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Reading 44: Capital Budgeting - LOS d~ Q1-5

1.Which of the following statements about the payback period is FALSE?

A)   The payback period provides a rough measure of a project's liquidity and risk.

B)   The cumulative net cash flow is the running total through time of a project's cash flows.

C)   The payback method considers all cash flows throughout the entire life of a project.

D)   The payback period is the number of years it takes to recover the original cost of the investment.

2.A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule:

Year 1: $3,000

Year 2: $2,000

Year 3: $2,000

Determine the project's NPV and IRR.

 

NPV

IRR

 

A)                                        $883      15%

B)                                        $243      20%

C)                                        $243      15%

D)                                        $883      20%


3.The process of evaluating and selecting profitable long-term investments consistent with the firm’s goal of shareholder wealth maximization is known as:

A)   capital budgeting.

B)   monitoring.

C)   ratio analysis.

D)   financial restructuring.


4.A firm is considering a $200,000 project that will last 3 years and has the following financial data:

Annual after-tax cash flows are expected to be $90,000.

Target debt/equity ratio is .4.

Cost of equity is 14 percent.

Cost of debt is 7 percent.

Tax rate is 34 percent.

Determine the project's payback period and net present value(NPV).

 

Payback Period

NPV

 

A)                                        2.43 years     $18,716

B)                                        2.22 years     $18,716

C)                                        2.43 years     $21,872

D)                                        2.22 years     $21,872


5.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 percent.

Cost of equity capital is 15 percent.

Cost of new debt is 9 percent.

Tax rate is 33 percent.

The project's net present value (NPV) is:

A)   +$33, so accept the project.

B)   -$4,968, so don't accept the project.

C)   +$4,968, so accept the project.

D)   -$33, so don't accept the project.

答案和详解如下:

1.Which of the following statements about the payback period is FALSE?

A)   The payback period provides a rough measure of a project's liquidity and risk.

B)   The cumulative net cash flow is the running total through time of a project's cash flows.

C)   The payback method considers all cash flows throughout the entire life of a project.

D)   The payback period is the number of years it takes to recover the original cost of the investment.

The correct answer was C)

The payback period does not take any cash flows after the payback point into consideration.


2.A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule:

Year 1: $3,000

Year 2: $2,000

Year 3: $2,000

Determine the project's NPV and IRR.

 

NPV

IRR

 

A)                                        $883      15%

B)                                        $243      20%

C)                                        $243      15%

D)                                        $883      20%

The correct answer was D)

To determine the NPV, enter the following:
PV of $3,000 in year 1 = $2,727, PV of $2,000 in year 2 = $1,653, PV of $2,000 in year 3 = $1,503. NPV = ($2,727 + $1,653 + $1,503) - $5,000 = 883.

You know the NPV is positive, so the IRR must be greater than 10%. You only have two choices, 15% and 20%. Pick one and solve the NPV. If it is not close to zero, then you guessed wrong; select the other one. [3000 / (1 + .2)1 + 2000 / (1 + .2)2 + 2000 / (1 + .2)3] - 5000 = 46 This result is closer to zero (approximation) than the $436 result at 15%. Therefore, the approximate IRR is 20%.


3.The process of evaluating and selecting profitable long-term investments consistent with the firm’s goal of shareholder wealth maximization is known as:

A)   capital budgeting.

B)   monitoring.

C)   ratio analysis.

D)   financial restructuring.

The correct answer was A)

In the process of capital budgeting, a manager is making decisions about a firm’s earning assets, which provide the basis for the firm’s profit and value. Capital budgeting refers to investments expected to produce benefits for a period of time greater than one year. Ratio analysis investigates financial statement values, financial restructuring is done as a result of bankruptcy, and monitoring is a critical assessment aspect of capital budgeting.


4.A firm is considering a $200,000 project that will last 3 years and has the following financial data:

Annual after-tax cash flows are expected to be $90,000.

Target debt/equity ratio is .4.

Cost of equity is 14 percent.

Cost of debt is 7 percent.

Tax rate is 34 percent.

Determine the project's payback period and net present value(NPV).

 

Payback Period

NPV

 

A)                                        2.43 years     $18,716

B)                                        2.22 years     $18,716

C)                                        2.43 years     $21,872

D)                                        2.22 years     $21,872

The correct answer was B)

Payback Period

$200,000/$90,000 = 2.22 years

NPV Method

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 * 0.07 * 0.66) + (0.714 * 0.14) = 0.0132 + 0.100 = 0.1132

Third, calculate the PV of the project cash flows
90 / (1 + .1132)1 + 90 / (1 + .1132)2 + 90 / (1 + .1132) 3 = $218,716

And finally, calculate the project NPV by subtracting out the initial cash flow
NPV = $218,716 - $200,000 = $18,716


5.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 percent.

Cost of equity capital is 15 percent.

Cost of new debt is 9 percent.

Tax rate is 33 percent.

The project's net present value (NPV) is:

A)   +$33, so accept the project.

B)   -$4,968, so don't accept the project.

C)   +$4,968, so accept the project.

D)   -$33, so don't accept the project.

The correct answer was D)

First, calculate the weights for debt and equity

wd + we = 1

wd= 0.50We

0.5We+We = 1

wd = 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



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