FIN 5405 Quiz #5: Module 3, Chapters 10-12

Quiz #5:  Module 3, Chapters 10-12                                                                       I2MBAF14

FIN 5405                                                                                                                       J. Houston

NPV sensitivity to WACC

1.         Last month, Harvey Corporation analyzed the project whose cash flows are shown below.  However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC.  The Fed's action did not affect the forecasted cash flows.  By how much did the change in the WACC affect the project's forecasted NPV?

Old WACC:  9.00%               New WACC:  10.50%

Year                           0                1                2                3    

Cash flows            -$1,000        $410          $410          $410

Answer:

NPV decreases by $27.10 when the cost of capital increases by 1.5%

Relevant cash flows

2.         Which of the following rules is CORRECT for capital budgeting analysis?

e.   Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.

WACC calculation

3.         Assume that you are on the financial staff of Chandler Enterprises, and you have collected the following data:  (1) The yield to maturity on the company’s outstanding 8% annual coupon bonds is 6.0%, and its tax rate is 35%.  (2) The risk-free rate is 4%, the market risk premium (r_M – r_RF) is 6%, and the firm’s beta is 1.1.  (3) The firm’s capital structure consists of 30% debt and 70% equity.  What is Chandler’s WACC?

Answer:

WACC: After tax cost of debt*weight of debt + cost of equity*weight of equity

NPV, constant CFs, NOWC, salvage value

4.         Alfredson Inc. is considering a new investment whose data are shown below.  The required equipment has a 3-year tax life and would be fully depreciated by the straight-line method over the 3 years, but it would have a positive salvage value at the end of Year 3, when the project would be closed down.  Also, some new net operating 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                                                                                                     11%

Net equipment cost (depreciable basis)                                             $75,000

Required new NOWC                                                                       $12,500

Straight line depreciation rate                                                             33.33%

Sales revenues                                                                                  $110,000

Operating costs excluding depreciation                                             $45,000

Expected pretax salvage value                                                             $7,500

Tax rate                                                                                                    40%

Answer:

NPV vs IRR

5.         Tyler Industries is considering Projects S and L, whose cash flows are shown below.  These projects are mutually exclusive, equally risky, and not repeatable.  If the decision is made by choosing the project with the higher IRR, how much value will be forgone?  Note that under some conditions choosing projects on the basis of the IRR will cause no value to be lost.  (Note:  A negative answer to this problem indicates that value is added not forgone.)

            WACC = 10%

            Year:              0                      1                      2                      3                      4          

            CF_S:           -$1,200              $500                $730                $300                $  40

            CF_L:           -$1,200              $210                $460                $550                $500

Answer:

NPV, SL depreciation, constant CFs

6.         Camden Industries 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 the project's 3-year life, and would have zero salvage value.  No new net operating 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?

WACC                                                                                                     11%

Net investment cost (depreciable basis)                                             $75,000

Straight line depreciation rate                                                             33.33%

Sales revenues                                                                                  $110,000

Operating costs excluding depreciation                                             $45,000

Tax rate                                                                                                    40%

Answer:

MIRR

7.         Jacobs Industries is considering a project that has the following cash flow and WACC data.  What is the project's MIRR?

WACC = 10%

Year:                          0                      1                      2                      3          

Cash flows:           -$2,000              $600                $800               $1,250

Answer:

Cost of capital concepts

8.         Which of the following statements is CORRECT?

Crossover rate

9.         Dalrymple Company is considering Projects A and B with the cash flows shown below.  The firm’s WACC is 10%.  There have been discussions within the company about which capital budgeting decision rule should be used to determine the better project.  A staff person has suggested that the crossover rate should be calculated so the firm has more information.  What is the crossover rate for these two projects?  In other words, at what discount rate are the NPVs of these two projects equal?

                          0                1                2                3                4                5    

Project A      -$   650        $300          $260          $200          $  50          $100

Project B      -$1,325        $220          $245          $500          $550          $325

Answer:

Discounted payback

10.       Isaacson Inc. is considering a project that has the following cash flow and WACC data.  What is the project's discounted payback?

WACC:  8.00%

Year                           0                1                2                3                4    

Cash flows              -$950         $525          $485          $445          $405

Answer: