FINANCE 634

Fall 1992 Exam 2

Part 2

Multiple Choice - 2 Points per Question

1. In calculating the incremental annual cashflow in a capital budgeting decision, interest expense on a loan needed to finance the acquisition of a new asset should be included as a cash flow only if the purchase of the new asset requires additional borrowing over and above the level of debt that would be required without the new asset.

2. The steeper the slope of an NPV profile, the greater the sensitivity of the NPV to changes in the discount rate.

3. For a given project, an IRR greater that the cost of capital means that the NPV must be positive for all discount rates greater than the IRR.

4. NPV profiles are always downward sloping, but the slope will be steeper or flatter depending on the behavior of the project's cashflows.

5. The selection of projects with the highest IRR will always result in the selection of projects with the highest NPV.

6. The payback period method of project evaluation has a built-in bias against long-lived projects.

7. The flatter the slope of an NPV profile, the higher the IRR for the project.

8. Projects that have larger cashflows in the earlier years and smaller cashflows in later years will have flatter (less steep) NPV profiles than projects with smaller cashflows in the earlier years and larger cashflows in later years.

9. When a depreciable asset is sold, it will produce a taxable expense if the selling price is greater than the asset's book value at the time of the sale.

10. If the depreciation for a firm with a 40% tax rate increases by $1,000 for the year, the firm will have $600 less in net income but it will have $400 more in cash.

11. The equivalent annual annuity is calculated as follows:

13. Other things equal, the use of straightline depreciation will result in a higher present value for a project's cashflows than will the use of modified ACRS depreciation.

14. The main difficulty in using simulation is the difficulty of identifying the interrelationships between and among the inputs.

15. The discounted payback period method of project evaluation ignores the time value of money during the payback period and ignores cashflows after the payback period.

16. If we find the present value of real cash flows using a nominal required return for the discount rate, we will underestimate inflation in periods of high inflation.

17. The average rate or return method of project evaluation ignores the time value of money.

18. When a single project is being analyzed, the NPV, IRR, and MIRR methods will all lead to the same accept or reject decision.

19. Both the NPV and IRR methods assume that cashflows are reinvested at the firm's cost of capital.

20. Multiple IRRs result in all cases where a project has more than one negative cash flow.

21. The MIRR method always gives the right ranking of mutually exclusive projects while the IRR method may not give the right ranking.

22. A project has an initial investment of $297,000. Cash flows at the end of years 1, 2, and 3 are $100,000, $200,000, and $150,000 respectively. The internal rate of return for this project is betwen 20% and 25%.

23. The IRR reinvestment rate assumption is more conservative than the MIRR reinvestment rate assumption.

24. The MIRR for a project will always be lower that the IRR for the same project.

25. Setting the IRR hurdle rate above the firm's cost of capital is a good idea because it encourages managers to be aggressive in seeking out high return projects.

Problems - Points as marked

1. Columbia books plans to begin a new product line making entire novels available on their book-shaped computers. The computers fold like a book and the reader simply downloads the latest best seller at a much lower price than hard-cover paper editions. The start-up costs include an initial price tag of $275,000. The firm estimates it will have to upgrade its hardware spending an additional $225,000 in the fourth year of the project's seven-year life. The firm expects that the project will generate $150,000 in after-tax operating cash flows (not including the hardware upgrade) in each of the project's seven years. The company's cost of capital is 11%. Show how you would use the Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return to evaluate this project. Indicate the decision that would result with each of the four methods. [12 Points]

2. A company is considering expanding its production of one product by replacing an existing production line with a newer and more efficient one. The existing equipment was purchased two years ago for $400,000 and is being depreciated using the straight-line method over 4 years (two years remaining) to a zero book value at the end of the fourth depreciation year. This equipment has a current market value of $300,000. This equipment requires a constant investment in net working capital of $125,000. If this equipment is used for three more years, it is expected to have a market value of $100,000 at the end of that time. This equipment generates $230,000 in annual revenue and $150,000 in annual expenses.

The proposed new equipment has cost of $800,000 and will be depreciated by 3-year ACRS-class rules using these percentages (.3334 in the first year, .4444 in the second year, .1481 in the third year) over the THREE years that the line will be used. This equipment requires a constant investment in net working capital of $100,000. If this equipment is used for three more years, it is expected to have a market value of $75,000 at the end of that time. Delivery, installation, and setup costs for the new equipment will total $125,000 in one-time costs. This new equipment is expected to generate $430,000 in annual revenue and $100,000 in annual expenses.

The company's marginal tax rate is 28%. The appropriate discount rate is 12.0%. Answer the following questions. Show all relevant work in the space provided here. LABEL EVERYTHING CLEARLY.

a. Net Cash Outlay at t=0: $_______________ [8]

b. Net Cash Flow at t=1: $_________________ [15 Total]

Net Cash Flow at t=2: $_________________

Net Cash Flow at t=3: $_________________

Based on your answers above, determine:

c. Modified Internal Rate of Return: _________________ [5]

d. Equivalent Annual Annuity: _______________________ [5]

e. What is the minimum annual revenue on the new equipment needed to produce a positive NPV for the project?

[5] Answer: ______________________

Answers:

1=F, 2=T, 3=F, 4=F, 5=F, 6=T, 7=F, 8=T, 9=T, 10=T, 11=F, 12=T, 13=F, 14=T, 15=F, 16=T, 17=T, 18=T, 19=F, 20=F, 21=F, 22=T, 23=F, 24=F, 25=F

Problem 1: NPV=$283,610 (Accept), PI=2.031 (or 1.031) Accept, IRR cannot be used because ther is more than one, MIRR=22.83%.

Problem 2: CF(0)=-593,000, CF(1)=226,682, CF(2)=251,546, CF(3)=186,773.

[c] 8.28%, [d] -23,788, [e] 213,038.40.