Reading 31- LOS g ～ Q1－4

1.Rachel Moore, an analyst with Dawson Corporation, is discussing a potential capital project with her colleague, Phillip Cora. The project involves producing a new product that will be sold in discount retail stores. If sales for the new product are favorable, Dawson has the ability to purchase new equipment for the existing production facility that will expand production to double its current rate. However, Moore is concerned that other companies may easily replicate the product and that low barriers to entry will reduce Dawson’s profitability. If sales for the new product are disappointing after the first two years, Dawson has a potential buyer that will pay $2 million for the production facility. Moore explains these facts to Cora and asks him for help in computing an accurate net present value (NPV) for the project. Cora replies with the following statements:

How should Moore respond to Cora’s statements?

A)          Agree                                    Disagree

B)          Disagree                             Disagree

C)          Disagree                               Agree

D)          Agree                                    Agree

The correct answer was B)

Moore should disagree with both of Cora’s statements. Even though both the option to double production and the option to sell the production facility cannot be exercised simultaneously, they both add value to the project and should be both be considered in any analysis. Even if it is difficult to compute an exact dollar value for each option’s contribution to the project, Moore can compute the value for the project without the options, and if the project does not already have a positive NPV, she can estimate whether the option values are enough to make the NPV positive. Cora’s second statement is also incorrect. The reaction from competitors has a definite impact on the potential profitability of the project and must be considered in the analysis.

2.Which of the following is least likely to cause a problem when analyzing a capital budgeting project?

A)   Incorporating actions taken by competitors in the capital budgeting analysis.

B)   Using standardized templates to analyze capital projects considered by a firm.

C)   Basing investment decisions on the impact on earnings per share.

D)   Using the firm’s weighted average cost of capital for the discount rate on all projects.

The correct answer was A)

One of the common pitfalls when analyzing capital projects is not incorporating economic responses from competitors. Economic responses to an investment often affect profitability.

Note that using standardized templates for all projects can cause errors when the template model does not match the project or if employees input incorrect information. Also, managers who make decisions based on short-term EPS considerations may fail to consider projects that do not boost accounting numbers in the short-run, but are in the best long term interests of the business. The discount rate for a project should be adjusted for the project’s risk.

3.Sharon Kelley and Joyce Wening are discussing potential capital projects for the Flagstaff Corporation. Kelley is concerned about making errors in the capital budgeting decision making process and wants to take necessary steps to avoid such errors. In response to Kelley’s concerns, Wening makes the following statements:

In regards to Wening’s statements, Kelley would find which statement(s) correct?

A)          Incorrect                             Incorrect

B)          Incorrect                               Correct

C)          Correct                                 Correct

D)          Correct                                 Incorrect

The correct answer was A)

Wening’s first statement is incorrect. Overhead costs are difficult quantify, but project costs should include any overhead costs that are attributable to a project. Wening’s second statement is also incorrect. Failure to consider investment alternatives is a major capital budgeting pitfall. Generating good investment ideas is the most important step in the capital budgeting process. Managers need to make sure they are not avoiding the consideration of “better” projects simply because the existing project under consideration is “good.”

4.Which of the following is most likely to cause a problem when evaluating a capital budgeting project?

A)   Including overhead costs in the total cost of a capital project.

B)   Avoiding the use of IRR when evaluating mutually exclusive projects.

C)   Returning excess funds when the amount of money in the capital budget exceeds the dollar amount of profitable projects.

D)   Taking on the pet projects of management without going through the complete capital budgeting process.

The correct answer was D)

Pet projects that influential managers want the company to invest in will ideally receive the same scrutiny received by other investments. Another potential concern with management’s pet projects is that overly optimistic projections will make the project appear more profitable than it really is. Note that using IRR for mutually exclusive projects will tend to steer management toward smaller, short term projects with high IRRs and may not lead management to the same decision as the more appropriate NPV method. Overhead costs are often difficult to estimate, but should be included in the cost of a capital project. Also, politics involved with spending the entire capital budget should be avoided. A capital budget should focus on profitable projects, and ideally, a manager will ask for additional funds if there are more profitable projects than what is called for the budget, and the manager will return excess funds if there are fewer profitable projects than called for by the budget.

done