65 terms

# Finance Cpt 8-11

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The ____ the standard deviation, the ___ the investment.
larger, riskier
Which of the following is not an example of a source of systematic risk?
foreign competition with an industry's products
examples of: interest rate changes
changes in the overall economic outlook
changes in the inflation rate
Beta is defined as
a measure of volatility of a security's returns relative to the returns of a broadbased market portfolio of securities.
Recalling the meaning and calculation of beta, a security that is completely uncorrelated (ρ = 0) with the market portfolio would have a beta of
0
The risk remaining after extensive diversification is primarily
systematic risk
What will happen to the Security Market Line if: (1) inflation expectations increase, and (2) investors become more risk averse?
shift up and have a steeper slope
Which of the following is not an approach for managing risk:
ignoring systematic risk
In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio, the correlation coefficient between the securities must be ____.
equal to -1.0
In the ____, the expected return on a security is equal to the risk-free rate plus a single risk premium that is equal to the product of the expected rate of return on the market portfolio less the risk-free rate times the sensitivity of the security's returns to the market return.
Capital Asset Pricing Model
____ can be achieved by investing in a set of securities that have different risk-return characteristics.
Diversification
Sally's broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities have an expected return of 10.3 percent and 20% have an expected return of 12.8 percent, what is the expected return of the remaining portion of her portfolio?
Solution:
14.2%-0.4(10.3%)-0.2(12.8%)=0.4X
X=18.8%
If the return on U.S. Treasury bills is 7.02%, the risk premium is 2.32%, and the inflation rate is 4.16%, then the real rate of return is:
Solution:
7.02%-4.16%=2.86%
The yield to maturity on ACL bonds maturing in 2005 is 8.75 percent. The yield to maturity on a similar maturity U.S. Government Treasury bond in 7.06 percent and the yield on Treasury bills is 6.51 percent. What is the default risk premium on the ACL bond?
Solution:
AKA's stock is currently selling for \$11.44. This year the firm had earnings per share of \$2.80 and the current dividend is \$0.68. Earnings are expected to grow 7% a year in the foreseeable future. The risk-free rate is 10 percent and the expected market return is 14.2 percent. What will be the effect on the price of AKAs' stock if systematic risk increases by 40 percent, all other factors remaining constant?
Solution:
Old ke=0.10+Betaj(0.142-0.10)=0.10+0.042Betaj
P=\$0.68(1.07)/(0.10+0.042Betaj-0.07)=\$11.44
Bj=0.80
New ke=0.10+0.8(1.4)(0.042)=0.147
P=\$0.7276/(0.147-0.07)=\$9.45
A decrease of \$1.99 a share
HDTV has planned on diversifying into the dual-VCR field. As a result, HDTV's beta would rise to 1.6 from 1.2 and the expected future long-term growth rate in the firm's earnings would increase from 12% to 16%. The expected market return, km, is 14%; the risk free rate, rf, is 7%; and the current dividend, Do, is \$0.50. Should HDTV go into the dual-VCR field?
Solution:
kold = .07 +1.2(.14-.07) = .154
knew = .07 +1.6(.07) = .182
Po = .50(1.12)/(.154 - .12) = \$16.47
Pn = .50(1.16)/(.182 - .16) = \$26.36
The decision by the Municipal Transportation Authority to either refurbish existing buses, to buy new large
buses, or to supplement the existing fleet with mini-buses is an example of:
mutually exclusive projects
If a firm sells an asset for less than its book value,
the loss may be used to offset operating income
In terms of the capital budgeting process, net cash flows are
incremental changes in a firm's cash flow.
The capital budgeting process is very important to the firm because it:
essentially plots the company's future direction
The set of investment projects arranged in descending order according to their expected rates of return is
known as the ____.
simplified capital budgeting model
Capital expenditure projects may be classified in all the following types except:
capital rationing
What is the net investment for an extruder that costs \$42,000, if shipping costs are \$1,500 and installation is
\$4,800? Assume this efficient machine is replacing an older extruder with a book and market value of zero.
