expected to generate cash flows of $2,000 per year for 6 years? FV = 0 PV = -10,000 PMT = 2,000 N=6 CPT I = 5.47% 9.4 QUIZ - NPV PROFILES Which of the following statements is correct for a project with a negative NPV? The cost of capital exceeds the IRR 9.5 QUIZ - THE MULTIPLE IRR PROBLEM The multiple IRR problem occurs when the signs of a project’s cash flows change more than once. True 9.6 QUIZ - THE IRR AND MUTUALLY EXCLUSIVE PROJECTS You are considering the following three mutually exclusive projects. The required rate of return for all three projects is 14%. Year

A

B

C

0

$ (1,000)

$(5,000)

$(50,000)

1

$ 300

$ 1,700

$0

2

$300

$ 1,700

$15,000

3

$ 600

$1,700

$ 28,500

4

$300

$1,700

$ 33,000

What is the IRR of the best project? % terms to 2 decimal places w/o % sign Project A: CF0 = $ (-1,000) CF1 = $300 CF2 = $300 CF3 = $600 CF4 = $300 I = 14 Using the financial calculator, CPT NPV = $76.61 CPT IRR = 17.49% Project B: CF0 = $ (-5,000) CF1 = $1700 CF2 = $1700 CF3 = $1700 CF4 = $1700 I = 14 Using the financial calculator, NPV = -$46.69 IRR = 13.54% Project C: CF0 = $ (-50,000) CF1 = $0 CF2 = $15,000

CF3 = $28,500 CF4 = $33,000 Using the financial calculator, NPV = $317.35 IRR = 14.23% ~ The best project is Project C, because it has the highest NPV. ~ Therefore, the IRR of the best project = 14.23% 9.7 QUIZ - PAYBACK PERIOD Compute the payback period for a project that requires an initial outlay of $204,236 that is expected to generate $40,000 per year for 9 years. payback period = (initial outlay) / (annual net cash generation) ($204,236)/($40,000) =5.11 years 9.8 QUIZ - PROFITABILITY INDEX What is the profitability index for Project A with a cost of capital of 8%? Year

Project A

Project B

0

($42,000.0)

($45,000.0)

1

$14,000.00

$28,000.00

2

$14,000.00

$12,000.00

3

$14,000.00

$10,000.00

4

$14,000.00

$10,000.00

5

$14,000.00

$10,000.00

It should be taken into account that only the profitability index of project A is being askedProfitability index of project a could be calculated using the net cash inflows at the present and comparing it with net cash outflows at the present. Value of cash inflows at the present =( (14000/1.08)+(14000/ (1.08)^2+(14000/(1.08)^3+(14000/(1.08)^4+(14000/(1.08)^5)

= (12962.96 + 12002.74 + 11113.65 + 10290.41 + 9528.16) = 55898 (Approx) Net value of cash outflow at the beginning = 42000 Profitability index=[present value of future inflows / initial outflows] =[55898/42000] =1.33 Profitability index is 1.33 for project A Capital rationing may be beneficial to a firm if it: Weeds out proposals with weaker or biased NPVs 9.9 CHAPTER 9 HW - PROBLEM MASTERY Match those following concepts for first principle ● The investment decision: Invest in assets that earn a return greater than the minimum acceptable hurdle rate ● The financing decision: Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations ● The dividend decision: If you can't find investments that make your minimum acceptable rate, return the cash to owners of your business List steps of the capital budgeting process ● ● ● ● ●

Step 1: Proposal generation Step 2: Review and analysis Step 3: Decision making Step 4: Implementation Step 5: Follow-up

It should not usually be clear whether we are describing independent or mutually exclusive projects in the following chapters because when we only describe one project then it can be assumed to be independent False

Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital. False Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $113 at the end of the next three years and then $1,897 per year for the three years after that. If the discount rate is 7.57% then what is the NPV? CFO=-5,000 CO1= 113 FO1=3 CO2=1897 FO2=3 Enter NPV I= 7.57% Enter Down arrow CPT NPV= -748.26 The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0 True

The disadvantages of the IRR period method is that it ● ● ●

Requires complex calculations Requires a lot of data (estimates of all CFs) Only works for normal cash flows

The multiple IRR problem occurs when the signs of a project’s cash flows change more than once. True NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital False

What are the advantages of payback period? ● ● ●

Does not require discount rate Does not require complex calculations Measures Liquidity, Easy to communicate

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. If the discount rate is 8% then what is the PI? Answer in % format with 2 number after the decimal point CF0= -5,000 C01=900 FO1=3 CO2= 1400 FO2=3 NPV I=8 enter down arrow CPT NPV= 183.48 PI= (183.48+5,000)/5,000 PI= 1.03669 PI=103.67%

CHAPTER 10

10.1 QUIZ - IDENTIFYING RELEVANT CASH FLOWS Identify which of these are the relevant cash flows when considering a capital budgeting project. ● ● ● ●

lost rent from retail facility remodeling expenses for new store increase in inventory expected salvage value of manufacturing equipment

A corporation is contemplating an expansion project. The CFO plans to calculate the project’s NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the corporation's cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows? Any opportunity costs associated with the project. 10.2 QUIZ - THE SUNK COST FALLACY According to the article, "Sunk cost fallacy: Throwing good money after bad," how can banks limit losses from bad loans? increase bank executive turnover

10.3 QUIZ - CAPITAL SPENDING Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet demand for a new line of solar charged motorcycles (who wants to ride on a cloudy day anyway?) The proposed project has the following features; • The firm just spent $300,000 for marketing study to determine consumer demand (@ t=0). • Aero Motorcycles purchased the land the factory will be built on 5 years ago for $2,000,000 and owns it outright (that is, it does not have a mortgage). The land has a current market value of $2,600,000. • The project has an initial cost of $28,381,689 (excluding land, hint: land is not subject to depreciation). • If the project is undertaken, the company will realize an additional $8,000,000 in sales over each of the next ten years. (i.e. sales in each year are $8,000,000) • The company’s operating cost (not includingdepreciation) will equal 50% of sales. • The company’s tax rate is 35 percent. • Use a 10-year straight-line depreciation schedule. • At t = 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $4,500,000 (assume land has a book value equal to the original purchaseprice). • The project’s WACC = 10 percent • Assume the firm is profitable and able to use any tax credits (i.e. negative taxes) .0 What is the project's outflow at t=0? Answer to the nearest whole dollar value.

