Practice Exam III

1
Practice Exam III

• Fin. 429
• Dr. Bruce A. Costa
• Fall 2003

2
Chapter 11 Capital Budgeting Decision Criteria
3

• The modified IRR method
• Always leads to the same decision as NPV for
  independent projects.
• Overcomes the problem of multiple rates of
  return.
• Compounds cash flows at the cost of capital.
• Overcomes the problem of cash flow timing but not
  the problem of project size that leads to
  criticism of the regular IRR method.
• All of the above statements are true.

4
Exam 3

• All of the above statements are true.

5

• Which of the following statements is most
  correct?
• The MIRR method will always arrive at the same
  conclusion as the NPV method.
• The MIRR method can overcome the multiple IRR
  problem, while the NPV method cannot.
• The MIRR method uses a more reasonable assumption
  about reinvestment rates than the IRR method.
• Statements a and c are correct.
• All of the above statements are correct.

6
Exam 3

• The MIRR method uses a more reasonable assumption
  about reinvestment rates than the IRR method.

7

• Which of the following is most correct?
• There can never be a conflict between NPV and IRR
  decisions if the decision is related to a normal,
  independent project, i.e., NPV will never
  indicate acceptance if IRR indicates rejection.
• To find the MIRR, we first compound CFs at the
  regular IRR to find the TV, and then we discount
  the TV at the cost of capital to find the PV.
• The NPV and IRR methods both assume that cash
  flows are reinvested at the cost of capital.
  However, the MIRR method assumes reinvestment at
  the MIRR itself.
• If you are choosing between two projects which
  have the same cost, and if their NPV profiles
  cross, then the project with the higher IRR
  probably has more of its cash flows coming in the
  later years.
• A change in the cost of capital would normally
  change both a projects NPV and its IRR.

8
Exam 3

• There can never be a conflict between NPV and IRR
  decisions if the decision is related to a normal,
  independent project, i.e., NPV will never
  indicate acceptance if IRR indicates rejection.

9

• Michigan Mattress Company is considering the
  purchase of land and the construction of a new
  plant. The land, which would be bought
  immediately (at t 0), has a cost of 100,000
  and the building, which would be erected at the
  end of the first year (t 1), would cost
  500,000. It is estimated that the firms
  after-tax cash flow will be increased by 100,000
  beginning at the end of the second year, and that
  this incremental flow would increase at a 10
  percent rate annually over the next 10 years.
  What would be the payback period (approx.)?
• 2 years
• 4 years
• 6 years
• 8 years
• 10 years

10
Exam 3

• 6 years

t 0 1 2 3
4 5 6 7
-100 -500 100 110
121 133.10 146.41 161.05
Cumulative Cash Flow
-600 -500 -390 -269
-135.90 10.51
Payback 5 135.90 / 146.41 5.928 6
Years
11

• As the capital budgeting director for Chapel Hill
  Coffins, Inc., you are evaluating construction of
  a new plant. The plant has a net cost of 5
  million in Year 0, and it will provide net cash
  inflows of 1 million in Year 1, 1.5 million in
  Year 2, and 2 million in Years 3 through 5. As
  a first approximation, you may assume that all
  cash flows occur at year-end. Within what range
  is the plants IRR?
• 14-15
• 15-16
• 16-17
• 17-18
• 18-19

12
Exam 3

• 18-19

T0 1 2 3
4 5
-5m 1m 1.5m 2m 2m 2m
CF0 -5 CF1 1 CF2 1.5 CF3
2 CF4 2 CF5 2
P/Yr. 1
IRR/Yr. 18.37
13

• Davis Corporation is faced with two independent
  investment opportunities. The corporation has an
  investment policy which requires acceptable
  projects to recover all costs within 3 years.
  The corporation uses the discounted payback
  method to assess potential projects and utilizes
  a discount rate of 10 percent. The cash flows
  for the two projects are

Which investment project(s) does the company
invest in?
14
6. cont.
Which investment project(s) does the company
invest in?

• Project A only.
• Neither Project A nor Project B.
• Project A and Project B.
• Project B only.

15
Exam 3

• Project B only.