The replacement investment will reduce operating costs by \$6,600 a year.
Solution:
NINV=\$42,000+\$1,500+\$4,800=\$48,300\$48,300
Capital Foods purchased an oven 5 years ago for \$45,000. The oven is being depreciated over its estimated
10-year life using the straight line method to a salvage value of \$5,000. Capital is planning to replace the oven
with a more automated one that will cost \$150,000 installed. If the old oven can be sold for \$30,000, what is
the tax liability? Assume a marginal tax rate of 40 percent
Solution:
Book Value=\$45,000-5(\$45,000-\$5,000)/10=\$25,000
Tax liability=(\$30,000-\$25,000)(0.4)=\$2,000\$2,000
Outback is purchasing a new machine that will cost \$98,000. The machine will qualify as MACRS 5-year
property but has an economic life of 8 years. The new machine is expected to increase revenues by \$35,000
per year and operating costs are expected to increase by \$15,000 per year. If the firm's marginal tax rate is 34
percent and the first year's depreciation rate is 20 percent, what is the net cash flow in the first year.
Solution:
NCF = (\$35,000 - \$15,000 - \$19,600)(1 - 0.34) + \$19,600 = \$19, 864
\$19,864
Allen Company is considering an investment project that is expected to generate \$100,000 in annual earnings
before taxes. Annual depreciation will be \$50,000. Allen's marginal tax rate is 40%. Determine the project's
annual net cash flows.
Solution:
NCF = ΔEBT (1 - T) + ΔDep
= \$100,000 (1 - 0.40) + \$50,000 = \$110,000
Ripstart is replacing an old, fully depreciated stamping line with a more efficient machine that will cost
\$245,000. The line will be depreciated as a 7-year MACRS asset. With the increased production, Ripstart
expects revenues to increase by \$55,000, and operating expenses to increase by \$20,000. If Ripstart expects to
sell the new machine at the end of year 5 for \$40,000, compute the net cash flow in the fifth year. The
MACRS depreciation rate during the fifth year is 8.93% and the accumulated MACRS depreciation after five
years totals 77.69 percent of the cost of the asset. Assume the firm's marginal tax rate is 40 percent and that
company does get to take the full benefit of year 5 depreciation.
Solution:
Dep5 = 245,000(0.0893) = 21,878.50
Book value at the end of year 5 = \$245,000 - \$245,000 (0.7769) = \$54,659.50
NCF5 = (\$55,000 - \$20,000 - \$21,878.50)(1 - 0.4) + \$21,878.50 +\$40,000
+ (\$54,659.50 - \$40,000)0.4 = \$7,872.90 + \$61,878.50 + \$5,863.80 = \$75,615.20
Anderson Clayton will purchase a new pellet mill that replace an older, less efficient, mill. The new mill costs
\$360,000 and shipping costs are \$10,000. Improving the steam lines to the new mill will cost an additional
\$22,000. The old mill has a book value of \$25,000 and can be sold for \$12,000. The installation of the new
mill will cause inventories to increase by \$8,000, accounts receivable will go up \$20,000, and accounts
payable will increase \$10,000. If Anderson Clayton has a marginal tax rate of 40%, what is the NINV for the
new mill?
Solution:
Installed cost \$392,000
Less: salvage - 12,000
Less: tax savings on sale - 5,200
\$392,800
A Lotta Bread Corp. is replacing an entire baking line that was purchased for \$420,000 and currently has a
book value of \$60,000. The new, more efficient line, will cost \$940,000 installed and can be depreciated as a
7-year MACRS asset. With the increased efficiency, Lotta expects annual revenues to increase by \$425,000,
and operating expenses to increase by \$170,000. The older machine, which was being depreciated at the
straight-line rate of \$20,000/year, will be sold for \$30,000. What are the net cash flows for year 2? Assume
the firm's marginal tax rate is 40% and that the year 2 depreciation rate is 24.49%.
Solution:
Year 2 depreciation = \$940,000(0.2449) = \$230,206
Change Dep (Yr. 2) = \$230,206 - \$20,000 = \$210,206
NCF2 = (\$425,000 - \$170,000 - \$210,206)(0.6) + \$210,206
= \$237,082
Com-Cat is considering expanding their current production facility. This year Com-Cat had an operating
income (EBIT) of \$760,000, interest expenses of \$120,000, depreciation expenses of \$45,000, and capital
expenditures of \$160,000. Next year, after the expansion is completed, operating income is expected to be
\$880,000, interest expenses will remain at \$120,000, but depreciation will increase to \$61,000. To support the
expansion, cash is to expected to increase by \$5,000, accounts receivable by \$12,000, inventories by \$8,000,
and accounts payable by \$7,000. What is the change in Com-Cat's net operating cash flows attributable to this
project, if the tax rate is 40%?
Solution:
NCF = (\$880,000 - \$760,000)(1 - 0.40) + (\$61,000 - \$45,000)
- (\$5,000 + \$12,000 + \$8,000 - \$7,000) = \$70,000
A contractor has a team of plumbers and assigns those plumbers to a new construction site. The fact that the
plumbers are unavailable for any other job makes the construction site project a/a
mutually exclusive project
The payback method is at best a crude measure of the risk of a project because it fails to consider the ____ of
a project's returns.
variability
The disadvantages of the payback approach include:
cash flows after the payback period are ignored in the calculation

payback ignores the time value of money

payback fails to provide an objective decision-making criterion
Which of the following is not a technique to handle the capital rationing problem?
ranking projects according to payback
If the net present value of an investment project is positive then the:
project's rate of return is greater than the firm's cost of capital
When dealing with ____ cash flows, the ____ is computed by trial and error.
uneven; internal rate of return
The ____ of an investment is the period of time for the ____ to equal the initial cash outlay.
payback period; cumulative cash inflows
The ____ approach takes into account both the magnitude and timing of cash flows over the entire life of a
project in measuring its economic desirability.
internal rate of return
An investment project requires a net investment of \$100,000. The project is expected to generate annual net
cash inflows of \$28,000 for the next 5 years. The firm's cost of capital is 12 percent. Determine the net
present value for the project.
Solution:
NPV = 28,000(PVIF0.12,5) - 100,000 = \$28,000(3.605) - 100,000 = \$940
Using the profitability index, which of the following mutually exclusive projects should be accepted?
Project A: NPV = \$6,000; NINV = \$50,000
Project B: NPV = \$10,000; NINV = \$120,000
Project C: NPV = \$8,000; NINV = \$80,000
Solution:
PIA = \$56/\$50 = 1.12
PIB = \$130/\$120 = 1.08
PIC = \$88/\$80 = 1.1
Therefore, choose project A
GoFlo is a small growing firm that is considering the purchase of another truck to serve GoFlo's expanding
customer base. The new truck will cost \$21,000 and should generate annual net cash flows of \$6,000 over the
truck's 5-year life. What is the payback period for this project?
Solution:
PB = \$21,000/\$6,000 = 3.5 years
ZPS Models is considering a project that has a NINV of \$564,000 and generates net cash flows of \$105,000
per year for 10 years. What is the NPV of this project if ZPS has a cost of capital of 12.45%?
Solution:
NPV = -\$564,000 + \$582,503 = \$18,503 (by calculator)
What is the internal rate of return for a project that has a net investment of \$169,165 and net cash flows of
\$25,000 in the first year and 40,000 in years 2-7?
Solution:
IRR = 12% (calculator)
Indexx, a maker of disease-detection systems based on biotechnology is considering purchasing some
diagnostic equipment that costs \$380,000. Shipping and installation costs will be an additional \$30,000. The
equipment will be depreciated based on a 3-year MACRS life. Revenues from the new equipment should be
\$400,000 the first year and increase 15% each year over the expected 5-year economic life. Operating
expenses should be \$250,000 the first year and these expenses will increase 10% each year. At the end of 5
years the equipment will be obsolete and have no salvage value. Should Indexx invest in this new equipment?
Assume Indexx has a cost of capital of 15% and a marginal tax rate of 40%. Use the depreciation schedule
listed below:
(3 Year Depreciation Schedule: 33.33%, 44.45%, 14.81%, 7.41%)
Solution:
NCF1 = (400,000 - 250,000 - 136,653)(.6) + 136,653 = \$144,661
NCF2 = (460,000 - 275,000 - 182,245)(.6) + 182,245 = \$183,898
NCF3 = (529,000 - 302,500 - 60, 721)(.6) + 60,721 = \$160,188
NCF4 = (608,350 - 332,750 - 30, 381)(.6) + 30,381 = \$177,512
NCF5 = (699,603 - 366,025)(.6) = \$200,147
NPV = -\$410,000 + \$144,661(0.870) + \$183,898(0.756)
+ \$160,188(0.658) + \$177,512(0.572) + \$200,147(0.497)
= \$161,296
G-III Apparel is considering increasing the size of a warehouse. The cost of the expansion is \$825,000 and the
increase in inventories and accounts payable will be \$410,000 and \$360,000 respectively. G-III expects that
the expansion will increase net cash flows by \$150,000 a year for the next 5 years and \$200,000 a year for
years 6-12. G-III has a 14% cost of capital and a marginal tax rate of 35%. What is the NPV of the warehouse
expansion?
Solution:
NPV = -\$825,000 - \$410,000 + \$360,000 + \$150,000(3.433) + \$200,000(5.216 - 3.433) +
\$50,000(0.270)
= \$10,050
What is the net present value of the following project if the required rate of return is 15%? The initial
investment is \$150,000
Years Cash Flows
1 \$30,000
2 \$80,000
3 \$100,000
4 \$200,000
\$116,681
Should the following project be accepted if the cost of capital is 12%?
Initial Investment is \$50,000
Years Cash Flows
1 \$25,000
2 \$35,000
3 \$55,000
Yes, because the internal rate of return is 48% which is more than 12%.
Creative Furniture is considering two mutually exclusive projects that would automate part of their production
facilities. Project A costs \$120,000 and would produce net cash flows of \$37,000 annually for 5 years. Project
B also costs \$120,000 and will produce annual net cash flows of \$25,000 for 10 years. Creative's cost of
capital is 11 percent.

Using a replacement chain, which project should be chosen? Assume that in 5 years, Project A will still cost
\$120,000 and produce 5 more years of \$37,000 annual net cash flows.
Project B. NPV is \$492 higher

Solution:
NPVB = -\$120,000 + \$25,000(5.889) = \$27,225
NPVA = -\$120,000 - \$120,000(.593) + \$37,000(5.889) = \$26,733
NPVB - NPVA = \$492
Dorati Inc. is considering two mutually exclusive projects. Dorati used a 15% required rate of return to
evaluate capital expenditure projects. If the two projects have the costs and cash flows shown below, using a
replacement chain determine the NPV for each.
Year Project S Project T
0 -\$70,000 -\$100,000
1 \$50,000 \$ 60,000
2 \$60,000 \$ 70,000
3 \$ 80,000
4 \$ 90,000
Assume in two years Project S will still cost \$70,000 and produce the same two years of cash flows.
Solution:
NPVT = -100,000 + 60,000(.870) + 70,000(.756) + 80,000(.658)
+ 90,000(.572) = \$109,240
NPVs = -70,000 - 70,000(.658) + 50,000(.870) + 60,000(.756)
+ 50,000(.658) + 60,000(.572) = 40,000
Toy Manufacturers (TM) is considering two mutually exclusive machines to use in its manufacturing process.
The net cash flows for each are given below:
Year Axa Beta
0 -\$90,000 -\$105,000
1 45,000 35,000
2 45,000 35,000
3 45,000 35,000
4 35,000
5 35,000
If the cost of capital for TM is 13%, which machine should they purchase?