Project cash outflow = Current market value of land + Project initial cost = 2,600,000 + 28,381,689 = 30,981,689 10.4 QUIZ - CHANGES IN NET WORKING CAPITAL What is the net effect on a firm's working capital if a new project requires: $32,701 increase in inventory, $36,573 increase in accounts receivable, $35,000.00 increase in machinery, and a $48,085 increase in accounts payable? Round to nearest dollar amount. A/R + 36,573 Inventory + 32,701 A/P + 48,085 36,573 + 32,701 - 48,085 = 21, 189

10.5 QUIZ - AFTER-TAX OPERATING CASH FLOWS Revenues generated by a new fad product are forecast as follows:

Year

Revenues

1

$39,482

2

40,000

3

20,000

4

10,000

Thereafter

0

Expenses are expected to be 50% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $40,000 in plant and equipment that will be depreciated using the straight-line method over 5 years. The firm recently spent $2,000 on a study to estimate the revenues of the new product. The tax rate is 20%. What is the operating cash flow in year 1? Answer the nearest whole dollar amount.

REVENUE - $39,482 EXPENSES (50% OF REVENUE) - 19,741 DEPRECIATION (40000/5) - 8000 EBT (SUBTRACT DEP. FROM EXPENSES) - 11,741 TAXES (20% OF EBT) - 2,348.2 NET INCOME (SUBTRACT TAXES FROM EBT) - 9,392.8

DEPRECIATION - 8,000 OCF (ADD NET INCOME AND DEP) - 17,392.8 What is the amount of the operating cash flow for a firm with $367,563 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate? Profit before tax $367,563 Taxes @ 35% - 128,647.05 Net Profit $238,915.95 + Depreciation 100,000 Cash Flow From Operations = 338,915.95

10.6 QUIZ - COMPUTING NPV (REVIEW) A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $122,046,311 now, and then spend $20 million in one year. In two years it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what is the project’s NPV? CF0 = -122,046,311 C01 = -20,000,000 C02 = 80,000,000 CO3 = 90,000,000 I = 11 CPT NPV -9,327,310.04 A company just paid $10 million for a feasibility study. If the company goes ahead with the project, it must immediately spend another $100 million now, and then spend $20 million in one year. In two years it will receive $80 million, and in three years it will receive $90 million. If the cost of capital for the project is 11 percent, what is the project’s IRR? % terms to 2 decimal places and without the % sign. CF0 = -100,000,00 C01 = -20,000,000 C02 = 80,000,000 CO3 = 90,000,000 I = 11 CPT IRR 15.95

10.7 QUIZ - ROBUSTNESS OF NPV ESTIMATES

If a 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggest: deemphasizing that variable as a critical factor. Which of the following changes, if of a sufficient magnitude, could turn a negative NPV project into a positive NPV project? A decrease in the fixed costs 10.8 QUIZ - BNSF CAPITAL BUDGETING PROCESS PART 2 What types of projects does the BNSF strategic studies team evaluate? Discretionary What types of analyses do the BNSF strategic studies team conduct? discounted cash flow sensitivity

Jon Stevens, BNSF Vice President and Controller describes the capital spending process primarily as a means to ensure regulatory compliance a balancing act that requires careful evaluation of the costs and benefits of each project

10.9 CHAPTER 10 HW - PROBLEM MASTERY Aero Motorcycles is considering opening a new manufacturing facility in Fort Worth to meet the demand for a new line of solar-charged motorcycles (who wants to ride on a cloudy day anyway?) The proposed project has the followingfeatures;

• The firm just spent $300,000 for a marketing study to determine consumer demand (@ t=0). • Aero Motorcycles purchased the land the factory will be built on 5 years ago for $2,000,000 and owns it outright (thatis, it does not have a mortgage). The land has a current market value of $2,600,000. • The project has an initial cost of $20,000,000 (excludingland, hint: the land is not subject to depreciation). • If the project is undertaken, at t = 0 the company will need to increase its inventories by $3,500,000, accounts receivable by $1,500,000, and its accounts payable by $2,000,000. This net operating working capital will be recovered at the end of the project’s life (t = 10). • If the project is undertaken, the company will realize an additional $8,000,000 in sales over each of the next ten years. (i.e. sales in each year are $8,000,000) • The company’s operating cost (not including depreciation)will equal 50% of sales. • The company’s tax rate is 35 percent. • Use a 10-year straight-line depreciation schedule. • At t = 10, the project is expected to cease being economically viable and the factory (including land) will be sold for $4,500,000 (assume land has a book value equal to the original purchase price). • The project’s WACC = 10 percent • Assume the firm is profitable and able to use any tax credits(i.e. negative taxes). What is the operating cash flow @ t=1? Round to nearest whole dollar value. The following is how I solved for operating cash flow at time 1 & 2 + Revenue...