13.6 Comprehensive Examples of Investment Decisions Flashcards
(11 cards)
Don Adams Breweries is considering an expansion project with an investment of $1,500,000. The equipment will be depreciated to zero salvage value on a straight-line basis over 5 years. The expansion will produce incremental operating revenue of $400,000 annually for 5 years. The company’s opportunity cost of capital is 12%. Ignore taxes.
What is the IRR of the investment?
A. 19.17%
B. 16.32%
C. 10.43%
D. 12.68%
C. 10.43%
First, calculate the annual earnings and cash flows:
Operating revenues $400,000
Less: Depreciation 300,000
Book income 100,000
Cash flow 400,000
IRR is calculated by trial and error. Calculate the NPV at different discount rates.
NPV at 10% = ($400,000 × Discount factor for 10%, 5 years) – $1,500,000 = $400,000 × 3.791 – $1,500,000 = $16,400
NPV at 11% = $400,000 × 3.696 – $1,500,000 = $(21,600)
Thus, IRR lies between 10% and 11%. By interpolation, the actual IRR appears to be 10.43% {10 + [$16,400 ÷ ($16,400 + $21,600)}.
NOTE: The NPV tables do not contain the factor for 11%. You can deduce the answer using the factor for 12%, but you cannot interpolate.
Don Adams Breweries is considering an expansion project with an investment of $1,500,000. The equipment will be depreciated to zero salvage value on a straight-line basis over 5 years. The expansion will produce incremental operating revenue of $400,000 annually for 5 years. The company’s opportunity cost of capital is 12%. Ignore taxes.
What is the NPV of the investment?
A. $0
B. $(58,000)
C. $(116,000)
D. $1,442,000
B. $(58,000)
First, calculate the annual earnings and cash flows:
Operating revenues $400,000
Less: Depreciation (300,000)
Book income $100,000
Cash flow $400,000
The cash flows associated with the investment are then discounted accordingly:
Amount Discount Factor Present Value
Year 0 initial investment $(1,500,000) 1 $(1,500,000)
Years 1-5 cash flow 400,000 3.605 1,442,000
Net present value $ (58,000)
McLean, Inc., is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the second year, and 30% in the third year. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects.
Discount rates for a 16% rate are as follows:
Present Value of $1
Year 1 .862
Year 2 .743
Year 3 .641
Present Value of an Ordinary Annuity of $1
Year 1 .862
Year 2 1.605
Year 3 2.246
What is the net present value of this project?
A. $15,842
B. $13,278
C. $40,910
D. $9,432
B. $13,278
The NPV method discounts the expected cash flows from a project using the required rate of return. A project is acceptable if its NPV is positive. The future cash inflows consist of $85,000 of saved expenses per year minus income taxes after deducting depreciation. In the first year, the after-tax cash inflow is $85,000 minus taxes of $16,000 {[$85,000 – ($150,000 × 30%) depreciation] × 40%}, or $69,000. In the second year, the after-tax cash inflow is $85,000 minus taxes of $10,000 {[$85,000 – ($150,000 × 40%) depreciation] × 40%}, or $75,000. In the third year, the after-tax cash inflow (excluding salvage value) is again $69,000. Also in the third year, the after-tax cash inflow from the salvage value is $6,000 [$10,000 × (1 – 40%)]. Accordingly, the total for the third year is $75,000 ($69,000 + $6,000). The sum of these cash flows discounted using the factors for the present value of $1 at a rate of 16% is calculated as follows:
$69,000 × .862 = $ 59,478
$75,000 × .743 = 55,725
$75,000 × .641 = 48,075
Discounted cash inflows $163,278
Thus, the NPV is $13,278 ($163,278 – $150,000 initial outflow).
McLean, Inc., is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the second year, and 30% in the third year. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects.
Discount rates for a 16% rate are as follows:
Present Value of $1
Year 1 .862
Year 2 .743
Year 3 .641
Present Value of an Ordinary Annuity of $1
Year 1 .862
Year 2 1.605
Year 3 2.246
The payback period for this investment would be
A. 2.94 years.
B. 1.76 years.
C. 2.09 years.
D. 1.14 years.
C. 2.09 years.
The payback period is the number of years required for the cumulative undiscounted net cash inflows to equal the original investment. The future net cash inflows consist of $69,000 in Years 1 and 3, and $75,000 in Year 2. After 2 years, the cumulative undiscounted net cash inflow equals $144,000. Thus, $6,000 ($150,000 – $144,000) is to be recovered in Year 3, and payback should be complete in approximately 2.09 years [2 years + ($6,000 ÷ $69,000 net cash inflow in third year)].
Hobart Corporation evaluates capital projects using a variety of performance screens, including a hurdle rate of 16%, payback period of 3 years or less.
Hobart’s management is completing review of a project on the basis of the following projections:
Capital investment $200,000
Annual cash flows $65,000
Straight-line depreciation 8 years
Terminal value $20,000
The projected net present value is negative $2,000. Which one of the following alternatives reflects the appropriate conclusions for the indicated evaluative measures?
Net Present Value / Payback
A. Reject / Accept
B. Reject / Reject
C. Accept / Reject
D. Accept / Accept
B. Reject / Reject
A capital project is acceptable if the net present value of its cash flows is greater than zero. Since the net present value of this project is negative, the appropriate decision is to reject it. Under the payback method, the undiscounted cash inflows must exceed the undiscounted cash outflows within a specified period. Since it takes more than 3 years for the inflows from this project ($65,000 × 3 = $195,000) to exceed the outflows ($200,000), the appropriate decision under this method is also to reject.
The net present value, internal rate of return, and payback period for four proposed capital budgeting projects are shown below.
Project: Net Present Value / Internal Rate of Return / Payback Period
I: +$800,000 / 16% / 5 years
II: +$300,000 / 21% / 4 years
III: +$200,000 / 25% / 4 years
IV: +$500,000 / 23% / 3 years
If the projects are mutually exclusive, which one of the following is the best project for the company to select?
A. Project II.
B. Project IV
C. Project I.
D. Project III.
C. Project I.
Although Project I’s IRR is lowest, its net present value is the highest. Net present value (NPV) is the most satisfactory method of evaluating competing capital projects.
A company is considering the acquisition of scanning equipment to mechanize its procurement process. The equipment will require extensive testing and debugging as well as user training prior to its operational use. Projected after-tax cash flows are as follows:
Time Period: After-Tax Cash Inflow/(Outflow)
0: $(600,000)
1: (500,000)
2: 450,000
3: 450,000
4: 350,000
5: 250,000
Management anticipates the equipment will be sold at the beginning of Year 6 for $50,000 and its book value will be zero. The company’s internal hurdle and effective income tax rates are 14% and 40%, respectively. Based on this information, a negative net present value was computed for the project. Accordingly, it can be concluded that
A. The company should examine the determinants of its hurdle rate further before analyzing any other potential projects.
B. The company should calculate the project payback to determine if it is consistent with the net present value calculation.
C. The project has an internal rate of return (IRR) less than 14% since IRR is the interest rate at which net present value is equal to zero.
D. The project has an IRR greater than 14% since IRR is the interest rate at which net present value is equal to zero.
C. The project has an internal rate of return (IRR) less than 14% since IRR is the interest rate at which net present value is equal to zero.
If a project’s NPV is negative at a given hurdle rate, the project can only be made profitable if the rate is lowered. The IRR of this project must therefore be something less than 14%.
The capital budgeting model that is generally considered the best model for long-range decision making is the
A. Discounted cash flow model.
B. Accounting rate of return model.
C. Payback model.
D. Unadjusted rate of return model.
A. Discounted cash flow model.
The capital budgeting methods that are generally considered the best for long-range decision making are the internal rate of return and net present value methods. These are both discounted cash flow methods.
The following methods are used to evaluate capital investment projects:
* Internal rate of return
* Average rate of return
* Payback
* Net present value
Which one of the following correctly identifies the methods that utilize discounted cash-flow (DCF) techniques?
Internal Rate of Return: Yes/No
Average Rate of Return: Yes/No
Payback: Yes/No
Net Present Value: Yes/No
Internal Rate of Return: Yes
Average Rate of Return: No
Payback: No
Net Present Value: Yes
A company requires that capital budgeting proposals meet the acceptability criteria of both the payback method and the net present value (NPV) method. The company uses a cutoff payback period of 4 years. Which one of the following projects would produce conflicting results when applying the payback method and the NPV method?
Project: Payback / Net Present Value
A: 5 years / $ 800,000
B: 3 years / 100,000
C: 5 years / (300,000)
D: 3 years / 50,000
A. Project C.
B. Project A.
C. Project B.
D. Project D.
B. Project A.
Under Project A, the payback period of 5 years is greater than the cutoff of 4 years. Additionally, the NPV is positive. However, management requires that both criteria be met for the project to be accepted. While one criterion (NPV) meets management’s requirements, the other (payback period) does not, creating a conflicting result.
If a project with positive after-tax cash flows for 8 years has a discounted payback period of 5 years when the cost of capital is 10%, the project has a(n)
A. Profitability index that is less than one.
B. Undiscounted payback period greater than 6 years.
C. Positive net present value.
D. Internal rate of return that is less than 10%.
C. Positive net present value.
Since the discounted cash flows pay off the project early, all of the additional discounted cash flows are profit, and thus there is a positive net present value.
