Finance Exam Continued AGAIN

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Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?

a. Changes in net working capital.
b. Shipping and installation costs.
c. Cannibalization effects.
d. Opportunity costs.
e. Sunk costs that have been expensed for tax purposes.

E

The relative risk of a proposed project is best accounted for by which of the following procedures?

a. Adjusting the discount rate upward if the project is judged to have above-average risk.
b. Adjusting the discount rate downward if the project is judged to have above-average risk.
c. Reducing the NPV by 10% for risky projects.
d. Picking a risk factor equal to the average discount rate.
e. Ignoring risk because project risk cannot be measured accurately.

A

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?

a. Project A, which has average risk and an IRR = 9%.
b. Project B, which has below-average risk and an IRR = 8.5%.
c. Project C, which has above-average risk and an IRR = 11%.
d. Without information about the projects' NPVs we cannot determine which one or ones should be accepted.
e. All of these projects should be accepted.

B

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

a. All sunk costs that have been incurred relating to the project.
b. All interest expenses on debt used to help finance the project.
c. The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.
d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
e. Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

C

Which of the following factors should be included in the cash flows used to estimate a project's NPV?

a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
b. Interest on funds borrowed to help finance the project.
c. The end-of-project recovery of any working capital required to operate the project.
d. Cannibalization effects, but only if those effects increase the project's projected cash flows.
e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

C

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:

a. Changes in net working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
c. The value of a building owned by the firm that will be used for this project.
d. A decline in the sales of an existing product, provided that decline is directly attributable to this project.
e. The salvage value of assets used for the project that will be recovered at the end of the project's life.

B

Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?

a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.
b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
c. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

B

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

a. The new project is expected to reduce sales of one of the company's existing products by 5%.
b. Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost.
c. The company has spent and expensed $1 million on R&D associated with the new project.
d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

A

Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?

a. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products.
b. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment.
c. The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.
d. The new product will cut into sales of some of the firm's other products.
e. If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project's life.

C

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
d. A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.

D

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

a. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.
b. Revenues from an existing product would be lost as a result of customers switching to the new product.
c. Shipping and installation costs associated with a machine that would be used to produce the new product.
d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
e. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

D

Taussig Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following numbers:

Project X Project Y
Expected NPV $350,000 $350,000
Standard deviation (sNPV) $100,000 $150,000
Project beta (vs. market) 1.4 0.8

Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.

Which of the following statements is CORRECT?

a. Project X has more stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has less market risk than Project Y.

C

A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?

a. Increase the estimated IRR of the project to reflect its greater risk.
b. Increase the estimated NPV of the project to reflect its greater risk.
c. Reject the project, since its acceptance would increase the firm's risk.
d. Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

E

Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:

Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low 9%
E Low 6%

Which set of projects would maximize shareholder wealth?

a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.

C

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

a. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.
b. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all.
c. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated.
d. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure.
e. DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments--managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.

E

As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?

Sales revenues $13,000
Depreciation $4,000
Other operating costs $6,000
Tax rate 35.0%

a. $5,950
b. $6,099
c. $6,251
d. $6,407
e. $6,568

A

Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues $22,250
Depreciation $8,000
Other operating costs $12,000
Tax rate 35.0%

a. $8,903
b. $9,179
c. $9,463
d. $9,746
e. $10,039

C

Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?

Equipment cost (depreciable basis) $65,000
Straight-line depreciation rate 33.333%
Sales revenues, each year $60,000
Operating costs (excl. deprec.) $25,000
Tax rate 35.0%

a. $28,115
b. $28,836
c. $29,575
d. $30,333
e. $31,092

D

As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow?

Sales revenues, each year $42,500
Depreciation $10,000
Other operating costs $17,000
Interest expense $4,000
Tax rate 35.0%

a. $16,351
b. $17,212
c. $18,118
d. $19,071
e. $20,075

E

You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues, each year $62,500
Depreciation $8,000
Other operating costs $25,000
Interest expense $8,000
Tax rate 35.0%

a. $25,816
b. $27,175
c. $28,534
d. $29,960
e. $31,458

B

Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

Equipment cost (depreciable basis) $65,000
Sales revenues, each year $60,000
Operating costs (excl. deprec.) $25,000
Tax rate 35.0%

a. $30,258
b. $31,770
c. $33,359
d. $35,027
e. $36,778

A

Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?

Equipment cost (depreciable basis) $70,000
Sales revenues, each year $42,500
Operating costs (excl. deprec.) $25,000
Tax rate 35.0%

a. $11,814
b. $12,436
c. $13,090
d. $13,745
e. $14,432

C

Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?

Risk-adjusted WACC 10.0%
Net investment cost (depreciable basis) $65,000
Straight-line deprec. rate 33.3333%
Sales revenues, each year $65,500
Operating costs (excl. deprec.), each year $25,000
Tax rate 35.0%

a. $15,740
b. $16,569
c. $17,441
d. $18,359
e. $19,325

E

Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale.

a. $5,558
b. $5,850
c. $6,143
d. $6,450
e. $6,772

B

Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

Year Depreciation Rate
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06

a. $8,878
b. $9,345
c. $9,837
d. $10,355
e. $10,900

E

TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC 10.0%
Pre-tax cash flow reduction for other products (cannibalization) -$5,000
Investment cost (depreciable basis) $80,000
Straight-line deprec. rate 33.333%
Sales revenues, each year for 3 years $67,500
Annual operating costs (excl. deprec.) -$25,000
Tax rate 35.0%

a. $3,636
b. $3,828
c. $4,019
d. $4,220
e. $4,431

B

Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC 10.0%
Opportunity cost $100,000
Net equipment cost (depreciable basis) $65,000
Straight-line deprec. rate for equipment 33.333%
Sales revenues, each year $123,000
Operating costs (excl. deprec.), each year $25,000
Tax rate 35%

a. $10,521
b. $11,075
c. $11,658
d. $12,271
e. $12,885

D

Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV?

WACC 10.0%
Net investment cost (depreciable basis) $200,000
Units sold 50,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. deprec. (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation rate per year 5.00%
Tax rate 40.0%

a. $15,925
b. $16,764
c. $17,646
d. $18,528
e. $19,455

C

Poulsen Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made?

WACC 10.0%
Net investment cost (depreciable basis) $200,000
Units sold 50,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. deprec. (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation 4.00%
Tax rate 40.0%

a. $12,018
b. $12,650
c. $13,316
d. $13,982
e. $14,681

C

Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No new working capital would be required. Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)

WACC 10.0%
Net investment cost (depreciable basis) $60,000
Number of cars washed 2,800
Average price per car $25.00
Fixed op. cost (excl. deprec.) $10,000
Variable op. cost/unit (i.e., VC per car washed) $5.375
Annual depreciation $20,000
Tax rate 35.0%

a. -$28,939
b. -$30,462
c. -$32,066
d. -$33,753
e. -$35,530

E

Foley Systems is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)

WACC 10.0%
Net investment in fixed assets (basis) $75,000
Required new working capital $15,000
Straight-line deprec. rate 33.333%
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $25,000
Tax rate 35.0%

a. $23,852
b. $25,045
c. $26,297
d. $27,612
e. $28,993

A

Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?

WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Straight-line deprec. rate 33.333%
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%

a. $20,762
b. $21,854
c. $23,005
d. $24,155
e. $25,363

C

Aggarwal Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm?

WACC = 11.5% Dollars in Thousands NPV This Prob. ×
t = 0 t = 1 t = 2 t = 3 State NPV
Prob. = 20% $800.0 $800.0 $800.0 $938.1 $187.6
Prob. = 60% -$1,000 $520.0 $520.0 $520.0 $259.8 $155.9
Prob. = 20% -$200.0 -$200.0 -$200.0 -$1,484.5 -$296.9
Exp. NPV = $ 46.6

a. $55.1
b. $58.0
c. $61.0
d. $64.1
e. $67.3

C

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