A)Start up of a Baseball Manufacturing Plant

Assignment #1

MULTIPLE-CHOICE QUESTIONS are designed to test general understanding of a variety of concepts, as well as knowledge of various specific points.

Which of the following project would likely have the least (if any) effect on net working capital?

____

A)Start up of a baseball manufacturing plant

B)Setting up retail outlets to sell your own manufactured products that you have previously wholesales to others

C)Doubling the size of your retail floor space in order to accommodate new product lines

D)Converting a manufacturing process from manual labor to automatic production

E)Using long-term bank credit to reduce payables enabling you to better take advantage of trade discounts

Consider the following data for a new capital project: equipment cost of $10,000, installation of equipment at $1,000, and inventory of spares with $2,000. Also, this project will use a freezer that cost $5,000 to install 5 years ago, with no alternative use now, having a zero market value. The initial investment outlay of the new project is

____

A)$18,000

B)$13,000

C)$12,000

D)$11,000

E)$10,000

Your company currently sells standard tennis rackets. The board of directors wants you to look at introducing a new line of oversized rackets. Which of the following are irrelevant costs?

____

A)$100,000 spent on R&D last year on oversized rackets

B)$300,000 drop in sales of standard size rackets when the oversized are introduced

C)Land the company already owns, but which may be used for this project, has a market value of $700,000

D)All of the above

E)None of the above

(The following information relates to Questions 4 and 5)

A firm in the 40% corporate tax bracket has two asset pools. There is no other asset left in Pool B after the sale.

Asset Pool A / Asset Pool B
Existing un-depreciated capital cost (UCC) / $150 / $350
Assets sold
Original cost / $400 / $100
Proceeds from sales / $450 / $300

What is the CCA recapture for Pool A and its total tax liability, if any?

____

A)$100; $0

B)$250; $100

C)$300; $180

D)$300; $50

E)$250; $110

How much is the terminal loss for Pool B?

____

A)$250

B)$200

C)$100

D)$50

E)Undetermined

Given the depreciable base C0 = $250, CCA rate d = 20%, corporate tax rate Tc = 40%, and year 2 project operating income (S – C) = $150,estimate the operating cash flow (OCF) at the end of year 2. The half-year rule applies when calculating the CCA deduction.

____

A)$250

B)$190

C)$108

D)$90

E)None of the above

Hint:OCFt = (St – Ct)(1 – Tc) + (CCAt)(Tc)

(The following information relates to Questions 7 to 9)

You are considering an investment in a process that promises to save you $75 every year. This process has an economic life of four years with a cost of $100. Such a capital cost is depreciated to zero with the straight-line method. Assume a 34% corporate tax rate and a discount rate of 10%.

What is the value of tax shields in each period that arises from the investment in this process?

____

A)$16.50

B)$26.95

C)$34.00

D)$8.50

E)None of the above

What is the (total) annual operating cash flow over the life of the project?

____

A)$49.50

B)$58.00

C)$75.00

D)$83.50

Hint:

What is the NPV of the investment in this process?

____

A)$62.25

B)$83.85

C)$114.50

D)$132.00

Hint:

Which of the following will NOT decrease the present value of the CCA tax shields associated with a capital investment project?

____

A)A decrease in the corporate tax rate

B)An increase in the discount rate

C)A decrease in the CCA rate

D)All of the above

E)None of the above

Hint:

If a project is expected to reduce inventory by $150, increase accounts payable by $100 and increase accounts receivable by $10, what kind of effect does working capital have during the life of the project?

____

A)Reduce investment outlay by $240

B)Reduce investment outlay by $60

C)Raise investment outlay by $40

D)Working capital has no effect during the life of this project

Hint:

M&M is considering the purchase of a new machine for $50,000, installed. M&M will use the CCA method to depreciate the machine. This machine is included in CCA class 8 (20%). MM expects to sell the machine at the end of its 4-year operating life for $10,000. If M&M’s tax rate is 40%, what will the present value of the CCA tax shield when it disposes of the machine at the end of year 4? Assume that the relevant discount rate is 10%.

