Exam 3: HW #6 - Capital Budgeting Flashcards
(17 cards)
Which of the following is NOT true about capital budgeting?
a. It involves identifying projects that will add to a firm’s value
b. It involves investing large amounts of capital
c. It allows a firm to reverse the decision of large capital investments at any time
d. It allows a firm’s management to analyze potential business opportunities and decide on which ones to undertake
c. It allows a firm to reverse the decision of large capital investments at any time
Two projects are considered to be independent if:
a. selecting one does not affect whether the other is accepted or not
b. selecting one does not affect whether the other is accepted or not, and their cash flows are unrelated
c. their cash flows are unrelated
d. acceptance of one project is contingent on the acceptance of the other
b. selecting one does not affect whether the other is accepted or not, and their cash flows are unrelated
The cost of capital is:
a. the maximum return a project can earn
b. the minimum return that a capital project must earn to be accepted
c. not viewed as an opportunity cost
d. the return the firm had earned on a previous project
b. the minimum return that a capital project must earn to be accepted
Capital rationing implies that:
a. the firm has more resources that it needs
b. the available capital will be allocated equally to all available projects
c. funding needs are equal to funding resources
d. a firm has constraints to funding all of the available projects
d. a firm has constraints to funding all of the available projects
When computing the NPV of a capital budgeting project, one should NOT:
a. discount the future cash flows over the project’s expected life
b. make a decision based on the project’s NPV
c. estimate the cost of the project
d. ignore the salvage value
d. ignore the salvage value
To accept a capital project when using NPV:
a. the project NPV should be less than zero
b. the project NPV should be equal to zero
c. the project NPV should be greater than zero
d. the project NPV should be greater than and less than zero
c. the project NPV should be greater than zero
The Cyclone Golf Resorts is redoing its golf course at a cost of $2,744,320. It expects to generate cash flows of $1,223,445, $2,007,812, and $3,147,890 over the next three years. If the appropriate discount rate for the firm is 13 percent, what is the NPV of this project? (Do not round intermediate calculations)
(1,223,445/ (1+0.13) ) + (2,007,812/ (1+0.13)^2 ) + (3,147,890/ (1+0.13)^3 ) - 2,744,320
= $2,092,432
Cortez Art Gallery is adding to its existing buildings at a cost of $2 million. The gallery expects to bring in additional cash flows of $520,000, $700,000, and $1,000,000 over the next three years. Given a required rate of return of 10 percent, what is the NPV of this project? (Do not round intermediate calculations)
(520,000/ (1+0.10) ) + (700,000/ (1+0.10)^2 ) + (1,000,000/ (1+0.10)^3 ) - 2,000,000
= -$197,446
Johnson Entertainment Systems is setting up to manufacture a new line of video game consoles. The cost of the manufacturing equipment is $1,750,000. Expected cash flows over the next four years are $725,000, $850,000, $1,200,000, and $1,500,000. Given the company’s required rate of return of 15 percent, what is the NPV of this project? (Do not round intermediate calculations)
(725,000/ (1+0.15) ) + (850,000/ (1+0.15)^2 ) + (1,200,000/ (1+0.15)^3 ) + (1,500,000/ (1+0.15)^4 ) - 1,750,000
= $1,169,806
Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, $5 million over the next four years. Its cost of capital is 16 percent. What is the net present value of this project? (Do not round intermediate calculations)
(2,000,000/ (1+0.16) ) + (3,000,000/ (1+0.16)^2 ) + (4,000,000/ (1+0.16)^3 ) + (5,000,000/ (1+0.16)^4 ) - 8,500,000
= $777,713
Which one of the following is an advantage of the NPV method of analyzing capital projects?
a. It uses cash flows from financial statements and hence it is more reliable
b. It uses a discounted cash flow technique to adjust for the time value of money
c. It is easy to understand even without an accounting or finance background
d. It is consistent with the goal of achieving higher net income
b. It uses a discounted cash flow technique to adjust for the time value of money
Which of the following rates should be used to calculate a project’s net present value?
a. Cost of capital
b. Required rate return on equity
c. Treasury bill rate
d. Coupon interest rate on bonds
a. Cost of capital
A machine costs $1000 and has a 3-year life. The estimated salvage value at the end of three years is $100. The project is expected to generate after tax-cash flows of $600 per year. If the required rate of return is 10%, what is the NPV of the project? (Do not round intermediate calculations)
(600/1.10) + (600/ (1.10)^2 ) + (600/ (1.10)^3 ) = $1492.11
100 / (1.10)^3 = 75.13
$1492.11 + $75.13 - $1000 = $567
Binder Corp. has invested in new machinery at a cost of $1,450,000. This investment is expected to produce cash flows of $640,000, $715,250, $823,330, and $907,125 over the next four years. What is the payback period for this project?
Initial Investment = $1,450,000
Cash Flows over 4 years:
Year 1: $650,000
Year 2: $715,250
Year 3: $823,330
Year 4: $907,125
Cumulative Cash flows:
Year 1: $640,000
Year 2: $640,000 +$715,250 = $1,355,250
Year 3: $1,355,250 +$823,330 = $2,178,580
= 2 + $1,450,000 - $1,355,250 / $823,330
= 2 + 0.14 = 2.12 years
Elmer Sporting Goods is getting ready to produce a new line of golf clubs by investing $1.85 million. The investment will result in additional cash flows of $525,000, $812,500, and $1,200,000 over the next three years. What is the payback period for this project?
= 2 + ($1,850,000 - $1,337,500 / $1,200,000 ) = 2.43 years
Creighton, Inc. has invested $2,165,800 on equipment. The firm uses payback period criteria of not accepting any project that takes more than four years to recover costs. The company anticipates cash flows of $424,386, $512,178, $561,755, $764,997, $816,500, and $825,375 over the next six years. What is the payback period, and does this investment meet the firm’s payback criteria?
Year 1:
Cumulative Cash Flow = $424,386
Remaining Investment = $2,165,800 - $424,386 = $1,741,414
Year 2:
Cumulative Cash Flow = $424,386 + $512,178 = $936,564
Remaining Investment = $2,165,800 -$936,564
Year 3:
Cumulative Cash Flow = $936,564 + $561,755 = $1,498,319
Remaining Investment = $2,165,800 - $1,498,319 = $667,481
Year 4:
Cumulative Cash Flow =
$1,498,319 + $764,997 = $2,263,316
Since $2,263,316 exceeds the initial investment, the payback period occurs during year 4
$667,481 / $764,997 = 0.872 + 3 = 3.87 years; yes