Project B
Project A
t0 1 2 3
t0 1 2 3
-80 50 20 20
-100 40 40 40
36.36 33.05 30.05 99.46
45.45 16.53 22.54 84.52
Project A doesnt pay
Project B pays back in 3 Yrs.
16

• Chapter 12
• Capital Budgeting
• Estimating Cash Flow And Analyzing Risk

17

• When evaluating a new project, the firm should
  consider all of the following factors except
• Changes in working capital attributable to the
  project.
• Previous expenditures associated with a market
  test to determine the feasibility of the project,
  if the expenditures have been expensed for tax
  purposes.
• The current market value of any equipment to be
  replaced.
• The resulting difference in depreciation expense
  if the project involves replacement.
• All of the statements above should be considered.

18
Exam 3

• Previous expenditures associated with a market
  test to determine the feasibility of the project,
  if the expenditures have been expensed for tax
  purposes.

19

• Which of the following is not a cash flow that
  results from the decision to accept a project?
• Changes in working capital.
• Shipping and installation costs.
• Sunk costs.
• Opportunity costs.
• Externalities.

20
Exam 3

• Sunk costs.

21

• Project X has an up-front cost of 1 million,
  whereas Project Y has an up-front cost of only
  200,000. Both projects last five years and
  provide positive cash flows in Years 1-5.
  Project X is riskier its risk-adjusted WACC is
  12 percent. Project Y is safer its risk-adjusted
  WACC is 8 percent. After discounting each of the
  projects cash flows at the projects
  risk-adjusted WACC, you find that Project X has a
  NPV of 20,000, and Project Y has a NPV of
  15,000. The projects are mutually exclusive and
  cannot be repeated. The firm is not capital
  constrained it can raise as much capital as it
  needs, provided it has profitable projects in
  which to invest. Given this information, which
  of the following statements is most correct?
• The firm should select Project Y because it has a
  higher return (15,000/200,000) is greater than
  (20,000/1,000,000).
• The firm should select Project X because it has a
  higher NPV.
• The firm should select Project Y because it is
  less risky.
• The firm should reject both projects because
  their IRRs are less than the risk-adjusted WACC.
• Statements a and c are correct.

22
Exam 3

• The firm should select Project X because it has a
  higher NPV.

23

• Pickles Corp. is a company which sells bottled
  iced tea. The company is thinking about
  expanding its operations into the bottled
  lemonade business. Which of the following
  factors should the company incorporate into its
  capital budgeting decision as it decides whether
  or not to enter the lemonade business?
• If the company enters the lemonade business, its
  iced tea sales are expected to fall 5 percent as
  some consumers switch from iced tea to lemonade.
• Two years ago the company spent 3 million to
  renovate a building for a proposed project which
  was never undertaken. If the project is adopted,
  the plan is to have the lemonade produced in this
  building.
• If the company doesnt produce lemonade, it can
  lease the building to another company and receive
  after-tax cash flows of 500,000 a year.
• All of the statements above are correct.
• Answers a and c are correct.

24
Exam 3

• Answers a and c are correct.

25

• Which of the following statements is correct?
• In a capital budgeting analysis where part of the
  funds used to finance the project are raised as
  debt, failure to include interest expense as a
  cost in the cash flow statement when determining
  the project's cash flows will lead to an upward
  bias in the NPV.
• The preceding statement would be true if "upward"
  were replaced with "downward.
• The existence of "externalities" reduces the NPV
  to a level below the value that would exist in
  the absence of externalities.
• If one of the assets that would be used by a
  potential project is already owned by the firm,
  and if that asset could be leased to another firm
  if the project is not undertaken, then the net
  rent that could be obtained should be charged as
  a cost to the project under consideration.
• The rent referred to in statement d is a sunk
  cost, and as such it should be ignored.

26
Exam 3

• If one of the assets that would be used by a
  potential project is already owned by the firm,
  and if that asset could be leased to another firm
  if the project is not undertaken, then the net
  rent that could be obtained should be charged as
  a cost to the project under consideration.

