JoeyDVivre

Which of the following statements regarding inflation is CORRECT? Inflation:

A) causes the weighted average cost of capital (WACC) to increase and the present value of the cash flows to increase.

B) is built into the weighted average cost of capital (WACC) and thus the net present value (NPV) is adjusted for expected inflation.

C) is already present in the future cash flows therefore they need no further adjustment.

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Inflation is built into the WACC and thus the NPV is adjusted for expected inflation. An increase in inflation causes the WACC to increase and the present value of the cash flows to decrease.  Future cash flows such as sales revenues should be adjusted upward to reflect the affect of inflation on future prices otherwise the NPV calculation will be biased downward

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A firm is unable to raise the necessary funding for all projects that have positive expected net present values. Therefore, this firm must:

A) declare bankruptcy.

B) engage in capital rationing.

C) cut overhead and other costs.

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When a firm is unable to fund all projects that have positive expected net present values, the firm must engage in capital rationing.

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A given firm cannot invest in all projects that have a higher return than the associated cost of capital. Therefore, the firm must engage in:

A) sensitivity analysis.

B) a pure play.

C) capital rationing.

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If a firm cannot invest in all the profitable projects available, the managers must engage in capital rationing and allocate available funds to the best projects.

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In the absence of capital rationing, a firm should take on the most profitable investments first and keep expanding their investments to the point where the marginal:

A) cost of debt equals the marginal cost of equity.

B) return of the last investment equals the risk free rate.

C) return of the last investment equals the marginal cost of capital.

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The firm will generally invest in the most profitable projects first. Subsequent projects will have lower expected returns. As the amount of capital increases, the marginal cost of capital tends to rise. The firm should invest in new projects until the expected return is equal to the marginal cost of capital.

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Which of the following statements about mutually exclusive projects with unequal lives is least accurate?

A) Mutually exclusive projects sometimes have long and different lives, which makes applying the replacement chain method difficult because the lowest common denominator is very large. The equivalent annual annuity is a substitute method that uses the annuity concept to value a project's cash flows.

B) In comparing mutually exclusive projects with unequal lives, you should always choose the project which has the highest NPV.

C) For comparing mutually exclusive projects with unequal lives, replacement chain analysis leads to the same decision as obtained by calculating the equivalent annual annuity.

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In comparing mutually exclusive projects, replacement chain or equivalent annual annuity analysis should be used if the projects have unequal lives and can be replicated. Therefore, you will not always choose the project that has the highest NPV, if a project with a lower NPV can be replicated and results in a higher NPV over the same period of time as the project that has a longer time period.

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Which of the following statements about the equivalent annual annuity approach for capital budgeting is least accurate?

A) The replacement chain approach assumes that it is possible to make continuous replacements each time the asset's life ends.

B) A 5-year project has a NPV of $2,000, if the firm's cost of capital is 10% the equivalent annual annuity is $725.

C) When comparing mutually exclusive projects with unequal lives, replacement chain analysis yields the same decision as the equivalent annual annuity method.

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Calculating EAA results in [i = 10, n = 5, PV = –2,000] PMT = 528, not 725.

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Jayco, Inc. is evaluating two mutually exclusive investment projects. Assume both projects can be repeated indefinitely. Printer A has a net present value (NPV) of $20,000 over a three-year life and Printer B has a NPV of $25,000 over a five-year life. The project types are equally risky and the firm's cost of capital is 12%. What is the equivalent annual annuity (EAA) of Project A and B?

Project A

Project B

A) $8,327 $5,326

B) $7,592 $6,935

C) $8,327 $6,935

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Printer A: PV = 20,000, N = 3, I = 12, FV = 0, Compute PMT = 8,327
Printer B: PV = 25,000, N = 5, I = 12, FV = 0, Compute PMT = 6,935.
(Note: take the highest EAA, Printer A in this example)

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Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

• The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.
• The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.
• Verban’s tax rate is 34 percent.
• Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.
• At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million. The building will be depreciated over 6 years. The equipment will be depreciated over 5 years. Depreciation expense will be $8.33 million in Year 1 and $11.68 in Years 2 through 6.
• Fixed operating costs are expected to be $65 million a year once the factory starts production.
• Variable operating costs should be 40 percent of sales.
• New inventories are likely to boost working capital by $7.5 million in the first year of production.
• Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

• Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”
• Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”
• Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”
• Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.
Verban is also considering building two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would be replaced at the end of their useful lives and their cash flows are as follows:

Project	Initial outlay	Year 1	Year 2	Year 3	Year 4	Year 5
A	−$30 million	$15 million	$17 million	$28 million	—	—
B	−50 million	$12 million	$15 million	$19 million	$22 million	$32 million

Verban is willing to pursue one of the smaller new factories but not both. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately reflect inflation, and would like to modify her models to reflect expected inflation over the next five years. She is uncertain, however, how this would affect WACC, IRR, and NPV. If Haggerty decides to properly allocate the maintenance, land-purchase, and equipment-installation expenses Jenkins claimed were connected with the new factory project, which of the following numbers on the capital-budgeting model will be least likely to change?

A) Year 4 depreciation.

B) The initial outlay.

C) Working capital.

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Working capital will not be affected. The maintenance contract is a sunk cost and should not be included in the calculation. However, the use of the land is an opportunity cost, and should be included in the analysis. Land is not usually depreciable, so it will not affect depreciation. However, the installation expense for the specialized machinery will be added to the cost basis of the machinery, which will affect depreciation in every year after Year 1. While the land was not purchased at the same time cash is paid to the builder, the cost of the land can only be accounted for as part of the initial outlay. While the effect of the higher cost basis for the equipment has a very small effect on the project’s NPV, the addition of $30 million in land costs to the initial outlay drops the NPV from positive to negative, changing the accept/reject recommendation. (Study Session 8, LOS 28.c)

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Ignoring Jenkins’s comments, in the last year of the new factory project, cash flows will be closest to:

A) $88.00 million.

