FIN 534 – Homework Chapter 10

1. Which of the following statements is CORRECT?

a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

d. The net present value method (NPV) is generally regarded by academics as being the best

single method for evaluating capital budgeting projects.

e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

2. Projects A and B have identical expected lives and identical initial cash outflows (costs).  However, most of one project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years.  The two NPV profiles are given below: Which of the following statements is CORRECT?

a. More of Project A’s cash flows occur in the later years.

b. More of Project B’s cash flows occur in the later years.

c. We must have information on the cost of capital in order to determine which project has the larger early cash flows.

d. The NPV profile graph is inconsistent with the statement made in the problem.

e. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project’s IRR.

3. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions.  Other things held constant, which of the following statements is most likely to be true?

a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).

b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).

c. The firm will accept too many projects in all economic states because a 4-year payback is too low.

d. The firm will accept too few projects in all economic states because a 4-year payback is too high.

e. If the 4-year payback results in accepting just the right set of projects under average

economic conditions, then this payback will result in too few long-term projects when the

economy is weak.

4. You are on the staff of Camden Inc.  The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC.  Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows:  $110,000 at the end of Year 1 and -$100,000 at the end of Year 2.  The president and the CFO both agree that the appropriate WACC for this project is 10%.  At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%.  Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?

a. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.

b. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.

c. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC.  You should explain this to the president and tell him that the firm’s value will increase if the project is accepted.

d. You should recommend that the project be rejected.  Although its NPV is positive it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted.

e. You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted.

5. A firm is considering Projects S and L, whose cash flows are shown below.  These projects are mutually exclusive, equally risky, and not repeatable.  The CEO wants to use the IRR criterion, while the CFO favors the NPV method.  You were hired to advise the firm on the best procedure.  If the wrong decision criterion is used, how much potential value would the firm lose?

WACC:  6.00%

Year 0 1 2 3 4

CFS -$1,025 $380 $380 $380 $380

CFL -$2,150 $765 $765 $765 $765

a. $188.68

b. $198.61

c. $209.07

d. $219.52

e. $230.49

FIN 534 – Homework Chapter 11

1. Which of the following statements is CORRECT?

a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations.  If the project would have a favorable effect on other operations, then this is not an externality.

b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline.

c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not.  This is another reason to favor the NPV.

d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.  However, the payback method does not.

e. Identifying an externality can never lead to an increase in the calculated NPV.

2. 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 data:

Project X Project Y

Expected NPV $350,000 $350,000

Standard deviation (σNPV) $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.

3. Which of the following statements is CORRECT?

a. If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions.

c. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project’s completion.  Working capital like inventory is almost always used up in operations.  Thus, cash flows associated with working capital should be included only at the start of a project’s life.

d. If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit.  In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.

e. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities.  Therefore, changes in net working capital should not be considered in a capital budgeting analysis.

4. 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 depreciation rate 33.3333%

Sales revenues, each year $65,500

Operating costs (excluding depreciation), each year $25,000

Tax rate 35.0%

a. $15,740

b. $16,569

c. $17,441

d. $18,359

e. $19,325

5.   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 decline?  (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