____

A)$10,905

B)$9,059

C)$9,400

D)$8,930

E)$1,822

Consider a project with real cash flows (RCF) given below.

Year / 0 / 1 / 2 / 3
Real Cash Flow / -$30 / $10 / $15 / $20

The expected inflation rate (πe) is 5% a year and the nominal discount rate (k) is 15.5%. What is the NPV?

____

A)$2.88

B)$6.52

C)$10.40

D)-$16.50

Hint:

Which of the following is TRUE for capital budgeting analysis?

____

A)The interest paid on funds borrowed to finance a project must be included in the project’s estimated cash flows

B)Only incremental cash flows are relevant when making accept/reject decisions

C)Since sunk costs are excluded from the annual cash flow calculation, they must be deducted from the present value of the project’s other costs when reaching the accept/reject decision

D)All of the above

E)None of the above

ABC Co. is considering a new project whose data are shown below. The equipment has a constant capital cost allowance (CCA) over its 3-year life with a zero salvage value. No new working capital will be required. Revenues and cash operating costs are expected to be constant over the project’s 3-year life. However, this project would compete with other ABC products and would reduce their pre-tax annual cash flows. What is the project’s NPV?

Relevant discount rate10%

Pre-tax cash flow reduction in other products

(cannibalization)$5,000

Investment cost$65,000

Annual CCA$21,665

Annual sales revenues$75,000

Annual cash operating costs$25,000

Corporate tax rate35%

____

A)$25,269

B)$26,599

C)$27,929

D)$29,325

Hint:Cash flows are constant in years 1 to 3. The proposed CCA is for computational convenience although the actual CCA varies in years 1 to 3.

XYZ Inc. is considering investing in some new projection equipment whose data are shown below. The required equipment has a 7-year project life falling into a CCA class of 30%, but it would have a positive pre-tax salvage value at the end of year 7. Also, some new working capital will be needed, but it can be recovered at the end of the project’s life. Revenues and cash operating costs are expected to be constant over the project’s 7-year life. What is the NPV?

Relevant discount rate12%

Net capital investment in fixed assets$950,000

Required new working capital$30,000

Sales revenues, each year$580,000

Cash operating costs, each year$330,000

Expected pre-tax salvage value$50,000

Corporate tax rate35%

____

A)$13,965

B)$15,226

C)$16,910

D)$17,882

Hint:

NPV = PV(project’s CF) + PV(tax shield) + PV(ending CF) – initial investment

Which of the following is true regarding externalities?

____

A)If a project can create employment in a depressed region, firm should include such an externality in its NPV calculations

B)If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward

C)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

D)Sometimes analysts think that an externality is present in a project, but they recognize that the particular externality cannot be quantified with any precision – estimates of its effect would really just be guesses. In such a situation, the externality should be ignored, i.e. not considered at all, because if it were considered it would make the analysis appear more precise than it actually is

E)None of the above

Which of the following is true about capital cost allowance (CCA)?

____

A)Since CCA deduction is not a cash expense, it plays no role in capital budgeting

B)The CCA method uses a specific mandated CCA rate for each asset class

C)The CCA deduction is equal to the year-end UCC of the pool divided by the mandated CCA rate

D)The CCA method allows that the net capital cost of an asset is added to the pool in the year the asset is put in use.

E)Under the CCA method, higher CCA deductions occur in the early years. This reduces the early cash flows and thus lowers a project’s projected NPV

What is the net operating cash flow in a particular year for a proposed project with the following data?

