Alliance is considering automating their production process to become more efficient. In order to do so they will buy a new monorail manufacturing system at a cost of $500,000. The system will be depreciated using seven-year MACRS (15%, 25%, 17%, 12%, 9%, 9%, 9%, 4%). The system will be sold in five years for $200,000. If they buy the system they will Trade In their current trolleys for $100,000. The trolleys were originally bought four years ago for $500,000 and are being depreciated using straight-line depreciation over five years. If Alliance does not replace the trolleys, they will be kept for the next five years when they will be sold for $10,000. The new system will not affect Alliance's sales but will reduce Costs of Goods Sold by $1,000,000. However, Fixed Costs will rise by $50,000 per year if the monorail system is installed. The tax rate is 40%. What are the incremental cash flows associated with this proposed project?
Balance Sheet Effects |----------Depreciation Expenses-------------|
Today Year 1 Year 2 Year 3 Year 4 Year 5 End
1. Buy New Assets
2. Trade In Old Assets
3. Keep Old Assets
4. Change in NWC
Income Statement Effects
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales
- Net COGS
- Net Depreciation
- Net Fixed Costs
= Net OEBT
- Net Taxes
= Net OEAT
+ Net Depreciation
= Net Operating CF
Total Cash Flows
CF0 =
C01 =
C02 =
C03 =
C04 =
C05 =
C06 =
1. What is the Initial Cost of this project?
$300,000
$400,000
$500,000
$600,000
2. What is net depreciation expense on the income statement in Year 1?
-$75,000
-$25,000
$100,000
$175,000
3. What is the After Tax Salvage Value of selling the equipment at the end?
$164,000
$182,000
$218,000
$236,000
4. What is the Operating Cash Flow in Year 2
$430,000
$510,000
$560,000
$620,000
5. What is the NPV of this project?
$500,000
$1,000,000
$1,500,000
$2,000,000
Kaffie Frederick is considering an expansion of it's operations by introducing a new product line. In order to expand, they will have to buy new machinery for $1,000,000. The machinery will be depreciated using three-year MACRS (33%, 45%, 15%, 7%). In four years they will be able to sell the machinery for $250,000. If they go through with the planned expansion, Sales of the new product will be $750,000 per year and sales of the old product will rise by $50,000 per year. Variable Costs on the new product are 75% of new product sales while variable costs on the old product are 65% of old product sales. The new project will require additional fixed costs of $20,000 per year. The tax rate is 40%. What are the incremental cash flows associated with this proposed project?
Balance Sheet Effects |----------Depreciation Expenses-------------|
Today Year 1 Year 2 Year 3 Year 4 Year 5 End
1. Buy New Assets
2. Trade In Old Assets
3. Keep Old Assets
4. Change in NWC
Income Statement Effects
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales
- Net COGS
- Net Depreciation
- Net Fixed Costs
= Net OEBT
- Net Taxes
= Net OEAT
+ Net Depreciation
= Net Operating CF
Total Cash Flows
CF0 =
C01 =
C02 =
C03 =
C04 =
C05 =
C06 =
6. What is the Initial Cost of this project?
$500,000
$1,000,000
$1,500,000
$2,000,000
7. What is net depreciation expense on the income statement in Year 1?
$175,000
$250,000
$330,000
$475,000
8. What is the After Tax Salvage Value of selling the equipment at the end?
$110,000
$150,000
$175,000
$215,000
9. What is the Operating Cash Flow in Year 2
$238,000
$291,000
$363,000
$422,000
10. What is the IRR of this project?
0%
5%
10%
15%
A company plans to introduce a new product and are trying to decide what size of factory to build. If the product is successful, then they will want to build a big factory, but if the product is not a success, then they will wish they had built a smaller factory or none at all. There is a 50% chance of the product being a success. The cash flows associated with each outcome are given below. The WACC of a small factory is 7% and the WACC for a large factory is 8% due to the greater risk.
