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Finance Chapter 8
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Most corporations measure the value of a project in terms of which of the following?
present value (PV)
The present value (PV) of an investment is ________.
the amount that an investment would yield if the benefit were realized today
Tanner is choosing between two investment options. He can invest $500 now and get (guaranteed) $550 in one year, or invest $500 now and get (guaranteed) $531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer?
Tanner should be indifferent between the two investments, since both are equivalent to the
same amount of cash today.
A firm has an opportunity to invest $95,000 today that will yield $109,250 in one year. If interest rates are 4%, what is the net present value (NPV) of this investment?
$10,048
A car dealership offers a car for $14,000 , with up to one year to pay for the car. If the interest rate is 5%, what is the net present value (NPV) of this offer to buyers who elect not to pay for the car for one year?
$667
Martin is offered an investment where for $6000 today, he will receive $6180 in one year. He decides to borrow $6000 from the bank to make this investment. What is the maximum interest rate the bank needs to offer on the loan if Martin is at least to break even on this investment?
3%
A security firm is offered $80,000 in one year for providing CCTV coverage of a property. The cost of providing this coverage to the security firm is $74,000, payable now, and the interest rate is 8.5%. Should the firm take the contract?
No, since net present value (NPV) is negative.
A farmer sows a certain crop. It costs $240,000 to buy the seed, prepare the ground, and sow the crop. In one yearʹs time it will cost $93,200 to harvest the crop. If the crop will be worth $350,000 , and the interest rate is 7%, what is the net present value (NPV) of this investment?
$0
A delivery service is buying 600 tires for its fleet of vehicles. One supplier offers to supply the tires for $80 per tire, payable in one year. Another supplier will supply the tires for $20,000 down today, then $45 per tire, payable in one year. What is the difference in PV between the first and the second offer, assuming interest rates are 8.1%?
-$574
Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices?
Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan.
An auto-parts company is deciding whether to sponsor a racing team for a cost of $1 million. The sponsorship would last for three years and is expected to increase cash flows by $570,000 per year. If the discount rate is 6.9%, what will be the change in the value of the company if it chooses to go ahead with the sponsorship?
$498,597
An orcharder spends $110,000 to plant pomegranate bushes. It will take four years for the bushes to provide a usable crop. He estimates that every year for 20 years after that he will receive a crop worth $10,500 per year. If the discount rate is 9%, what is the net present value (NPV) of this investment?
-$42,098
The owners of a chain of fast-food restaurants spend $25 million installing donut makers in all their restaurants. This is expected to increase cash flows by $11 million per year for the next five years. If the discount rate is 5.3%, were the owners correct in making the decision to install donut makers?
Yes, as it has a net present value (NPV) of $22.23 million.
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. At what discount rate does her decision to renovate become untenable?
3.3%
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. If her discount rate is 6%, should she accept the project?
No, because the NPV is negative at that rate.
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value (NPV) as a function of the discount rate. At what dollar value should the NPV profile cross the vertical axis?
The vertical axis crossing point cannot be calculated since the cash inflows are in
perpetuity.
A manufacturer of video games develops a new game over two years. This costs $830,000 per year with one payment made immediately and the other at the end of two years. When the game is released, it is expected to make $1.20 million per year for three years after that. What is the net present value (NPV) of this decision if the cost of capital is 10%?
$950,349
Which of the following statements is FALSE?
If the cost of capital estimate is more than the internal rate of return (IRR), the net present
value (NPV) will be positive.
Consider a project with the following cash flows:
If
closest to ________.
the appropriate discount rate for this project is 13%, then the net present value (NPV) is
-$3077
Given the cash flows in the table above, the point at which the NPV profile crosses the vertical axis is ________.
$0
The net present value (NPV) of project A is closest to ________.
20.5
The net present value (NPV) of project B is closest to ________.
9.3
The net present value (NPV) for this project is closest to ________.
$206,265
The net present value (NPV) for project alpha is closest to ________.
$25.08
The net present value (NPV) for project beta is closest to ________.
$18.06
Which of the following situations can lead to IRR giving a different decision than NPV?
All of the above can lead to IRR giving a different decision than NPV.
According to Graham and Harveyʹs 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________.
IRR, NPV, Payback period
Which of the following is NOT a limitation of the payback rule?
It is difficult to calculate.
A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?
No, since the value of the cash flows over the first two years are less than the initial
investment.
If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?
Project A
If WiseGuy Inc. uses IRR rule to choose projects, which of the projects (Project A or Project B) will rank highest?
Project B
A florist is buying a number of motorcycles to expand its delivery service. These will cost $78,000 but are expected to increase profits by $3000 per month over the next four years. What is the payback period in this case?
26.00 months
The cash flows for three projects are shown above. The cost of capital is 9.5%. If an investor decided to take projects with a payback period two years or less, which of these projects would he take?
none of these investments
A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct?