Sales revenues$35,000

Capital cost allowance, CCA$10,000

Cash operating costs$17,000

Interest expense$4,000

Tax rate35%

____

A)$12,380

B)$13,032

C)$14,440

D)$15,200

DEF ltd. Is building a manufacturing plant that will require a cash outlay of $300,000 for the initial purchase of a building, $450,000 for remodeling in first year, and $710,000 for new equipment in the second year. If the firm’s discount rate is 12%, what will be the total investment cost at time zero?

____

A)$300,000

B)$1,460,000

C)$1,267,720

D)$1,132,070

A decision tree shows a 30% probability of $2 million in returns and a 70% chance of $1 million in returns. What is the maximum you would invest today in this project if the cash inflow occurs one year in the future and the discount rate is 10%?

____

A)$818,182

B)$1,181,818

C)$1,300,000

D)$1,363,636

Which of the following sources would most likely be responsible for persistent “project cost overruns”?

____

A)Rapidly rising inflation

B)Delays in obtaining contracts and permits

C)Lack of raw materials

D)Forecasting bias by the sponsoring manager

What is the NPV break-even for a project costing $4 million and generating cash flows according to (0.3 ×sales - $450,000)? Assume this project lasts for ten years and requires a discount rate of 12%.

____

A)$2,093,654

B)$2,359,047

C)$3,859,798

D)$13,783,333

Hint: PVIFA (12%, 10) = 5.65

If a 20% reduction in forecast sales would not extinguish a project’s profitability, then sensitivity analysis would suggest

____

A)De-emphasizing that variable as a critical factor

B)Requiring a more detailed sales forecast

C)The initial sales forecast were inflated

D)A reallocation of fixed costs to this project

What happens to the NPV of a one-year project if fixed costs increase from $400 to $600? The firm has a 15% tax rate and a 12% cost of capital.

____

A)NPV decreases by $200.00

B)NPV decreases by $173.91

C)NPV decreases by $130.00

D)NPV decreases by $113.04

A firm has to select a project from among four mutually exclusive projects with the risk/return characteristics in the table below. Which of the following statements BEST describes how this selection should be made?

Project / A / B / C / D
Expected Return / 23% / 15% / 18% / 20%
Standard Deviation / 12% / 7.69% / 8.23% / 10.67%

____

A)Project A should be chosen because it has the highest expected return

B)Project B should be selected because it has a standard deviation of only 7.69%

C)Project C should be accepted because it has the lowest coefficient of variation

D)Project D should be picked because it has the highest coefficient of variation

Which of the flowing technique may be more appropriate to analyze projects with interrelated variables?

____

A)Sensitivity analysis

B)Scenario analysis

C)Breakeven analysis

D)Decision tree analysis

What is the maximum percentage of variable costs in relation to sales that a firm can experience and still break even with $5 million revenues, $1 million fixed costs and $500,000 depreciation?

____

A)60%

B)70%

C)80%

D)90%

Hint:EBIT = S – C - D

Economic value added

____

A)Aligns the decision-making process with the objective of profit maximization

B)Aligns the decision-making process with the objective of share price maximization

C)Aligns the decision-making process with the objective of value maximization

D)Aligns the decision-making process with the objective of cost minimization

ABC Co. is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV would be negative. No competitors are likely to invest in a similar project if ABC decides to wait. Which of the following best describes the issues that ABC faces when considering this investment timing option?

____

A)The more uncertainty about the future cash flows, the more logical it is for ABC to go ahead with this project today

B)Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year

C)With a positive expected NPV today, the project should be accepted in order to lock in that NPV

D)Waiting would probably reduce the project’s risk

Which of the following is not a real option?

____

A)The option to expand production if the product is successful

B)The option to buy shares of stock if its price goes up

C)The option to expand into a new geographic region

D)The option to switch the type of fuel used in an industrial furnace

E)None of the above

Which of the following is true about real options?

____

A)Real options affect the size, but not the risk, of a project’s expected cash flows

B)Real options are most valuable when the underlying source of risk is very low

C)Real options are rights to buy real assets, like stocks, rather than interest-bearing assets, like bonds

D)All of the above

E)None of the above

Generally, the existence of a(n) ___ option reduces the downside risk of a project and should be considered in project analysis.

____

A)Abandonment

B)Flexibility

C)Timing

D)Growth

If an asset consistently goes up (down) by 1.2% when the market portfolio goes up (down) by 1.6%, then its beta equals

____

A)0.75

B)1.33

C)1.92

D)Undetermined

Hint:

What is the beta for a portfolio with 60% invested in X and 40% invested in Y?

Stock X / Stock Y
Expected Return / 14% / 18%
Standard Deviation / 40% / 54%
Beta / 1.2 / 1.5
Correlation (X, Y) = 0.25

____

A)1.42

B)1.32

C)1.22

D)1.12

Hint:

What is the beta of the risk-free asset?

____

A)+1.0

B)0

C)-0.5

D)-1.0

A common stock has a beta of 0.9, the risk-free rate is 7% and the market risk premium is 3%. If the rate of return is expected to be 8.5%, this stock has been ____ and its price would ____.

____

A)under-priced; rise

B)under-priced; fall

C)over-priced; rise

D)over-priced; fall

Stock X with a beta of 2 has a required return of 15% when the return on the average asset is 10%. Now, the return on the average asset increases to 13%. What will be the percentage in return on this stock according to the capital asset pricing model (CAPM)?

____

A)Undetermined due to insufficient information

B)21.0%

C)16.5%

D)9.4%

Hint:

A project requires an initial investment outlay of $3,335 and produces cash inflows of $925 for each of five years. If it has a zero NPV and the risk-free rate is 6%, what is the implied risk premium?

____

A)6%

B)4%

C)8%

D)10%

E)12%

Hint:

The value of a negative beta asset is

____

A)The higher expected return of this asset

B)Non-existent because negative beta assets are theoretically impossible

C)The risk reducing property when added to a portfolio

D)That it is a necessary component to have a fully diversified portfolio

E)None of the above

As the number of securities in a portfolio increases, the amount of systematic risk

____

A)Remains constant

B)Decreases

C)Increases

D)Changes up and down

Utilizing the security market line (SML), an investor owning a stock with a beta of -2 would expect the stock’s return to ____ in a market that was expected to decline 15%.

____

A)Rise or fall an indeterminate amount

B)Fall by 3%

C)Fall by 30%

D)Rise by 13%

E)Rise by 30%

An increase in the risk-adjusted discount rate (RADR) for a risky project will result in

____

A)No change to the NPV

B)An increase in the IRR

C)An increase in the NPV

D)A decrease in the NPV

XYZ Inc. has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk. XYZ 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, B, and C

B)A, B, and D

C)A, B, C, and D

D)A, B, C, D, and E

A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?

____

A)Increase the estimated IRR of the project to reflect its greater risk

B)Reject the project, since its acceptance would increase the firm’s risk

C)Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets

D)Increase the cost of capital used to evaluate the project to reflect the project’s higher-than-average risk

Currently, DEF Ltd. Has a beta of 1 and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than one of the company’s average projects. Also, the new project’s sales would be counter-cyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following is true?

____

A)The proposed new project would have more stand-alone risk than the firm’s typical project

B)The proposed new project would increase the firm’s corporate risk

C)The proposed new project would not affect the firm’s risk at all

D)The proposed new project would have less stand-alone risk than the firm’s typical project

If a firm is losing money, then the after-tax cost of debt is

____

A)Equal to kd(1-T)

B)Found by trial and error

C)Equal to the pre-tax cost of debt

D)Equal to the yield-to-maturity

E)Both (C) and (D)

Determine the weighted average cost of capital for the ABC Co. that will finance its optimal capital budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ks = 16%). ABC’s current capital structure is considered optimal. The company’s tax rate is 40%.

____

A)14.3%

B)12.6%

C)14.6%

D)None of the above

Hint: