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Reading 44: Capital Budgeting - LOS d ~ Q7-11

Q7. Which of the following statements about the discounted payback period is least accurate? The discounted payback:

A)   period is generally shorter than the regular payback.

B)   frequently ignores terminal values.

C)   method can give conflicting results with the NPV.

Q8. Which of the following statements about NPV and IRR is least accurate?

A)   For independent projects if the IRR is > the cost of capital accept the project.

B)   The NPV method assumes that all cash flows are reinvested at the cost of capital.

C)   For mutually exclusive projects you should use the IRR to rank and select projects.

Q9. A company is considering a $10,000 project that will last 5 years.

  • Annual after tax cash flows are expected to be $3,000

  • Target debt/equity ratio is 0.4

  • Cost of equity is 12%

  • Cost of debt is 6%

  • Tax rate 34%

What is the project's net present value (NPV)?

A)   -$1,460.

B)   +$1,460.

C)   $+1,245

Q10. Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return?

A)   $325,859.

B)   $376,872.

C)   $280,913.

Q11. A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data:

  • Debt/equity ratio is 50%.

  • Cost of equity capital is 15%.

  • Cost of new debt is 9%.

  • Tax rate is 33%.

Determine the project's net present value (NPV) and whether or not to accept it.

NPV                 Accept / Do not accept

 

A)  -$33                                        Do not accept

B)  +$33                                       Accept

C)   +$4,968                               Accept

答案和详解如下:

Q7. Which of the following statements about the discounted payback period is least accurate? The discounted payback:

A)   period is generally shorter than the regular payback.

B)   frequently ignores terminal values.

C)   method can give conflicting results with the NPV.

Correct answer is A)

The discounted payback period calculates the present value of the future cash flows. Because these present values will be less than the actual cash flows it will take a longer time period to recover the original investment amount.

Q8. Which of the following statements about NPV and IRR is least accurate?

A)   For independent projects if the IRR is > the cost of capital accept the project.

B)   The NPV method assumes that all cash flows are reinvested at the cost of capital.

C)   For mutually exclusive projects you should use the IRR to rank and select projects.

Correct answer is C)

For mutually exclusive projects you should use NPV to rank and select projects.

Q9. A company is considering a $10,000 project that will last 5 years.

  • Annual after tax cash flows are expected to be $3,000

  • Target debt/equity ratio is 0.4

  • Cost of equity is 12%

  • Cost of debt is 6%

  • Tax rate 34%

What is the project's net present value (NPV)?

A)   -$1,460.

B)   +$1,460.

C)   $+1,245

Correct answer is B)

First, calculate the weights for debt and equity

wd + we = 1

we = 1 − wd

wd /  we = 0.40

wd = 0.40 × (1 − wd)

wd = 0.40 − 0.40wd

1.40wd = 0.40

wd = 0.286, we = 0.714

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.06 × 0.66) + (0.714 × 0.12) = 0.0113 + 0.0857 = 0.0970

Third, calculate the PV of the project cash flows

N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $11,460 − $10,000 = $1,460

Q10. Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return?

A)   $325,859.

B)   $376,872.

C)   $280,913.

Correct answer is C)

The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913.

Q11. A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data:

  • Debt/equity ratio is 50%.

  • Cost of equity capital is 15%.

  • Cost of new debt is 9%.

  • Tax rate is 33%.

Determine the project's net present value (NPV) and whether or not to accept it.

NPV                 Accept / Do not accept

 

A)  -$33                                        Do not accept

B)  +$33                                       Accept

C)   +$4,968                               Accept

Correct answer is A)

First, calculate the weights for debt and equity

d + we = 1

d = 0.50We

e + We = 1

d = 0.333, we = 0.667

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.333 × 0.09 × 0.67) + (0.667 × 0.15) = 0.020 + 0.100 = 0.120
Third, calculate the PV of the project cash flows

N = 8, PMT = -1,000, FV = 0, I/Y = 12, CPT PV = 4,967

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $4,967 − $5,000 = -$33

TOP

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abcd

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TOP

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