1. Which of the following statements is most correct, assuming that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows?
a. If the project’s internal rate of return (IRR) exceeds the cost of capital, then the project’s net present value (NPV) must be positive.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the cost of capital.
d. None of the statements above is correct.
2. Mills Mining is considering an expansion project. The proposed project has the following features:
The project has an initial cost of $500,000. This is also the amount that can be depreciated using the following depreciation schedule:
MACRS
Depreciation
Year Rates
1 0.33
2 0.45
3 0.15
4 0.07
If the project is undertaken, at t = 0 the company will need to increase net operating capital by $60,000. This net operating working capital will be recovered at the end of the project’s life (t = 4).
If the project is undertaken, the company will realize an additional $600,000 in sales over each of the next four years (t = 1, 2, 3, and 4). The company’s operating costs (not including depreciation) will equal $400,000 a year.
The company’s tax rate is 40 percent.
At t = 4, the project’s economic life is complete, but it will have a salvage value (before-tax) of $50,000.
The project’s WACC is 10 percent.
The company is very profitable, so any accounting losses on this project can be used to reduce the company’s overall tax burden.
3. How much is the total initial investment outlay (total cash flow at t = 0)?
a. $60,000
b. $440,000
c. $500,000
d. $560,000
4. How much is the after-tax salvage value?
a. $20,000
b. $30,000
c. $50,000
d. $95,000
5. What is the project’s net present value (NPV)?
a. $11,122.87
b. $48,336.86
c. $54,676.59
d. $68,336.86
e. $80,035.52
6. Pickles Corp. is a company that sells bottled iced tea. The company is thinking about expanding its operations into the bottled lemonade business. Which of the following factors shouldn’t the company incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade business?
a. If the company enters the lemonade business, its iced tea sales are expected to fall 5 percent as some consumers switch from iced tea to lemonade.
b. Two years ago the company spent $3 million to renovate a building for a proposed project that was never undertaken. If the project is adopted, the plan is to have the lemonade produced in this building.
c. If the company doesn’t produce lemonade, it can lease the building to another company and receive after-tax cash flows of $500,000 a year.
d. None of the statements above is correct.