27

• Virus Stopper Inc., a supplier of computer
  safeguard systems, uses a cost of capital of 12
  percent to evaluate average-risk projects, and it
  adds or subtracts 2 percentage points to evaluate
  projects of more or less risk. Currently, two
  mutually exclusive projects are under
  consideration. Both have a cost of 200,000 and
  will last 4 years. Project A, a
  riskier-than-average project, will produce annual
  end of year cash flows of 71,104. Project B, of
  less than average risk, will produce cash flows
  of 146,411 at the end of Years 3 and 4 only.
  Virus Stopper should accept
• B with a NPV of 10,001.
• Both A and B because both have NPVs greater than
  zero.
• B with a NPV of 8,042.
• A with a NPV of 7,177.
• A with a NPV of 15,968.

28
Exam 3

• B with a NPV of 10,001.

Project A
0 1 2 3 4
-200,000 71,104 71,104 71,104 71,104
CF0 -200,000 CF1-4 71,104 NPVA
7,176.60 I/Yr 12 2 14
29
Exam 3

• 12. cont.

Project B
0 1 2 3 4

-200,000 0 0 146,411
146,411
CF0 -200,000 CF1-2 0 CF3-4 146,411 I/Yr
12 2 10
NPVB 10,001.43
30

• Tech Engineering Company is considering the
  purchase of a new machine to replace an existing
  one. The old machine was purchased 5 years ago
  at a cost of 20,000, and it is being depreciated
  on a straight-line basis to a zero salvage value
  over a 10-year life. The current market value of
  the old machine is 15,000. The new machine,
  which falls into the MACRS 5-year class, has an
  estimated life of 5 years, it costs 30,000, and
  it has a zero estimated salvage value. The new
  machine is expected to generate cash savings
  (before taxes) of 3,000 per year. What is the
  IRR of the proposed project? The companys tax
  rate is 40 percent.
• 4.1
• 2.2
• 0
• -1.5
• -3.3

31
Exam 3

• 0

1. Find cash flow at t0
32
Exam 3
13. cont.
2. Calculate change in depreciation
33
Exam 3
13. cont.
3. Find cash flows, t1 5 Calculate IRR
0 1 2 3
4 5
(17,000) 3,000(0.60) 3,000(0.60)
3,000(0.60) 3,000(0.60) 3,000(0.60)
4,000(0.40) 7,600(0.40) 3,700(0.40)
1,600(0.40) 1,300(0.40)
1,800(0.40) (17,000) 3,400
4,840 3,280 2,440
3,040
IRR 0.00
34

• Pierce Products is deciding whether it makes
  sense to purchase a new piece of equipment. The
  equipment costs 100,000 (payable at t 0). The
  equipment will provide before-tax cash inflows of
  45,000 a year at the end of each of the next
  four years (t 1, 2, 3, 4). The equipment can
  be depreciated according to the following
  schedule
• t 1 0.33 t 3 0.15
• t 2 0.45 t 4 0.07
• At the end of four years the company expects to
  be able to sell the equipment for a salvage value
  of 10,000 (after-tax). The company is in the
  40 tax bracket. The company has an after-tax
  cost of capital of 11. Since there is
  uncertainty about the salvage value, the company
  has chosen to discount the salvage value at 12.
  What is the net present value of purchasing the
  equipment?
• 9,140.78
• 16,498.72
• 20,564.23
• 22,853.90
• 28.982.64

35
Exam 3

• 22,853.90

1. Find project NPV Cash Flows
t0 -100,000 t1 (45,000 33,000)(1 .04)
33,000 40,200 t2 (45,000 45,000)(1
.04) 45,000 45,000 t3 (45,000 15,000)(1
.04) 15,000 33,000 t4 (45,000
7,000)(1 .04) 7,000 29,800
I/Yr 11
NPV 16,498.72
36
Exam 3

• 14. cont.

2. Find PV of salvage value
N 4 I 12 PMT 0 FV -10,000
PV 6,355.18
16,498.72 6,355.18 22,853.90
37

• Problems

38

• Problem 1
• Your firm is considering the following two
  mutually exclusive investments, A and B.
• Your firms cost of capital is 12 percent.
  Compute the NPV, IRR, and modified internal rate
  of return (MIRR) on the two investments and
  compare the projects.

