Quiz #5: Module 3, Chapters 10-12 I2MBAF14 FIN 5405 J. Houston NPV sensitivity to WACC 1. Last month, Harvey Corporation analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firms WACC. The Feds action did not affect the forecasted cash flows. By how much did the change in the WACC affect the projects forecasted NPV? Old WACC: 9.00% New WACC: 10.50% Year 0 1 2 3 Cash flows -$1,000 $410 $410 $410 Relevant cash flows 2. Which of the following rules is CORRECT for capital budgeting analysis? a. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. b. The interest paid on funds borrowed to finance a project must be included in estimates of the projects cash flows. c. If a product is competitive with some of the firms other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firms other products, this fact need not be reflected in the analysis. d. A proposed projects estimated net income as determined by the firms accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the projects cost, the project should be accepted. e. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the projects other costs when reaching the accept/reject decision. WACC calculation 3. Assume that you are on the financial staff of Chandler Enterprises, and you have collected the following data: (1) The yield to maturity on the companys outstanding 8% annual coupon bonds is 6.0%, and its tax rate is 35%. (2) The risk-free rate is 4%, the market risk premium (rM rRF) is 6%, and the firms beta is 1.1. (3) The firms capital structure consists of 30% debt and 70% equity. What is Chandlers WACC? NPV, constant CFs, NOWC, salvage value 4. Alfredson Inc. is considering a new investment whose data are shown below. The required equipment has a 3-year tax life and would be fully depreciated by the straight-line method over the 3 years, but it would have a positive salvage value at the end of Year 3, when the project would be closed down. Also, some new net operating working capital would be required, but it would be recovered at the end of the projects life. Revenues and other operating costs are expected to be constant over the projects 3-year life. What is the projects NPV? WACC 11% Net equipment cost (depreciable basis) $75,000 Required new NOWC $12,500 Straight line depreciation rate 33.33% Sales revenues $110,000 Operating costs excluding depreciation $45,000 Expected pretax salvage value $7,500 Tax rate 40% NPV vs IRR 5. Tyler Industries is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by cho
osing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause no value to be lost. (Note: A negative answer to this problem indicates that value is added not forgone.) WACC = 10% Year: 0 1 2 3 4 CFS: -$1,200 $500 $730 $300 $ 40 CFL: -$1,200 $210 $460 $550 $500 NPV, SL depreciation, constant CFs 6. Camden Industries is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over the projects 3-year life, and would have zero salvage value. No new net operating working capital would be required. Revenues and other operating costs are expected to be constant over the projects 3-year life. What is the projects NPV? WACC 11% Net investment cost (depreciable basis) $75,000 Straight line depreciation rate 33.33% Sales revenues $110,000 Operating costs excluding depreciation $45,000 Tax rate 40% MIRR 7. Jacobs Industries is considering a project that has the following cash flow and WACC data. What is the projects MIRR? WACC = 10% Year: 0 1 2 3 Cash flows: -$2,000 $600 $800 $1,250 Cost of capital concepts 8. Which of the following statements is CORRECT? a. gher flotation costs tend to reduce the cost of equity capital. b. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. c. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. d. If a company assigns the same cost of capital to all of its projects regardless of each projects risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. e. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. Crossover rate 9. Dalrymple Company is considering Projects A and B with the cash flows shown below. The firms WACC is 10%. There have been discussions within the company about which capital budgeting decision rule should be used to determine the better project. A staff person has suggested that the crossover rate should be calculated so the firm has more information. What is the crossover rate for these two projects? In other words, at what discount rate are the NPVs of these two projects equal? 0 1 2 3 4 5 Project A -$ 650 $300 $260 $200 $ 50 $100 Project B -$1,325 $220 $245 $500 $550 $325 Discounted payback 10. Isaacson Inc. is considering a project that has the following cash flow and WACC data. What is the projects discounted payback? WACC: 8.00% Year 0 1 2 3 4 Cash flows -$950 $525 $485 $445 $405