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Exam 13: Capital Budgeting-Estimating Cash Flows and Analyzing Risk

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Question 1

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Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new warehouse. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) $\begin{array}{lr}\text { Project cost of capital (r) } & 10.0 \% \\\text { Opportunity cost } & \$ 100,000 \\\text { Net equipment cost (depreciable basis) } & \$ 65,000 \\\text { Straight-line deprec. rate for equipment } & 33.333 \% \\\text { Sales revenues, each year } & \$ 123,000 \\\text { Operating costs (excl. deprec.) , each year } & \$ 25,000 \\\text { Tax rate } & 35 \%\end{array}$

A) $10,521
B) $11,075
C) $11,658
D) $12,271
E) $12,885

F) A) and D)
G) A) and E)

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Question 2

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Shultz Business Systems is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV? $\begin{array}{lr}\text { Project cost of capital (r) } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 200,000 \\\text { Units sold } & \$ 0,000 \\\text { Average price per unit, Year 1 } & \$ 25.00 \\\text { Fixed op. cost excl. deprec. (constant) } & \$ 150,000 \\\text { Variable op. cost/unit, Year 1 } & \$ 20.20 \\\text { Annual depreciation rate } & 33.333 \% \\\text { Expected inflation rate per year } & 5.00 \% \\\text { Tax rate } & 40.0 \%\end{array}$

A) $15,925
B) $16,764
C) $17,646
D) $18,528
E) $19,455

F) B) and E)
G) A) and B)

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Question 3

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Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm?

Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a risk-adjusted project cost of capital of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing projects?

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.

Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects.

Which of the following statements is CORRECT?

Sylvester Media is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made? $\begin{array}{lr}\text { Project cost of capital (r) } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 200,000 \\\text { Units sold } & \$ 0,000 \\\text { Average price per unit, Year 1 } & \$ 25.00 \\\text { Fixed op. cost excl. deprec. (constant) } & \$ 150,000 \\\text { Variable op. cost/unit, Year } 1 & \$ 20.20 \\\text { Annual depreciation rate } & 33.333 \% \\\text { Expected inflation } & 4.00 \% \\\text { Tax rate } & 35.0 \%\end{array}$

A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

Garden-Grow Products is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that 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 life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.) $\begin{array}{lr}\text { Project cost of capital ( } r \text { ) } & 10.0 \% \\\text { Net investment in fixed assets (basis) } & \$ 75,000 \\\text { Required new working capital } & \$ 15,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sales revenues, each year } & \$ 75,000 \\\text { Operating costs (excl. deprec.) , each year } & \$ 25,000 \\\text { Tax rate } & \$ 35.0 \%\end{array}$

DeVault Services recently hired you as a consultant to help with its capital budgeting process. The company 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? $\begin{array} { l r } \text { Risk-adjusted cost of capital } & 10.0 \% \\\text { Net investhent cost (depreciable basis) } & \text { \$65,000 } \\\text { Straight-line deprec. rate } & 33.3333 \% \\\text { Sales revenue5, each year } & \$ 65,500 \\\text { Operating costs (excl. teprec.) , each year } & 35,000 \\\text { Terate } & 35 \%\end{array}$

Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%. What is the project's coefficient of variation?

Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that the proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is CORRECT?

McPherson Company must purchase a new milling machine. The purchase price is $50,000, including installation. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? $\begin{array} { c c } \text { Year } & \text { Depreciation Rate } \\1 & 0 .20 \\2 & 0.32 \\3 & 0.19 \\4 & 0.12 \\5 & 0.11 \\6 & 0.06\end{array}$

In your first job with TBL Inc. your task is to consider a new project whose data are shown below. What is the project's Year 1 cash flow? $\begin{array}{lr}\text { Sales revenues }&\$ 22,250 \\\text { Depreciation}& \$ 8,000 \\\text { Other operating costs}&\$ 12,000\\\text { Tax rate}&35.0\%\end{array}$

Whitestone Products is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow? $\begin{array}{l}\begin{array} { l } \text { Equipment cost (depreciable basis) } \\\text { Sales revenues, each year }\\\text {Operating costs (excl. deprec.) }\\\text { Tax rate}\end{array}\begin{array} { l } \$ 70,000 \\\$ 42,500 \\\$ 25,000 \\35.00\%\end{array}\end{array}$

Fitzgerald Computers is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow? $\begin{array} { l r } \text { Equpment cost (depreciable basis) } & \text { \$65,000 } \\\text { Staight-line depreciation rate } & 33.333 \% \\\text { Sales revenue5, each year } & \text { \$60,000 } \\\text { Operating casts (excl. deprec.) } & 35,000 \\\text { Ter rate } & 35.0 \%\end{array}$

We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis.