Topic 5 Practice Questions with Solutions PDF

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Topic 5 Capital Budgeting IPractice Questions with Solutions Mattel, the toy manufacturer, is considering the following independent investment opportunities in Australia. It has a capital budget of $50 million. Which projects should it accept, given that the projects are not divisible? Project Initi...

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Topic 5 Capital Budgeting I

FINC5001

Practice Questions with Solutions

1.

Mattel, the toy manufacturer, is considering the following independent investment opportunities in Australia. It has a capital budget of $50 million. Which projects should it accept, given that the projects are not divisible? Project

Initial Cost (millions)

NPV (millions)

Profitability index

Koala

$20

+$9

(20 + 9) / 20 = 1.45 

Wombat

$20

+$6

(20 + 6) / 20 = 1.3

Echidna

$10

+$4

(10 + 4) / 10 = 1.4 

Kangaroo

$30

+$10

(30 +10) / 30 = 1.33

Platypus

$10

+$5

(10 + 5) / 10 = 1.5 

Tasmanian devil

$10

+$3

(10 + 3) / 10 = 1.3 

a) Kangaroo and Koala b) Kangaroo, Echidna and Platypus c)

Koala, Wombat and Platypus

d) Koala, Echidna, Platypus and Tasmanian Devil e) All of them

2.

Note. While Kangaroo has a larger PI than Tasmanian Devil, there are insufficient funds remaining to invest in Kangaroo.

Project Tee has the following set of cash flows and a required rate of return of 5% p.a. Year 0

Year 1

Year 2

-$80

+$220

-$150

When evaluating Project Tee using an IRR technique, what problem will arise? a) The project’s IRR is impossible to determine b) The project will have multiple IRR’s c) The project’s cash flows are impossible since projects cannot have negative cash flows in any year other than year zero d) The project’s required rate of return is too low e) No problem should arise

3.

Which of the following is not a benefit associated with using the NPV technique in capital budgeting? a) The NPV technique always selects projects that maximise shareholders wealth b) The NPV technique considers all cash flows expected to be generated by the project and hence uses all available information c)

The NPV technique provides evaluation in percentage format making it easier to interpret

d) The NPV technique considers the time value of money e) All these are benefits associated with the NPV technique

4.

Projects that compete with one another so that only one can proceed are: a) independent b) mutually exclusive c)

capital rationed

d) conventional e) profitable

5.

A project consists of an initial outflow followed by a series of inflows. It is best described as: a) capital rationed b) independent c)

mutually exclusive

d) conventional e) unconventional

6.

Should a firm invest in projects with a NPV equal to $0? a) Yes b) No, the profit from the project is zero c) Depends on the size of the initial investment d) The firm is indifferent between accepting or rejecting projects with zero NPVs e) It depends on the project’s payback period and IRR

Questions 7 to 11 relate to the following information. Frying Nemo, a manufacturer of frozen fish products, is considering a project requiring an initial outlay of $500,000. The project is expected to generate after-tax cash inflows of $250,000 per year over the next four years. 7.

What is the payback period for this investment? a) 1.8 years

𝑃𝑃 =

b) 2.0 years c) 2.5 years

500,000 =2 250,000

d) 3 years e) 4 years

8.

If the project has a 15% p.a. cost of capital, what is its discounted payback period? a) 1.5 years

𝑃𝑉1 =

b) 2 years c) 2.4 years d) 2.6 years e) 3 years

9.

𝑃𝑉2 =

250,000 (1.15)2

𝐷𝐷𝑃 = 2 +

250,000 𝐹𝑉 = = $217,391.30 (1 + 𝑟 )𝑛 (1.15)1

= $189,035.92

𝑃𝑉3 =

250,000 (1.15)3

= $164,379.06

500,000 − 217,391.30 − 189,035.92 = 2.569 164,379.06

If the project has a 15% p.a. cost of capital, what is its net present value? a) $213,745 b) $185,865 c) $713,745 d) $500,000

𝑁𝑃𝑉 = 250,000 [ = +$213,744.59

1 − (1.15)−4 ] − 500,000 0.15

e) $70,806.28 10. If the project has a 15% p.a. cost of capital, what is its profitability index? a) b) c) d) e)

1.43 2.43 2.0 1.14 0.43

𝑃𝐼 =

1 − (1.15)−4 ] 0.15 = 1.4275 500,000

250,000 [

11. Which of the following is closest to the IRR for the project? a) 23.4% p.a. b) 15.0% p.a. c) 34.9% p.a. d) 100% p.a. e) 27.5% p.a.

𝑁𝑃𝑉 = 0 = 250,000 [

1 − (1 + 𝐼𝑅𝑅 )−4 ] − 500,000 𝐼𝑅𝑅

At 23.4%, NPV = +$107,628.01 At 15%, NPV = +$213,744.59 At 34.9%, NPV = +$27.27 At 100%, NPV = -$265,625.00

Closest to an NPV of zero

At 27.5%, NPV = $65,084.47

12. Wondadrug Pharmaceuticals shares were trading for $30 yesterday. Its share price rose today to $32 on the news that their long-awaited new drug Wondex is to hit the market next month. If Wondadrug have 50 million shares outstanding, what is the market's consensus of the NPV that the new drug will generate for them? a) $100 million

(32 – 30) x 50 million

b) $200 million c) $1,500 million d) $1,600 million e) None of these

13. You must know the discount rate of an investment project to compute its: a) NPV, IRR, PI, and the discounted payback period b) NPV, PI, and discounted payback period c) NPV, PI, and IRR d) NPV, payback period, PI, and discounted payback period e) NPV, payback period, PI, IRR and discounted payback period

14. You must know all the cash flows of an investment project to compute its: a) NPV, IRR, PI, and the discounted payback period b) NPV, PI, and discounted payback period c) NPV, PI, and IRR d) NPV, payback period, PI, and discounted payback period e) NPV, payback period, PI, IRR and discounted payback period

15. The preferred technique for evaluating most capital investments is: a) Payback period b) Discounted payback period c)

Internal rate of return

d) Profitability index e) Net present value

Questions 16 and 17 relate to the following information: The following table lists a project’s yearly cash flows: Year Cashflow

0

1

2

3

4

5

-235,000

0

0

90,000

90,000

90,000

16. What is the payment period for this project? a) 2.61 years 𝑃𝑃 = 4 +

b) 3 years c)

4.61 years

235,000 − 90,000 − 90,000 = 4.61 90,000

d) 5 years e) The project does not payback

17. What is the NPV of this project if the discount rate is 8% p.a.? a) -$36,150 b) -$20,242 c)

-$3,061

d) +$214,758 e) +$231,939

𝑁𝑃𝑉 =

1 − (1.08)−3 ] 0.08 − 235,000 = −$36,149.92 (1.08)2

90,000 [

18. Zoo Ltd is considering investing in a new project codenamed Project Lion at a cost now of $12,000. The project is expected to generate cash flows of $1000 every four years forever with the first cash flow starting in year 2 and $4000 every four years forever with the first cash flow starting in year 4. The timeline of the first 8 years of cash flows is given below: Year 0

Year 1

Year 2

Year 3

Year 4

$1000

Year 5

$4000

Year 6 $1000

Year 7

Year 8 $4000

Suppose similar investments are paying a return of 10% p.a. compounded quarterly. What is the NPV of Project Lion? a) -$1,680.20 b) -$773.97 c) -$1,229.43 d) -$542.02

𝐸𝑅 = (1 + 𝑁𝑃𝑉 =

e) -$1,246.77

0.1 4×4 𝑟𝑛𝑜𝑚 𝑚×𝑛 ) − 1 = (1 + ) − 1 = 0.48450562 𝑚 4

1,000 0.1 8 4,000 (1 + ) + − 12,000 0.48450562 4 0.48450562 = −$1,229.43

Questions 19 and 20 relate to the following information. Torbay Group is evaluating five potential manufacturing projects. The finance department of Torbay has undertaken detailed capital budgeting evaluation and come up with the following information about those projects. Project Name

NPV

IRR (% p.a.)