39
Problem 1 Exam 3

• Mutually exclusive projects
• Project A
• NPV -14,000 4,500(PVIFA12,5)
• -14,000 4,500(3.6048) 2,221.60.
• 14,000 4,500(PVIFA) 3.1111 PVIFAk,5.
• IRR is approximately equal to 18. (Calculator
  solution18.23)
• PVOutflows 14,000.
• TVInflows 4,500(FVIFA12,5) 4,500(6.3528)
  28,587.60.
• 14,000 28,587.60(PVIFk,5) 0.4897
  PVIFk,5.
• MIRR is approximately equal to 15. (Calculator
  solution15.35)

40
Problem 1 Exam 3

• Project B
• NPV -14,000 30,000(0.5674) 3,022.
• 14,000 30,000(PVIFk,5) 0.4667 PVIFk,5.
• IRR is approximately equal to 16 percent.
  (Calculator solution is 16.47.)
• PVOutflows 14,000. TVInflows 30,000.
• 14,000 30,000(PVIFk,5) 0.4667
  PVIFk,5.
• MIRR is approximately equal to 16 percent.
  (Calculator solution is 16.47.)

41
Problem 1 Exam 3

• There is a conflict between the choice indicated
  by NPV and that indicated by IRR. By the NPV
  criterion, B should be chosen however, the IRR
  method chooses A. By the MIRR criterion, B
  should be chosen. Note that there is no conflict
  between the NPV and MIRR methods in this
  instance the MIRR method assumes reinvestment at
  the cost of capital (as does the NPV method).
• MIRR is superior to the regular IRR as an
  indicator of a projects true rate of return or
  expected long-term rate of return, but the NPV
  method is still best, especially for choosing
  among competing projects that differ in size,
  because it provides a better indicator of how
  much each project will cause the value of the
  firm to increase.

42
Problem 2

• The Harris Company has a choice between two
  mutually exclusive projects, S, which costs
  200,000 and will provide cash flows of 100,000
  per year at the end of each of the next 3 years,
  or L, which costs 425,000 and will provide cash
  flows of 200,000 per year for 3 years. Harriss
  cost of capital is 10 percent.
• Calculate the NPV, IRR, and modified internal
  rate of return (MIRR) for each project.
• Which project should Harris choose? Explain your
  answer.
• Since these two projects have the same time
  pattern of returns, would Project L be preferred
  to S regardless of Harriss cost of capital?
  Explain.

43
Problem 2 Exam 3
44
Problem 2a Exam 3

• A.
• NPV CF(PVIFAk,n) - Outlay.
• NPVS 100,000(2.4869) - 200,000 48,690.
• NPVL 200,000(2.4869) - 425,000 72,380.
• IRRS 23.38. IRRL 19.44.

45
Problem 2a Exam 3

• MIRRS
• PVOutflows 200,000.
• TVInflows 100,000(FVIFA10,3)
  100,000(3.3100) 331,000.
• 200,000 331,000(PVIFk,3) 0.6042 PVIFk,3.
• MIRR is approximately 18
• (Calculator solution is 18.29.)

46
Problem 2a Exam 3

• MIRRL
• PVOutflows 425,000.
• TVInflows 200,000(FVIFA10,3)
• 200,000(3.3100) 662,000.
• 425,000 662,000(PVIFk,3) 0.6420 PVIFk,3.
• MIRR is approximately 16
• (Calculator solution is 15.92.)

47
Problem 2b Exam 3

• If capital is readily available at a cost of 10
  percent, then Project L should be selected
  because selecting L adds the most to the value of
  the firm. The problem can also be viewed this
  way

NPV? 100,000(2.4869) - 225,000
23,690 IRR? 15.9.
48
Problem 2b Exam 3
The NPV of Project? gt 0 and IRR? gt k. If we
take the smaller project, we lose the opportunity
of taking Project?, and thereby give up 23,690
of increased value to the firm. Note that the
modified internal rate of return method selects
Project S, and thus, conflicts with the NPV
method. The reason for the conflict is because
the 2 projects differ in size. The NPV method
always chooses the correct project and thus is
superior to the MIRR method.
49
Problem 2c Exam 3

• Look at the graph above, which shows that the
  statement is false--at any cost of capital above
  15.9, Project S would be preferred to Project L.
  The difference in the sizes of the two projects
  causes their NPV profiles to cross.

50
End of Practice Exam III