You have been asked to analyze a capital investment proposal. The project's cost is $2,775,000

You have been asked to analyze a capital investment proposal. The project's cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital projects at 15.5%. What is the project's NPV?

A) $101,247

B) $285,106

C) $473,904

D) $582,380

Which of the following is a correct equation to solve for the NPV of the project that has an initial outlay of $30,000, followed by incremental cash inflows in the next 3 years of $15,000, $20,000, and $30,000? Assume a discount rate of 10%.

A) NPV = - $30,000 + $15,000(1.10)1 + $20,000(1.10)2 + $30,000(1.10)3 

B) NPV = - $30,000 + $15,000/(1.10)1 + $20,000/(1.10)2 + $30,000/(1.10)3 

C) NPV = - $30,000 + $15,000/(1.01).10 + $20,000/(1.02).10 + $30,000/(1.03).10 

D) NPV = - $30,000 + $15,000/(1.1).10 + $20,000(1.2).10 + $30,000(1.3).10

Project EH! requires an initial investment of $50,000, and has a net present value of $12,000. Project BE requires an initial investment of $100,000, and has a net present value of $13,000. The projects are mutually exclusive. The firm should accept

A) project EH!.

B) project BE.

C) both projects.

D) neither project.

Project Eh! requires an initial investment of $50,000, and has a net present value of $12,000. Project B requires an initial investment of $100,000, and has a net present value of $13,000. The projects are proposals for increasing revenue and are not mutually exclusive. The firm should accept

A) project Eh!.

B) project B.

C) both projects.

D) neither project.

A machine has a cost of $5,375,000. It will produce cash inflows of $1,825,000 (Year 1); $1,775,000 (Year 2); $1,630,000 (Year 3); $1,585,000 (Year 4); and $1,650,000 (Year 5). At a discount rate of 16.25%, what is the NPV?

A) $81,724

B) $257,106

C) $416,912

D) $190,939

The information below describes a project with an initial cash outlay of $10,000 and a required return of 12%

Use the following to answer the following question(s).

The information below describes a project with an initial cash outlay of $10,000 and a required return of 12%.

                  After-tax cash inflow

                Year 1                    $6,000

                Year 2                    $2,000

                Year 3                    $2,000

                Year 4                    $2,000

Which of the following statements is correct?

A) The project should be accepted since its NPV is $353.87.

B) The project should be rejected since its NPV is -$353.87.

C) The project should be accepted since it has a payback of less than four years.

D) The project should be rejected since its NPV is -$23.91.

Suppose you determine that the NPV of a project is $1,525,855. What does that mean?

A) In all cases, investing in this project would be better than investing in a project that has an NPV of $850,000.

B) The project would add value to the firm.

C) Under all conditions, the project's payback would be less than the profitability index.

D) Other investment criteria might need to be considered.

Project January has a NPV of $50,000, project December has a NPV of $40,000. Which of the following circumstances could make it possible to choose December over January?

A) January has a shorter payback period.

B) The projects are mutually exclusive.

C) The projects have unequal lives.

D) The projects are mandated.

The present value of the total costs over a five year period for Project April is $50,000. The net present value of total costs over a 4 year period for Project October is $40,000. The company uses a discount rate of 9%. Which project should it choose and why?

A) April because it has a higher net present value (NPV).

B) April because is has a higher equivalent annual cost (EAC).

C) October because it has a shorter life.

D) October because it has a lower equivalent annual cost (EAC).

Warchester Inc. is considering the purchase of copying equipment that will require an initial investment of $15,000 and $4,000 per year in annual operating costs over the equipment's estimated useful life of 5 years. The company will use a discount rate of 8.5%. What is the equivalent annual cost?

A) $4,000

B) $7,000

C) $6,152.51

D) $7,806.49

Answer:  D

Artie's Soccer Ball Company is considering a project with the following cash flows:

        Initial outlay = $750,000

        Incremental after-tax cash flows from operations Years 1-4 = $250,000 per year

Compute the NPV of this project if the company's discount rate is 12%.

A) $9,337

B) $7,758

C) $4,337

D) $2,534

Project H requires an initial investment of $100,000 and the produces annual cash flows of $50,000, $40,000, and $30,000

Project H requires an initial investment of $100,000 and the produces annual cash flows of $50,000, $40,000, and $30,000. Project T requires an initial investment of $100,000 and the produces annual cash flows of $30,000, $40,000, and $50,000. If the required rate of return is greater than 0% and the projects are mutually exclusive

A) H will always be preferable to T.

B) T will always be preferable to H.

C) H and T are equally attractive.

