AGEC 424 Third Hour Exam Spring 2011 (100 points)

Name______

To receive credit you must show all work (calculator inputs/output when appropriate).

  1. (2 points) The appropriate interest rate to use in capital budgeting is:

a. / always the company’s cost of capital.
b. / the company’s cost of capital if the project’s risk is about the same as the company’s.
c. / the cost of capital plus any additional risk premium required to compensate for the project’s higher risk.
d. / both b & c
  1. (2 points) The ______method consists of regressing historical values of a division’s return on equity against the return on a major stock market index.

a. / accounting beta model
b. / CAPM
c. / overlay
d. / pure play
  1. (2 points) The technique for incorporating risk into capital budgeting that involves the use of numbers drawn randomly from probability distributions is called a:

a. / probability simulation.
b. / scenario analysis.
c. / sensitivity analysis.
d. / Monte Carlo simulation.

4. (2 points) A company is evaluating a capital project on a new line of business for the firm. The firm’s current cost of equity capital is 12%. However, another firm, whose principal focus is in the same field, is publicly traded and has a beta of 1.6. The market is currently yielding 12% and the yield on short-term treasury bills is 6%. The appropriate cost of equity for this project is:

a. / 12%
b. / 18%
c. / 25.2%
d. / 15.6%

5. (2 points) Scenario/Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive the _____ is to changes in a particular variable.

a. / probability
b. / return distribution
c. / net present value
d. / standard deviation

Don’t forget to show your work.

6. (9 points)Norlin Corporation is considering an expansion project that will begin next year (Time 0). Norlin’s cost of capital is 12%. The initial cost of the project will be $275,000, and it is expected to generate the following cash flows over its five-year life:

Year / $
1 / $60,000
2 / $60,000
3 / $60,000
4 / $90,000
5 / $90,000
a. / What is the payback period for the expansion project?
b. / What are the net present value (NPV) and internal rate of return (IRR) of the expansion project?

7. (12 points) Projected cash flows for two mutually exclusive projects are as follows:

Year / Project A / Project B
0 / ($150,000) / ($200,000)
1 / 80,000 / 40,000
2 / 60,000 / 50,000
3 / 50,000 / 50,000
4 / 60,000
5 / 50,000
6 / 53,000

If the firm’s cost of capital is 10% and the equivalent annual annuity method is used to eliminate the disparity between the projects’ lives, which project should be undertaken? Why?

New Investment

8. (30 points) The Ewert Company is evaluating the proposed acquisition of a new milling machine. The machine’s base price is $108,000, and it would cost another $12,000 to modify it for special use by the firm. The machine falls into the MACRS three-year class(MACRS depreciation percentages: 33%, 45%, 15% and 7%), and it would be sold after three years for $58,400. The machine would require an increase in net working capital (inventory) of $5,500. The milling machine would have no effect on revenues, but it is expected to save the firm $44,000 per year in before-tax operating costs, mainly labor. Ewert’s marginal tax rate is 40 percent and the cost of capital is 10%. Determine the cash flows, payback, NPV, and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

Replacement Problem:

9. (39 points) Meals on Wings Inc. supplies prepared meals for corporate aircraft (as opposed to public commercial airlines), and it needs to purchase new broilers. If the broilers are purchased, they will replace old broilers purchased 10 years ago for $105,000 and which are being depreciated on a straight line basis to a zero salvage value for tax purposes with a 15year depreciable life. The old broilers can be sold today for $60,000, but will have a market value of $15,000 in 3 years. The new broilers will cost $200,000 installed and will be depreciated using MACRS using the 5year class life (percentages: 20, 32, 19, 12, 11, 6)they will be sold at their book value at the end of the 3rdyear. The firm expects to increase its revenues by $75,000 per year if the new broilers are purchased, but cash expenses will also increase by $5,000 per year. There will be no change in net working capital. The firm's required rate of return is 10 percent and its tax rate is 40 percent.

Determine the cash flows, NPV, and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

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Question 8

Initial Outlay / Depreciation [initial basis = / ]
Operating Cash flow
minus
deprec.
EBT
less taxes
EAT
Dep. add-back
OCF
Terminal CF / Timeline and calculator inputs/outputs and investment decision
TCF workspace

Question 9

Initial Outlay / Depreciation [initial basis = / ]
Work space
Operating Cash flow
minus
deprec.
EBT
less taxes
EAT
Dep. add-back
OCF
Terminal CF / Timeline and calculator inputs/outputs and investment decision
TCF workspace

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