Reading 31: capital investments Flashcards
Which of the following is most likely a going concern project?
Opening a retail outlet in a new region.
Acquiring and merging with a supplier to secure a source for a key component.
Purchasing a new model of a factory machine that will decrease unit production costs.
Going concern projects are those to maintain the business or to increase the efficiency of existing operations. The other two projects are business growth investments that increase the size of the company. (LOS 31.a)
In the capital allocation process, a post-audit is used to:
improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts.
improve cash flow forecasts and eliminate potentially profitable but risky projects.
stimulate management to improve operations, bring results into line with forecasts, and eliminate potentially profitable but risky projects.
A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations. (LOS 31.b)
Which of the following statements concerning the principles underlying the capital allocation process is most accurate?
Cash flows should be based on opportunity costs.
Financing costs should be reflected in a project’s incremental cash flows.
The net income for a project is essential for making a correct capital allocation decision.
Cash flows are based on opportunity costs. Financing costs are recognized in the project’s required rate of return. Accounting net income, which includes non-cash expenses, is irrelevant; incremental cash flows are essential for making correct capital allocation decisions. (LOS 31.b)
A manufacturer of clothes washing machines decides to add matching clothes dryers to its product line. In this case, it is most likely important in the project analysis to consider:
cannibalization.
positive externalities.
sunk costs.
It is quite possible that offering a matching dryer will increase sales of their washers, because some consumers will prefer a matching set. The increased sales of their washers is a positive externality, and those incremental sales should be considered in the analysis. Cannibalization would be a consideration if the introduction of dryers was expected to decrease washer sales. Sunk costs should not be considered in project analysis. (LOS 31.b)
A company is considering the purchase of a copier that costs $5,000. Assume a required rate of return of 10% and the following cash flow schedule:
Year 1: $3,000.
Year 2: $2,000.
Year 3: $2,000.
The project’s NPV is closest to:
–$309.
+$883.
+$1,523.
CF0 = –5,000; CF1 = 3,000; CF2 = 2,000; CF3 = 2,000; I / Y = 10; NPV = $883. (LOS 31.c)
A company is considering moving its manufacturing facilities to either Texas or South Carolina to decrease taxes and labor costs. After estimating all the relevant incremental after-tax cash flows of each move, an analyst estimates the IRR of a move to Texas to be 13% and the IRR of a move to South Carolina to be 15%. If the appropriate discount rate to evaluate the moves is 14%, the analyst:
can conclude that the move to South Carolina should be undertaken.
cannot conclude that the move to South Carolina should be undertaken because the two moves are mutually exclusive.
may find that the move to Texas is preferable when projects are ranked by their NPVs.
Based on the IRRs, the move to South Carolina will have a positive NPV (the IRR is greater than the discount rate) and the move to Texas will have a negative NPV. In this case, we can rank the two projects based on their IRRs. If the appropriate discount rate was less than both IRRs, for example, 10%, the IRR rankings could not reliably be used to choose between the two proposed moves. (LOS 31.c)
An analyst is estimating the NPV of a project to introduce a new spicier version of its well-known barbeque sauce into its product line. A cost that should most likely be excluded from his analysis is:
$200,000 to develop a recipe for the new sauce.
a $150,000 decrease in sales of its current sauce as some current customers switch to the spicier sauce.
$100,000 for a marketing survey that was conducted to determine demand for a spicier sauce.
The cost of the marketing survey should not be included because it is a sunk cost; it will be incurred whether they decide to do the project or not. The decrease in sales of their current sauce if the spicier version is introduced (cannibalization) should be considered in the analysis. The cost of recipe development should be included because it will only be incurred if they decide to go ahead with the introduction of the new spicier sauce. (LOS 31.d)
Fullen Machinery is investing $400 million in new industrial equipment. The present value of the future after-tax cash flows resulting from the equipment is $700 million. Fullen currently has 200 million shares of common stock outstanding, with a current market price of $36 per share. Assuming that this project is new information and is independent of other expectations about the company, what is the theoretical effect of the new equipment on Fullen’s stock price? The stock price will:
decrease to $33.50.
increase to $37.50.
increase to $39.50.
The NPV of the new equipment is $700 million − $400 million = $300 million. The NPV of this project is added to Fullen’s current market value. On a per share basis, the addition is worth $300 million / 200 million shares, for a net addition to the share price of $1.50. $36.00 + $1.50 = $37.50. (LOS 31.e)
Albert Duffy, a project manager at Crane Plastics, is considering taking on a new capital project. When presenting the project, Duffy shows members of Crane’s executive management team that because the company has the ability to have employees work overtime, the project makes sense. The project Duffy is taking on would be best described as having:
a fundamental option.
an expansion option.
a flexibility option.
The project described has a production-flexibility regarding the level of production. Other flexibility options might be to produce a different product or to use different inputs at some future date. Including the value of real options can improve the NPV estimates for individual projects. (LOS 31.f)
A company is considering building a distribution center that will allow it to expand sales into a new region comprising three provinces. John Parker, a firm analyst, has argued that the current analysis fails to incorporate the amount they could get from selling the distribution center at the end of year 2, rather than operating it to the end of the project’s assumed economic life. Parker is suggesting that:
the assumed investment horizon is too long.
the analysis should include the value of a put option.
the analysis should include the value of a call option.
The option to abandon the project and receive the market value of the facility if actual cash flows are less than expected over the first two years can be viewed as a valuable put option that should be included in the calculation of the project’s NPV. (LOS 31.f)