D) The project rankings will change with different discount rates.

Project H requires an initial investment of $100,000 and the produces annual cash flows of $45,000 per year for each of the next 3 years. Project T also requires an initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are mutually exclusive

A) Project H should be chosen.

B) Project T should be chosen.

C) H and T are equally attractive.

D) Both projects should be chosen.

Project H requires an initial investment of $100,000 and the produces annual cash flows of $45,000 per year for each of the next 3 years. Project T also requires an initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are not mutually exclusive

A) Project H should be chosen.

B) Project T should be chosen.

C) H and T are equally attractive.

D) Both projects should be accepted.

Project H requires an initial investment of $100,000 and the produces annual cash flows of $45,000 per year for each of the next 3 years. Project T also requires an initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If the discount rate increases from 10% to 16%

A) Project T should be chosen.

B) Both projects should be rejected.

C) H and T are equally attractive.

D) The project rankings will change.

A machine costs $1,000, has a three-year life, and has an estimated salvage value of $100. It will generate after-tax annual cash flows (ACF) of $600 a year, starting next year. If your required rate of return for the project is 10%, what is the NPV of this investment? (Round your answer to the nearest $10.)

A) $490

B) $570

C) $900

D) -$150

Project Sigma requires an investment of $1 million and has a NPV of $10. Project Delta requires an investment of $500,000

Project Sigma requires an investment of $1 million and has a NPV of $10. Project Delta requires an investment of $500,000 and has a NPV of $150,000. The projects involve unrelated new product lines.

A) Both projects should be accepted because they have positive NPV's.

B) Neither project should be accepted because they might compete with one another.

C) Only project Delta should be accepted. Alpha's NPV is too low for the investment.

D) The company should look at other investment criteria, not just NPV.

Answer:  A

ABC Service can purchase a new assembler for $15,052 that will provide an annual net cash flow of $6,000 per year for five years. Calculate the NPV of the assembler if the required rate of return is 12%. (Round your answer to the nearest $1.)

A) $1,056

B) $4,568

C) $7,621

D) $6,577

Central Mass Ambulance Service can purchase a new ambulance for $200,000 that will provide an annual net cash flow of $50,000 per year for five years. Calculate the NPV of the ambulance if the required rate of return is 9%. (Round your answer to the nearest $1.)

A) $50,000

B) $(5,061)

C) $(5,517)

D) $5,517

Central Mass Ambulance Service can purchase a new ambulance for $200,000 that will provide an annual net cash flow of $50,000 per year for five years. The salvage value of the ambulance will be $25,000. Assume the ambulance is sold at the end of year 5. Calculate the NPV of the ambulance if the required rate of return is 9%. (Round your answer to the nearest $1.)

A) $(10,731)

B) $10,731

C) $(5,517)

D) $5,517

Fitchminster Armored Car can purchase a new vehicle for $200,000 that will provide annual net cash flow over the next five years of $40,000, $45,000, $50,000, $55,000, $60,000. The salvage value of the vehicle will be $25,000. Assume that the vehicle is sold at the end of year 5. Calculate the NPV of the ambulance if the required rate of return is 9%. (Round your answer to the nearest $1.)

A) $7,390

B) $6,048

C) $6,780

D) $19,483

Why are capital budgeting decisions among the most important decisions made by any company?

Why are capital budgeting decisions among the most important decisions made by any company? Give a few examples from recent business developments.

Answer:  The main objective of financial management is to maximize the value of the firm. The main source of value is the company's cash flows discounted at rates that reflect their risk. Both the firm's cash flows and their level of risk are determined by the projects the company chooses to undertake. Recent examples include Apples string of "I" products (pod, phones, pad), and Amazon's Kindle which have added tremendous value to those companies. Students may cite examples from the text such as Kimberly-Clark's Huggies or Walmart's use of central distribution centers. Examples of less than successful decisions, at least so far, might include the Segue or the Gap's ephemeral redesigned logo. (Students' answers will vary their experience and recent events.)

Distinguish between revenue enhancement investments, cost-reduction investments, and mandated investments.

Answer:  Revenue enhancements investments may include new product lines such as Amazon's Kindle or GM's Chevy Volt undertaken, obviously, to increase cash flows by increasing sales. Companies such as Walmart may expand internationally or enter new businesses such as groceries for the same reason. Cost reduction investments such as improved distribution, energy saving equipment or loss prevention systems may not increase sales, but increase cash flows by reducing costs. Mandated investments may include such issues as access for the handicapped, pollution abatement, or employee safety. They are unavoidable because required by federal, state, or local laws. In these cases, companies will seek the least expensive way to comply.

Why is it so difficult for firms to find good investment ideas?

Answer:  All firms are competing to maximize their value, so if an idea is obvious, many companies will pursue it at the same time. The Blackberry, for example, soon faced intense competition from any number of smart phones. Companies often find the best opportunities in areas where they have some protection from competition because they possess proprietary technology (Pfizer, Merck), strong brand loyalty (Coca Cola), or because the business is very expensive to enter (Toyota, Disney).

Which of the following are typical consequences of good capital budgeting decisions?

 Which of the following are typical consequences of good capital budgeting decisions?

A) The firm increases in value.

B) The firm gains knowledge and experience that may be useful in future decisions.

C) Good capital budgeting decisions help a company define its core competencies.

D) All of the above.

Errors in capital budgeting decisions

A) tend to average out over time.

B) decrease the firm's value.

C) are diminished because the time value of money makes future cash flows less important.

D) are easily reversed.

Which of the following factors is least important to capital budgeting decisions?

A) The time value of money

B) The risk-return tradeoff

C) Net income based on accrual accounting principles

D) Cash flows directly resulting from the decision

Which of the following would be considered a capital budgeting decision?

A) Walmart purchases inventory for resale to customers.

B) Apple sells bonds and uses the proceeds to repurchase stock.

C) Goldman Sachs obtains short-term loans to finance day to day operations.

D) Pfizer develops a new therapy and brings it to market.

Which of the following is a typical capital budgeting decision?

A) Purchase of office supplies

B) Granting credit to a new customer

C) Replacement of manufacturing equipment with more modern and efficient equipment

D) Financing the firm with more long-term debt and less equity

Good capital investment opportunities are most likely to exist when

A) many firms compete to sell similar products.

B) interest rates are high and rising.

C) goods and services can be produced cheaply using readily available tools and technologies.

D) a line of business is expensive to enter and uses proprietary technology.

Errors resulting from a capital budgeting decision are not considered major since the consequences of such errors average out over the life of the investment.

Answer:  FALSE

Competitive market forces make it imperative for a firm to have a systematic strategy for generating capital-budgeting projects.

Answer:  TRUE

The size of capital investments and the difficulty in reversing them once they are made make capital-budgeting decisions very important to the firm.

Answer:  TRUE

Capital budgeting is the decision-making process with respect to investment in working capital.

Answer:  FALSE

Some capital budgeting decisions may be mandated by government regulations.

Answer:  TRUE

The primary objective of all capital budgeting decisions is to increase the size of the firm.

Answer:  FALSE

Explain why an increase in the inflation rate will cause the yield to maturity on a bond to increase.

Explain why an increase in the inflation rate will cause the yield to maturity on a bond to increase.

Answer:  When the inflation rate increases, it means that the risk free rate of return will increase. This happens because investors need to make some real return, even on a risk free investment. This means that in order to keep the real rate of return constant, when the inflation rate goes up, the nominal interest rate goes up as well. Consequently, to maintain the same real rate of return, the nominal rate must go up, which in turn raises the required return, or yield to maturity.

What elements determine what the yield to maturity will be for a bond?

Answer:  The starting point is the risk free rate, a rate for a bond with no risks. A short term treasury bill reflects the risk free rate. The risk free rate comprises the real rate of return plus an inflation premium, so that the investor can earn the real return. If one knows the nominal risk free rate and the inflation rate, one can determine the real rate through the Fisher effect. When there is a possibility of default, the investor must receive a default premium to reflect that risk. Finally, there is the risk that the yield to maturity of the bond may change over the life of the bond, possibly lowering its value. This risk is reflected by the investor adding a maturity premium to the required return. In summary, the yield to maturity will be the real return, plus premiums for inflation, default, and maturity.

Given the anticipated rate of inflation (i) of 6.3% and the real rate of interest (R) of 4.7%, find the nominal rate of interest (r).

Answer: 

r = R + i + iR

r = .047 + 0.63 + (.063)(.047)

r = 11.3%

If provided the nominal rate of interest (r) of 14.2% and the anticipated rate of inflation (i) of 5.5%, what is the real rate of interest (R)?

Answer: 

r = R + i + iR

.142 = R + .055 + (.055)(R)

.142 - .055 = 1.055R + .055 - .055

.087 = 1.055R

R = 8.2%

Given the anticipated rate of inflation (i) of 6.13% and the real rate of interest (R) of 7.56%, what is the true inflation premium?

Answer:  We know the inflation premium to equal i + iR or = 0.0613 + (.0613)(.0756) = 6.59%