Yes, because it agrees with the Net Present Value rule.
Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%?
Rule I: The Net Present Value rule
Rule II: The Payback Rule with a payback period of two years Rule III: The internal rate of return (IRR) Rule
Rule I only
A local government awards a landscaping company a contract worth $1.5 million per year for five years for maintaining public parks. The landscaping company will need to buy some new machinery before they can take on the contract. If the cost of capital is 6%, what is the most that this equipment could cost if the contract is to be worthwhile for the landscaping company?
$6.32 million
A mining company plans to mine a beach for rutile. To do so will cost $14 million up front and then produce cash flows of $7 million per year for five years. At the end of the sixth year the company will incur shut-down and clean-up costs of $6 million. If the cost of capital is 13.0%, then what is the MIRR for this project?
-87.10%
An investor is considering a project that will generate $900,000 per year for four years. In addition to upfront costs, at the completion of the project at the end of the fifth year there will be shut-down costs of $400,000 . If the cost of capital is 4.4%, based on the MIRR, at what upfront costs does this project cease to be worthwhile?
$2.91 million
Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?
Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the projectʹs lifetime.
Which of the following statements is FALSE?
An internal rate of return (IRR) will always exist for an investment opportunity.
Which of the following statements is false?
The payback rule is reliable because it considers the time value of money and depends on
the cost of capital.
Assume the appropriate discount rate for this project is 13%. The payback period for this project is closest to ________.
2.40 years
The payback period for project A is closest to ________.
2.1 years
The payback period for project B is closest to ________.
2.9 years
The appropriate discount rate for this project is 15%. The internal rate of return (IRR) for this project is closest to ________.
21%
The cash flows for four projects are shown below, along with the cost of capital for these projects. If these projects are mutually exclusive, which one should be taken?
Year: 0 1 2 3 4 5 Cashflow: -$12,000 $4000 $4000 $4000 $4000 $4000 Cost of Capital: 5.0%
An investor has the opportunity to invest in four new retail stores. The amount that can be invested in each store, along with the expected cash flow at the end of the first year, the growth rate of the concern, and the cost of capital is shown for each case. It is assumed each investment will operate in perpetuity after the initial investment. Which investment should the investor choose?
Initial investment: $60,000; Cash flow in year 1: $6,000; Growth Rate: 2.50%; Cost of Capital: 7.2%
The following show four mutually exclusive investments. Which one is the best investment?
Initial investment: $1.3 million; Cash flow in year 1: $160,000; Annual Growth Rate: 1%;
Cost of Capital: 5.6%
Based on the above information, and with an interest rate of 7%, which is the best investment?
Investment B
Two mutually exclusive investment opportunities require an initial investment of $7 million. Investment A pays $2.0 million per year in perpetuity, while investment B pays $1.4 million in the first year, with cash flows increasing by 4% per year after that. At what cost of capital would an investor regard both opportunities as being equivalent?
13%
A company has identified the following investments as looking promising. Each requires an initial investment of $1.2 million. Which is the best investment?
a perpetuity that generates a cash flow at the end of year 1 of $800,000, has a growth rate of 2.25%, and a cost of capital of 11.8%
An investor is considering the two investments shown above. Her cost of capital is 8%. Which of the following statements about these investments is true?
The investor should take investment B since it has a greater net present value (NPV).
An investor is considering the two investments shown above. Which of the following statements about these investments is true?
Neither investment should be taken since they both have a negative net present value
(NPV).
You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is ________.
net present value (NPV)
Assume that projects A and B are mutually exclusive. The correct investment decision and the best rationale for that decision is to ________.
invest in project A, since NPVB < NPVA
Assume that projects Alpha and Beta are mutually exclusive. The correct investment decision and the best rationale for that decision is to ________.
invest in project Beta, since NPVBeta > NPVAlpha > 0
When comparing two projects with different lives, why do you compute an annuity with an equivalent present value (PV) to the net present value (NPV)?
so that the projects can be compared on their cost or value created per year
A janitorial services firm is considering two brands of industrial vacuum cleaners to equip their staff. Option A will cost $1,500, require servicing of $200 per year, and it will last five years. Option B will cost $1,000, require servicing of $100 per year, and it will last three years. If the cost of capital is 8%, which is the better option, given that the firm has an ongoing requirement for vacuum cleaners?
Option B, since it has a greater equivalent annual annuity.
A garage is comparing the cost of buying two different car hoists. Hoist A will cost $20,000, will require servicing of $1000 every two years, and last ten years. Hoist B will cost $15,000, require servicing of $800 per year, and last eight years. If the cost of capital is 7%, which is the better option, given that the firm has an ongoing requirement for a hoist?
Hoist B, since it has a greater equivalent annual annuity.
A security company offers to provide CCTV coverage for a parking garage for ten years for an initial payment of $50,000 and additional payments of $30,000 per year. What is the equivalent annual annuity of this deal, given a cost of capital of 5%?
-$36,475
A company buys a color printer that will cost $16,000 to buy, and last 5 years. It is assumed that it will require servicing costing $500 each year. What is the equivalent annual annuity of this deal, given a cost of capital of 8%?
-$4507
A lawn maintenance company compares two ride-on mowersthe Excelsior, which has an expected working-life of six years, and the Grassassinator, which has a working life of four years. After examining the equivalent annual annuities of each mower, the company decides to purchase the Excelsior. Which of the following, if true, would be most likely to make them change that decision?
The mower is only expected to be needed for three years.
Jenkins Security has learned that a rival has offered to supply a parking garage with security for ten years for $45,000 up front and a further $15,000 per year. If Jenkins Security offers to provide security for eight years for an upfront cost of $60,000 and a separate yearly payment, by what maximum amount can this yearly payment be over $20,000, so that Jenkinsʹ offer matches the equivalent annual annuity of their rivalʹs offer? (Assume a cost of capital of 5%.)
-$111
A consultancy calculates that it can supply crude oil assaying services to a small oil producer for $115,000 per year for five years. There are some upfront costs the consultancy will require the oil producer to absorb. What is the maximum that these upfront costs could be, if the equivalent annual annuity to the oil company is to be under $160,000 , given that the cost of capital is 9%?
$175,034
The timeline of an investment is shown above. If the cost of capital is 8%, what is the profitability index of this investment?
0.110
The owner of a number of gas stations is considering installing coffee machines in his gas stations. It will cost $270,000 to install the coffee machines, and they are expected to boost cash flows by $120,536 per year for their five-year working life. What must the cost of capital be if this investment has a profitability index of 1?
3.78%
A company that creates education products is planning to create a suite of books to help customers prepare for high-stakes tests for entry into college and grad school. They have 33 in-house writers to create these books. Due to the expertise needed in creating this content it will not be possible to hire temporary writers within the planned time-frame. Which projects should be undertaken?
Prep for the Grad School Entry Test, Prep for the Law School Entry Test, and Prep for the Medical School Entry Test
A print shop has contracted to print a number of jobs within 24 hours. Any jobs not completely printed within this time will result in a penalty, as shown in the table above. However too many jobs have been accepted, and not all can be printed. Which jobs should be printed in the next 24 hours?
JobC,JobB,andJobE
A small department store in a mall has the opportunity to rent an additional 20,000 square feet of space for five years. It can divide up this space between the above new departments. Each department will require a different amount of space, and each department is expected to make a yearly profit as shown, for each of the next five years. The discount rate is 10%. Based on this information, what departments should be added?
Fabrics, Luggage, Hardware, Watches, and Shoe Repair
A company has four projects it wishes to undertake. Which of these investments should be the lowest priority, given a discount rate of 5%?
Project II
You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space?
profitability index
Assume the appropriate discount rate for this project is 14%. The profitability index for this project is closest to ________.
0.17
The profitability index for project A is closest to ________.
0.16
The profitability index for project B is closest to ________.
0.15
Assuming that your capital is constrained, which investment tool should you use to determine the correct investment decisions?
profitability Index
Assuming that your capital is constrained, which project should you invest in first?
Project C
Assuming that your capital is constrained, what is the fifth project that you should invest in?
Project A
Assuming that your capital is constrained, which project should you invest in last?
Project C
Assuming that your capital is constrained, so that you only have $600,000 available to invest in projects, which project should you invest in and in what order?
CBFH
Assume that your capital is constrained, so that you only have $600,000 available to invest in projects. If you invest in the optimal combination of projects given your capital constraint, then the total net present value (NPV) for all the projects you invest in will be closest to ________.
$80,000
Assume that your capital is constrained, so that you only have $500,000 available to invest in projects. If you invest in the optimal combination of projects given your capital constraint, then the total net present value (NPV) for all the projects you invest in will be closest to ________.
$69,000
Which of the following best describes the Net Present Value rule?
Take any investment opportunity where the net present value (NPV) is not negative; turn
down any opportunity when it is negative.
Which of the following is a disadvantage of the Net Present Value rule?
relies on accurate estimate of the discount rate
Which of the following decision rules is best defined as the amount of time it takes to pay back the initial investment?
payback period
Which of the following decision rules might best be used as a supplement to net present value (NPV) by a firm that favors liquidity?
payback period
Which of the following is NOT a limitation of the payback period rule?
It is difficult to calculate
Which of the following is true regarding the profitability index?
Attention must be taken when using it to make sure that all of the constrained resource is
utilized.
A firm is considering several mutually exclusive investment opportunities. The best way to choose between them is which of the following?
net present value (NPV)
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