Solution:
NPVA = \$-90,000 + \$45,000(2.361) = \$16,245
NPVB = \$-105,000 + \$35,000(3.517) = \$18,095
EAAA = \$16,245/2.361 = \$6,881
EAAB = \$18,095/3.517 = \$5,145
NPVA = \$6,881/0.13 = \$52,931
NPVB = \$5,145/0.13 = \$39,577
Marvec needs to replace an extruder and two replacements look good. Extruder A costs \$102,000 and has a
10 year life. Extruder B costs only \$56,000 but its expected life is 6 years. Extruder A will generate net cash
flows of \$17,600 per year for 10 years and B will generate net cash flows of \$13,800 per year for 6 years. If
Marvec's cost of capital is 11%, which extruder should be chosen and what is its NPV? Use equivalent annual
annuities.
Solution:
NPVA = \$-102,000 + \$17,600(5.889) = \$1,646
NPVB = \$-56,000 + \$13,800(4.231) = \$2,388
EAAA = \$1,646/5.889 = \$279.50
EAAB = \$2,388/4.231 = \$564.41
NPVA = \$279.50/0.11 = \$2,541
NPVB = \$564.41/0.11 = \$5,131
The discount rate used in calculating the certainty equivalent net present value is the
risk-free rate
Simulation techniques are
mostly beneficial for large projects
Total project risk is
the chance that a project will perform different from expectations
Which of the following techniques can be used to analyze total project risk?
net present value/payback approach

simulation analysis
The net present value/payback approach is a useful approach when
screening projects characterized by rapid technological advances
Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive
the ____ is to changes in a particular variable.
net present value
The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is
the
simulation approach
The certainty equivalent factors used in capital budgeting analysis are equal to the ____ divided by ____.
certain return; risky return
The ____ of a firm is a weighted average of the ____ of the individual assets in the firm.
systematic risk; systematic risk
SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and
proportions of the firm's total assets:
Division Beta % of Assets
Electric & Gas 0.85 60
Bus transportation 0.95 10
Real estate 1.40 25
Recreation 1.15 5

The risk-free rate is 8 percent and the market risk premium is 5 percent. If SCAN is considering a residential
development, what should the firm use as its cost of equity in evaluating this project?
Solution:
ke = 0.08 + 1.40(0.05) = 0.15 or 15%
The Chris-Kraft Co. is financed entirely with equity and the firm has a beta of 1.6. The current risk-free rate is
9.5 percent and the expected market return is 16 percent. What rate of return should Chris-Kraft require on a
project of average risk?
Solution:
ke = 0.095 + 1.6(0.16 - 0.095) = 0.199 or 19.9%
IKON is financed entirely with equity and its beta is 1.31. If the current risk-free rate is 6.25% and the
expected market return is 12.8%, what is IKON's required rate of return on a project of average risk?
Solution:
ke = 6.25 + 1.31(12.8 - 6.25) = 14.83%
The Chris-Kraft Co. is financed entirely with equity and the firm has a beta of 1.25. The current risk-free rate
is 7 percent and the expected market return is 15 percent. Chris-Kraft is considering an investment project
with a risk that matches the firm's average risk, requires a net investment of \$70,000, and has net cash flows
of \$18,000 per year for 8 years. Should Chris-Kraft invest in the project?
Solution:
ke = 0.07 + 1.25(0.15 - 0.07) = 0.17
NPV = \$18,000(4.207) - \$70,000 = \$5,726
M-tel is financed entirely with equity and the firm's stock has a beta of 0.85. M-tel is considering investing in
a project that is expected to have a beta of 1.3. The project requires an initial outlay of \$6 million and is
expected to generate after-tax net cash flows of \$1.3 million each year for 8 years. Calculate the NPV of the
project. Assume the risk-free rate is 7% and the expected market return is 14%. (Note: Problem requires either
calculator use or interpolation from the tables. The suggested solutions use calculator accuracy.)
Solution:
ke = 7% + 1.3(14% - 7%) = 16.1%
NPV = -\$371,484 (calculator accuracy)
The certainty equivalent approach is a risk evaluation technique. Which of the following statements is/are
correct?
I. Certainty equivalents adjust the cash flows in the numerator of the NPV equation.
II. Using the RADR involves adjustments to the denominator of the NPV equation.
Both I and II