17. Which of the following statements is normally correct for a project with a positive NPV?

a. IRR exceeds the cost of capital.

b. Accepting the project has an indeterminate effect on shareholders.

c. The traditional payback period exceeds the life of the project.

d. The present value index equals one.

18. Capital budgeting proposals for investment projects should be evaluated as if the project were financed:

a. entirely by debt.

b. entirely by debt, adjusting for taxes.

c. half by debt and half by equity.

d. with the highest cost source of funds, to be safe.

e. the financing and investment decisions should be viewed separately.

19. When projects are mutually exclusive, can be undertaken only once, and capital is unconstrained, selection should be made according to the project with the:

a. longer life.

b. larger initial size.

c. highest IRR.

d. highest NPV.

e. highest PVI (present value index).

20. Which of the following can be deduced about a three-year investment project that has a two year traditional payback period?

a. The NPV is positive.

b. The IRR is greater than the cost of capital.

c. Both ‘a’ and ‘b’ can be deduced.

d. Neither ‘a’ nor ‘b’ can be deduced.

21. If a project has a cost of $50,000 and a present value index of 1.4, then:

a. its cash inflows are $70,000.

b. the present value of its cash inflows is $30,000.

c. its IRR is 20%.

d. its NPV is $20,000.

22. If two projects offer the same, positive NPV, then:

a. they also have the same IRR.

b. they have the same traditional payback period.

c. they are mutually exclusive projects.

d. they add the same amount to the value of the firm.

e. all the above

23. The likely effect of discounting nominal cash flows with real interest rates (assuming positive NPV) will be to:

a. make an investment’s NPV appear more attractive.

b. make an investment’s NPV appear less attractive.

c. correctly calculate an investment’s NPV if inflation is expected.

d. correctly calculate an investment’s NPV, regardless of expected inflation.

24. Which of the following is representative of how depreciation expense is handled in the face of inflation?

a. It increases annually with the rate of inflation.

b. It decreases annually in nominal terms.

c. The depreciable base is not altered by inflation.

d. The real value of the depreciation is fixed.

25. When analyzing a capital project, an increase in net working capital associated with the project:

a. is not a relevant cash flow.

b. is a relevant cash outflow.

c. is a relevant cash inflow.

d. is a relevant cash outflow that must be adjusted for taxes.

e. is a relevant cash inflow that must be adjusted for taxes.

Problems

26. What is Plato’s Inc.’s weighted average cost of capital (WACC) given the following information? Dollar amounts are in millions. There are two debt components and YTM (yield to maturity) for these two components are: 4% for notes due in May 2015, and 6% for notes due in January 2020. The risk-free rate is 3%, and market risk premium is 8%. The company has a beta of 1.5. The firm’s tax rate is 35%. (7 points)

Book Value Market Value

Notes due 2015 15 17

Notes due 2020 12 16

Equity 54 74

Total 81 107

WACC = 11.37%

27. Calculate the traditional payback period, IRR, NPV, and PVI (present value index) for the project with the following cash flows. The opportunity cost of capital for the project is 14%. (8 points)

Cash

Year Flows

0 -1,500,000

1 400,000

2 600,000

3 550,000

4 450,000

5 200,000

Payback = 2.91 Years

IRR = 15.60%

NPV = $54,101.90

PVI = 1.04

28. Calculate the relevant cash flows (for each year) for the following capital budgeting proposal. Enter the total net cash flows for each year in the answer sheet. (10 points)

• $90,000 initial cost for machinery;

• depreciated straight-line over 4 years to a book value of $10,000;

• 35% marginal tax rate;

• $55,000 additional annual revenues;

• $25,000 additional annual cash expense;

• annual expense for debt financing is $7,500.

• $3,500 previously spent for engineering study;

• The project requires inventory increase by $32,000 and accounts payable increase by $14,000 at the beginning of the project;

• The investment in working capital occurs one time at the beginning of the project and it requires working capital return to the original level when the project ends in 4 years;

• 11% cost of capital;

• life of the project is 4 years; and

• The new equipment will be sold at the end of 4 years; expected market value of the new equipment at the end of 4 years is $15,000;

Year

0

1

2

3

4

Net Cash Flow

-$108,000

$26,500

$26,500

$26,500

$57,750

29. You are analyzing a capital budgeting project and, as shown by ???, some numbers are unreadable. You can read the following information:

Cash Flows at the end of:

Year 0 = -$25,000

Year 1 = +$8,000

Year 2 = +$ 6,000

Year 3 = +$ 2,600

Year 4 = $ ???

Year 5 = +$ 9,500

The Cost of Capital is 13%, the NPV = -$5,650.01 and the IRR = ???%. Your superior, ignoring the important fact that we should reject the project, is demanding to know the Cash Flow in Year 4.

Calculate the cash flow in Year 4. (5 points)

Cash Flow Year 4 = +$1000

30. We can continue to use an existing machine at a cost of $22,500 annually (after-tax cash basis, including depreciation tax benefits) for the next 4 years. Alternatively, we can purchase a new machine that has an expected life of 7 years for $45,000. The new machine is expected to cost $11,000 each year to operate (after-tax cash basis, including depreciation tax benefits). The new machine will reduce inventory needs by $5,000 starting immediately. This is a one-time reduction in inventory that will last for the entirety of the new machine’s life. This reduction in inventory will be reversed at the end of 7 years. The cost of capital is 14%. The existing machine has no salvage value and we estimate that the new machine’s salvage value will be 0 in 7 years. Should we purchase the new machine? In the exam answer sheet, indicate your decision to replace or not replace, and provide support for your answer (i.e., indicate the criteria used to make the decision and the values for that criteria). (10 points)

Additional facts for question 31:

• The existing machine has been fully depreciated.

• As stated, the $22,500 and $11,000 are annual after-tax cash operating costs (i.e., after-tax cash operating costs = net income + depreciation), thus no further adjustments need to be made to them for depreciation.

Initial Investment

Incremental Benefit

PVIF @ 14%

Present Value

0

-40000

1.000

-40000

1

11500

0.877

10087.72

2

11500

0.769

8848.88

3

11500

0.675

7762.17

4

11500

0.592

6808.92

5

-11000

0.519

-5713.06

6

-11000

0.456

-5011.45

7

-16000

0.400

-6394.2

NPV

-23611.01

Since NPV is negative machinery should not be purchased.

31. For the following project, calculate the NPV break-even level of annual revenue, assuming that the operating cash flows will be stable for an 8 year horizon and that the discount rate is 12%. (10 points)

• The project requires an initial investment of $600,000.

• Expected annual sales are $770,000.

• Annual fixed costs (excluding depreciation and any other non cash expenses) will be $100,000.

• Straight-line depreciation of the initial investment over 8 years to a book value of 0.

• Variable costs (all of which are cash expenses) of 65% of revenues.

• Working capital will not be affected.

• Market values for salvage purposes in 8 years are estimated to be $40,000.

• 35% tax rate.

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