Small Factory Large Factory
Not a success Success Average Not a success Success Average
Today -9000 -9000 -9000 -12000 -12000 -12000
Year 1 1600 2000 1800 1600 4000 2800
Year 2 1700 3000 2350 1800 5000 3400
Year 3 2000 4000 3000 2100 6500 4300
Year 4 2200 5000 3600 2300 9000 5150
1. What should the company do?
a. Reject both Projects
b. Build a small factory
c. Build a large Factory
2. What is the expected NPV of building the small factory?
a. -115 b. -70 c. 84 d. 223
3. What kind of option does this project represent?
a. Expansion
b. Timing
c. Flexibility
d. Shutdown
4. Which of the following is an example of a flexibility option?
a. A company has the option to invest in a project today or to wait a year.
b. A company has the option to back out of a project that turns out to be unproductive.
c. A company pays a higher cost today in order to be able to reconfigure the project's inputs or outputs at a later date.
d. A company invests in a project today that may lead to enhanced technological improvements that allow it to expand into different markets at a later date.
5. Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $4,000 at the end of each of the next 4 years. Each project has a WACC of 8%. Use the replacement chain approach to determine the NPV of the most profitable project.
a. $3,248
b. $3,734
c. $4,484
d. $5,197
6. The firm has the following projects available to them:
Project IRR Cost
A 18% $5,000,000
B 16% $4,000,000
C 14% $3,000,000
D 12% $2,000,000
E 10% $1,000,000
It can raise the following amounts at different costs of capital.
WACC Amount Raised
9% $10,000,000
11% $12,000,000
13% $15,000,000
Which set of projects would maximize shareholder wealth?
a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
7. Kish Consolidated has two divisions of equal size: a computer division and a restaurant division. Its CFO believes that stand-alone restaurant companies typically have a WACC of 8%, while stand-alone computer companies typically have a 12% WACC. Consequently, Kish estimates that its average WACC is 10%. If Kish uses the 10% WACC for all projects in both divisions, then which of the following would occur?
a. Kish would accept too many projects in the computer division and not enough projects in its restaurant division resulting in lost value to shareholders.
b. Kish would accept too many projects in the restaurant division and not enough projects in its computer division resulting in lost value to shareholders.
c. Kish would be maximizing shareholder wealth by accepting only those projects which exceed their average WACC
d. None of the above
8. The relative risk of a proposed project is best accounted for by
a. Adjusting the discount rate upward if the project is judged to have above average risk.
b. Adjusting the discount rate downward if the project is judged to have above average risk.
c. Reducing the NPV by 10% for risky projects.
d. Picking a risk factor equal to the average discount rate.
9. Which of the following statements is CORRECT?
a. Using MACRS depreciation rather than straight line would normally have no effect on a project's total projected cash flows but would affect the timing of the cash flows and thus the NPV.
b. Under current laws and regulations, corporations must use straight line depreciation for all assets whose lives are 10 years or longer.
c. Corporations must use the same depreciation method (e.g., straight line or MACRS) for stockholder reporting and tax purposes.
d. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
10. Which of the following statements is CORRECT?
a. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.
b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits of the bank's other offices to decline.
c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
11. Merlin Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Merlin evaluates low-risk projects with a WACC of 8%, average projects at 10%, and high-risk projects at 12%. The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12
C High 11
D Low 9
E Low 6
Which set of projects would maximize shareholder wealth?
a. A and B.
b. A, B, and C.
c. A, C, and D.
d. A, B, and D.
12. Which of the following statements is CORRECT?
a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.
b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
c. Well-diversified stockholders do not need to consider market risk when determining required rates of return.
d. Simulation analysis is a computerized version of scenario analysis where input variables are selected based on their probability distributions.
13. Which of the following is NOT considered a relevant concern in determining incremental cash flows for a new product?
a. The use of high quality factory floor space that is currently unused but is available for production of other products.
b. Revenues from an existing product that would be lost as a result of customers switching to the new product.
c. Shipping and installation costs associated with preparing the machine to be used to produce the new product.
d. The cost of a marketing study completed last year related to the new product. This costs was expensed for tax purposes last year.
14. The firm has the following projects available to them, but they can only spend $10,000,000.
Project IRR Cost NPV at 9% WACC
A 18% $3,000,000 400,000
B 16% $6,000,000 600,000
C 14% $5,000,000 500,000
D 12% $1,000,000 100,000
E 10% $4,000,000 300,000
Which set of projects would maximize shareholder wealth?
a. A and B.
b. B, C, and D.
c. A, B, and D.
d. C, and E.