Payback

Alpha

$50,900

15.6%

4 years

Beta

-$20,000

4.9% and 22.1%

2 years

Gamma

$88,500

31%

5 years

Delta

$2,350

53.4%

3 years

Epsilon

-$5,800

5.5%

4 years

The company believes the appropriate discount rate for all these projects is 11% p.a. 19. Based on this information which project should Torbay invest in if the projects are mutually exclusive? a) Alpha b) Beta c)

Gamma

d) Delta e) Epsilon

20. What is the likely cause of project Beta having two IRR values? a) The project is small in scale b) The project has one or more negative future cash flows c)

The project is mutually exclusive

d) The project has a negative NPV e) The project has a short payback period

Questions 21 through 23 relate to the following information. The directors of EcoCapital Corporation Ltd are considering investing in the following five short term projects. The cash flows (after taxes), required rate of return and IRR’s associated with each of these projects are given in the table below. Project Name

Year 0

Year 1

Year 2

Year 3

Year 4

Required Rate of Return

IRR

Falcon

-100

+50

+70

+20

+80

10%

40%

Eagle

-250

+80

+140

+100

+120

12%

26%

Hawk

-150

+120

+40

+70

+30

10%

34%

Osprey

-250

+80

+80

+80

+80

14%

11%

Owl

-50

+40

+40

+20

+20

11%

57%

21. Which of the five projects would be considered acceptable to EcoCapital if the NPV technique is being used to make capital budgeting decisions? a) Falcon, Hawk, Osprey and Owl b) Falcon, Eagle, Hawk and Osprey c)

Falcon, Eagle, Osprey and Owl

d) Eagle, Hawk, Osprey and Owl e) Falcon, Eagle, Hawk, and Owl 𝑁𝑃𝑉𝐹𝑎𝑙𝑐𝑜𝑛 = 𝑁𝑃𝑉𝐸𝑎𝑔𝑙𝑒 =

140 100 120 80 + + + − 250 = $80.48 (1.12) (1.12)2 (1.12)3 (1.12)4

𝑁𝑃𝑉𝐻𝑎𝑤𝑘 = 𝑁𝑃𝑉𝑂𝑠𝑝𝑟𝑒𝑦 = 𝑁𝑃𝑉𝑂𝑤𝑙 =

50 70 20 80 − 100 = $72.97 + + + 2 3 (1.1) (1.1) (1.1) (1.1)4

120 40 70 30 + + + − 150 = $65.23 (1.1) (1.1)2 (1.1)3 (1.1)4

80 80 80 80 − 250 = −$16.90 + + + (1.14) (1.14)2 (1.14)3 (1.14)4 40 20 20 40 + + + − 50 = $46.30 2 3 (1.11) (1.11) (1.11) (1.11)4

22. EcoCapital has set a minimum payback period of 2 years for determining acceptable projects using the payback capital budgeting technique. Which of the projects would EcoCapital consider acceptable using this evaluation technique? a) Falcon, Eagle, Osprey b) Eagle, Osprey, Owl c)

Falcon, Eagle, Hawk

d) Hawk, Osprey, Owl e) Falcon, Hawk, Owl

50 = 1.71 𝑦𝑒𝑎𝑟𝑠 70 30 𝑃𝑃𝐸𝑎𝑔𝑙𝑒 = 2 + = 2.3 𝑦𝑒𝑎𝑟𝑠 100 30 𝑃𝑃𝐻𝑎𝑤𝑘 = 1 + = 1.75 𝑦𝑒𝑎𝑟𝑠 40 250 𝑃𝑃𝑂𝑠𝑝𝑟𝑒𝑦 = = 3.13 𝑦𝑒𝑎𝑟𝑠 80 10 𝑃𝑃𝑂𝑤𝑙 = 1 + = 1.25 𝑦𝑒𝑎𝑟𝑠 40

𝑃𝑃𝐹𝑎𝑙𝑐𝑜𝑛 = 1 +

23. After further analysis EcoCapital has determined that the five projects are mutually exclusive. In this situation which of the projects should EcoCapital choose? a) Falcon b) Eagle c)

Hawk

d) Osprey e) Owl...