B) $90.21 million.

C) $95.71 million.

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To calculate cash flows for Year 6, we must determine both the operating cash flow and the terminal value. Based on $205 million in sales, $65 million in fixed costs, variable costs equal to 40 percent of sales, and a 34 percent tax rate, the operating cash flow = ($205 − $65 − $82) × (1 − 34%) = $38.28 million. Depreciation = ($85 million for building − $35 million salvage value) / 6 + $20 million for equipment − $3.25 million salvage value) / 5 = $11.68. Operating cash flow = cash from factory operations + (depreciation × t) = $42.25 million. The terminal value represents the salvage value of the building and equipment, adjusted for taxes, plus the return of the $7.5 million in working capital added in Year 2. Terminal value = ($35 million for the building + $3.25 million for the equipment) + $7.5 million for working capital = $45.75 million. Since the market value and book value of the building and equipment are the same, there is no taxable gain or loss, and no need for a tax adjustment in the terminal-value calculation.
Year 6 Cash flows = 42.25 + 45.75 = $88.00 million. (Study Session 8, LOS 28.a)

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Which of the following statements about the effect of inflation on the capital-budgeting process is most accurate?

Statement 1: Inflation is reflected in the WACC, but future cash flows should still be adjusted when calculating the NPV.
Statement 2: Inflation will cause the WACC to decrease.
Statement 3: Incorporating inflation in the cash flows tends to exert downward pressure on the NPV.
Statement 4: Because the IRR does not depend on the WACC, inflation has no effect on it.

A) Statement 1 only.

B) Statements 3 and 4.

C) Statements 2 and 3.

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Inflation causes the WACC to increase, so Statement 2 is false. Because the WACC reflects inflation, future cash flows must be adjusted to avoid a downward bias, so Statement 1 is true. Both the NPV and the IRR will tend to decline if cash flows are not adjusted — Statements 3 and 4 are false. (Study Session 8, LOS 28.b)

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Jenkins advice is CORRECT with respect to:

A) Comments 1 and 2.

B) Comment 4 only.

C) Comment 2 only.

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Potential cannibalization of sales should be reflected in the budget, so Comment 2 is correct. The maintenance contract represents a sunk cost and should not be included in any capital budgeting, so Comment 1 is incorrect. Since the land could be used for another purpose, it represents an opportunity cost. The value of the land should be reflected in the budget, so Comment 4 is incorrect. Installation costs add to the purchase price of the equipment, increasing its depreciable basis over the life of the item. They should not be charged as a variable cost, so Comment 3 is incorrect. (Study Session 8, LOS 28.a)

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Ignoring Jenkins’s comments, in Year 2 of the new factory project, cash flows will be closest to:

A) $19.35 million.

B) $15.61 million.

C) $23.32 million.

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Verban begins selling products in the second half of Year 2, so sales and expenses are half of what is projected on an annual basis. $102.5 million in sales, $32.5 million in fixed costs and (102.5 × 0.4) = $41 million in variable expenses yield pretax cash flows of $29 million and after-tax cash flows of $19.41 million.
Depreciation = $11.68 million (given)
In Year 2, the first year of production, Verban also adds $7.5 million in working capital.
Cash flow = cash from factory operations + depreciation × t − additions to working capital = $15.61 million. (Study Session 8, LOS 28.a)

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Haggerty is using the equivalent annual annuity method, depending only on data from the cash-flow estimates for the remodeling projects. Which project should Haggerty recommend, and which of the following is closest to the difference between that project’s EAA and that of the other project?

Project [td=1,1,100]EAA difference

A) A $0.88 million

B) B $1.23 million

C) A $2.34 million

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In order to answer this question, we must determine the NPV for both projects:

Project A: NPV = 14.8865
Project B: NPV = 13.9963
Project A: PV = 14.8865; N = 3; I = 14.3; EAA= PMT = 6.44
Project B: PV = 13.9963; N = 5; I = 14.3; EAA = PMT = 4.10
(Study Session 8, LOS 28.c)

invic

Define sensitivity analysis and Monte Carlo simulation.

[td=1,1,200]Sensitivity analysis is:

Monte Carlo simulation

A) when a firm looks at the sensitivity of only one variable, holding all others constant. uses historical values from which repeated samples are drawn.

B) when a firm looks at the sensitivity of only one variable, holding all others constant. assumes a specified distribution to generate random samples in order to estimate true distribution parameters.

C) when a firm looks at the sensitivity of many variables, holding some constant. assumes a specified distribution to generate random samples in order to estimate true distribution parameters.

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Monte Carlo simulation assumes a specified distribution to generate random samples in order to estimate true distribution parameters.
When a firm looks at the sensitivity of only one variable, holding all others constant, they are performing sensitivity analysis.

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Which of the following simulation techniques computes as many as 1,000 net present values, based on multiple values for each cash flow?

A) Sensitivity analysis.

B) Scenario analysis.

C) Monte Carlo simulation.

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Through the computation of multiple net present values, Monte Carlo simulation provides insight to the possible distribution of net present values arising from a project. Scenario analysis, on the other hand focuses on the worst case, best case, and base case. Sensitivity analysis inputs could be modified 1,000 times, but typically only one variable is changed at a time from the base case scenario.