Please answer the question from Chap 9 – Chap 14. I uploaded the chapter lectures. Please use the words or methods from the lecture to solve the problems. Thank you.

chap_9___chap_14.docx

a_chapter_9_with_loc.ppt

a_chapter_10_with_loc_________.ppt

a_chapter_11_with_loc.ppt

a_chapter_12_with_loc.ppt

Unformatted Attachment Preview

CHAPTER 9 – 14

Answer questions on this document only.

Any explanatory or descriptive answers must be in your own chosen works

not cut and paste from text

All Answers must be typed and legible

RESPONSES ARE REVIEWED BY TURPIN

1. A project’s average net income divided by its average book value is

referred to as:

2. Explain the project methodology Discounted Cash Flow

3. Which of the following values will be equal to zero when estimating a firm’s

Accounting Break-even level of output

A. IRR and OCF

B. Net Income and interest expense

C. IRR and Contribution Margin

D. OCF and NPV

E. Net Income and NPV

4. What is the rate for a project that produces a rate of return just equal

to its requirement

5. If an individual is responsible for Capital Budgeting that individual is

responsible for?

6. Where is the Payback evaluation best used? Name two problems.

7. What is the present value of an investments future cash flows divided by the

initial cost of the investment is called?

8 What two problems can arise in the standard IRR calculation?

Which is most important?

9. Dividend Growth Model can only be used if what condition exists?

10. When considering a project’s investment suitability where are Opportunity

Costs Incorporated?

11. For Financial Breakeven does operating cash flow include interest expense?

12. What is the most straight forward way of calculating Operating Cash Flows?

Mention two other methods to determine Operating Cash Flow.

13. While a company’ estimated Weighted Average Cost of Capital can be

estimated from historical and current data for the purposes of a new project,

the risk and real cost of capital, often unknown, will be dependent on what

consideration?

14. What is the difference between investing and financing?

15. Rossitti restaurants is planning a renovation that requires $180,000 of stoves

and venting. They have a 10 year lease and when the lease ends the

equipment is expected to have an after-tax salvage value of 25,000, how

should they handle this in their financial plan?

16. What should be used instead of Straight Line Depreciation?

17. What is Scenario Analysis? Why is Scenario Analysis useful?

18. What is Sensitivity Analysis? Why is Sensitivity Analysis useful?

19. Solution A has a life of 3 years and solution B a life of 5 years each with

differing cash flows how can they be compared?

20. What is the major limitation of the Discounted Payback method of project

Evaluation?

21. What is the Soft Rationing?

22. The Chief Accountant has presented an investment proposal to the board of

directors based on Accounting Break-even. What alternative would you

suggest.

23. What are the three forms of market efficiency?

24. Define Risk Premium.

25. In 1968 the Micron Company stock went up from $26 to $32 per share and

paid a $1.50 dividend. Inflation that year increase from 12% to 15% for the

year. What was the real total return for Micron shareholders in 1968.

26. Why does the Variance calculation, leading to standard deviation, square all

returns, positive or negative?

27. What are two ways to calculate average returns?

28. How can an investor eliminate Unsystematic Risk?

29. Describe Systematic risk and how can it be measured?

30. The Security Market Line plots ___________ against _____________

31. Swifty Corporation has three outstanding bonds with market values of

98,000, 231,000 and 185,000 with respective interest coupons of 8, 10 and

12 percent. The current yield of those bonds are 4%, 6% and 5.5%. The

corporation is considering a new project, what rate should be used for an

expected interest rate.

32. How is the cost of preferred stock determined?

33. The Standard and Poor’s index retuned 8% in 1993 when treasury rates were

2%. Hall Industries had a beta of 1.12. Hall Industries also has two bonds

outstanding in equal amounts that yield 3% and 4% respectively. Hall

Industries also has a preferred stock that yields 5%. The following weights

are stocks 50%, bonds 20% and 20% and the preferred stock 10%. What is

the Weighted Average Cost of Capital for Hall industries in1993 if taxes

are .32%.

34. How can WACC be used?

35. There are two necessary conditions to apply Economic Operating Cost

36. Are side effects good or bad?

37. How are financing costs and dividends considered in Scenario Analysis

38. You buy a stock for $125, receive a dividend of $12 and sell the stock for $95

one year later. What is your dollar and percent return? Later you learn

inflation was 5% during the period you owned the stock. What was your real

percentage return?

39. Name two ways cost of equity can be determined?

40. You are evaluating a regulatory mandatory investment for HR, is the firm’s

WACC always the right discount rate to always use?

41. A company’s stock trades at $23, pays no dividend and has a Beta of 1.25.

The stock market declines 10%, what percent will the stock decline

42. What are floatation costs

43. The risk-free rate is 2%. Stock A is expected return is 18% with a beta of 1.7

Stock B expected return is 15% with a beta of 1.3. What is the risk reward

ratio of each and which is the better choice ignoring the investor risk

preference.

44. Calculate the payback, the discounted payback, and the NPV at a required

Return of 10%

Year

Cash Flow

0

1

2

3

4

-$300

50

80

100

150

45. A firm evaluates all of its projects by applying the NPV rule. If the required return is 14

percent, should the firm accept the following project?

Year

0

1

2

3

Cash

Flow

-26,000

11,000

14,000

10,000

46. A proposed new investment has projected sales of $700,000, Variable Costs are 40% of

sales, and Fixed Costs are $175,000, Depreciation is $54,000. Prepare a pro-forma income

statement assuming a tax rate of .34%. What is the projected Net Income, what is Operating

Cash Flow and EBITDA

47.The weighted average cost of capital for a firm is dependent upon which of the following:

a. rate of growth.

b. debt-equity ratio.

c. preferred dividend payment.

d. retention ratio.

e. all of the above

48. The stock market in the past week had declined 17%. The Risk free rate is 3%, the Green

Shoe Company’s stock beta is 1.25 and the markets expected long term return is 12%. An

investor’s long term expected return from the Green Shoe Company’s stock would be?

49. Consider the following: Sales are $725,500, Depreciation $97,000, Operating Cost

$325,000, Fixed Costs $197,000, tax rate 34% What is EBIT and Net Income? What is the

Contribution Margin? What is Operating Cash Flow?

50. Use the following base-case information:

A project under consideration costs $750,000, has a five-year life

and has no salvage value. Depreciation is Straight-Line to zero and the Tax

Rate is 34 percent. Sales are projected at 500 units per year. Price per

unit is $2,500, Variable Cost per unit is $1,500, and Fixed Costs

are $100,000 per year.Suppose you think that the unit sales, price, variable cost, and fixed

cost projections given here are accurate to within 10 percent either way. What is the worstcase scenario net income?

ReplyForward

NET PRESENT VALUE AND OTHER CRITERIA

Chapter 9

Net Present Value and Other

Investment Criteria

Projects and Methods of Capital Budgeting

A toolkit based on what we learned in previous chapters

9-1

Financial Integration, LLC

McGraw-Hill/Irwin

1

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

NET PRESENT VALUE AND OTHER CRITERIA

REVIEW HP12c REGISTERS,

MULTIPLE UNEQUAL AMOUNTS

Previously “mentioned” Chapter 6

Financial Integration, LLC

3

NET PRESENT VALUE AND OTHER CRITERIA

Review NPV: 80,000, uneven and/or negative cash flow

Financial Integration, LLC

5

NET PRESENT VALUE AND OTHER CRITERIA

What about IRR for irregular amounts, but no

second negative, which would invalidate IRR

Financial Integration, LLC

9

NET PRESENT VALUE AND OTHER CRITERIA

IRR IRREGULAR AMOUNTS

Financial Integration, LLC

10

NET PRESENT VALUE AND OTHER CRITERIA

OVERVIEW – Big Picture

Chapter 1: Introduction to Corporate Finance

Chapter 2: Financial Statements, Taxes, and Cash Flow

FINANCIAL STATEMENTS AND PLANNING – Sources of Information

Chapter 3: Working with Financial Statements&ratios

Chapter 4: Long-term Financial Planning and Growth

VALUATION OF FUTURE CASH FLOWS – Calculating Nuts and Bolts

Chapter 5: Introduction to Valuation: Time Value of Money

Chapter 6: Discounted Cash Flow Valuation

Chapter 7: Interest Rates and Bond Valuation

Chapter 8: Stock Valuation

CAPITAL BUDGETING – Deep Inside, Committing Money

Chapter 9: Net Present Value and Other Investment Criteria

Chapter 10: Making Capital Investment Decisions

Chapter 11: Project Analysis and Evaluation

RISK AND RETURN – External Input and Influences

Chapter 12: Some Lessons from Capital Market History

Chapter 13: Return, Risk, and the Security Market Line

Chapter 14: Cost of Capital

Chapter 15: Raising Capital

Financial Integration, LLC

15

NET PRESENT VALUE AND OTHER CRITERIA

WHERE DO WE GET THE MONEY

Financial Integration, LLC

26

NET PRESENT VALUE AND OTHER CRITERIA

Capital Budgeting Process

WORKING CAPITAL

MANAGEMENT

Current

Assets

Current

Liabilities

Bonds

Customers

and the

Product

market

Fixed

Assets

Equity

CAPITAL

BUDGETING

Financial Integration, LLC

Preferred

Stock

CAPITAL

STRUCTURE

27

NET PRESENT VALUE AND OTHER CRITERIA

Capital Budgeting Process

⚫ Bonds, Stocks and Project: Differences:

– The goal with stocks and bonds: determine value

today (P0)

–

The goal with project investment:

■

Will a project’s present value cash flows exceed the

project cost

■

Will the project add value to the firm’s shares.

Financial Integration, LLC

31

NET PRESENT VALUE AND OTHER CRITERIA

Capital Budgeting Process

⚫ Decision criteria for capital budgeting

– All: Are ALL payments and receipts

included?

–TVM: Is TVM incorporated?

– Risk: Does decision rule adjust for risk?

■

Duration and Beta not good measure for projects.

■

Much more subtle and requires quantification

■

This leads to the question of whether investors can

see forward risk: Beta and Duration are historical

– Is Shareholder Value created:

9-32

Financial Integration, LLC

Yes-No

32

NET PRESENT VALUE AND OTHER CRITERIA

1. Payback

⚫ Example 1: years until cash flows equal or exceed cost:

‒

Management’s pay back period is 2 years

‒

Take the project

Financial Integration, LLC

35

NET PRESENT VALUE AND OTHER CRITERIA

1. Payback

● Class exercise

– “estimated” the following cash flows for a project:

■

■

■

■

–

Year 0:

Year 1:

Year 2:

Year 3:

CF = -250,000

CF = 100,000

CF = 125000

CF = 100,000

Required /established payback is 3 years

– Yes or no

Financial Integration, LLC

43

NET PRESENT VALUE AND OTHER CRITERIA

1. Payback

⚫ Summary table:

Payback: an investment is acceptable if its

calculated payback period is less than some prespecified number of years

Advantages

Disadvantages

Easy to understand: intuitive

Can be used as a screener

Ignores TVM and Risk

Adjust for uncertainty of future

Arbitrary cut-off point, Ignores

cash flow beyond cutoff

cash flows by

ignoring them

Biased toward liquidity

Biased against long term projects

such as R&D. No real economic

rational

Biased to short term projects

DOESN’T SHOW VALUE CREATED

DOESN’T SHOW VALUE CREATED

Financial Integration, LLC

44

NET PRESENT VALUE AND OTHER CRITERIA

1. Payback

⚫ Capital Budgeting Decision Comparison of criteria

9-45

Technique

Units

1. Payback

Time

Financial Integration, LLC

Accept if:

Payback < Mgt’s #
45
NET PRESENT VALUE AND OTHER CRITERIA
2. Discounted Payback
⚫ Example 1: Discounted Payback Computation, Step 4
1R = 12%2
$ -165,000
CF1 =
63,120
CF2 =
70,800
3
CF3 =
91,080
56,357
56,441
64,829
9-51
Year 3: 52,202 – 64,829 = -12,627; accept
Financial Integration, LLC
51
NET PRESENT VALUE AND OTHER CRITERIA
2. Discounted Payback
● Class exercise
– “estimated” the following cash flows for a project:
■
■
■
■
–
Year 0:
Year 1:
Year 2:
Year 3:
CF = -250,000
CF = 100,000
CF = 125,000
CF = 100,000
Required rate is 15%
– Required /established payback is 3 years
– Yes or no
Financial Integration, LLC
53
NET PRESENT VALUE AND OTHER CRITERIA
2. Discounted Payback
⚫ Summary table:
Discounted Payback: an investment is acceptable if
its discounted payback period is less than some prespecified number of years
Advantages
Disadvantages
Easy to understand
Arbitrary cut-off point. May reject
larger positive NPV Investments;
Ignores cash flow beyond cutoff
Hence more profitable maybe
overlooked
Includes TVM and Includes Risk in
discount factor
Biased against long term projects
such as R&D
No negative NPV investments
DOESN’T SHOW VALUE CREATED
DOESN’T SHOW VALUE CREATED
Shows time
?Biased to Liquidity (short term)?
Financial Integration, LLC
54
NET PRESENT VALUE AND OTHER CRITERIA
2. Discounted Payback
⚫ Capital Budgeting Decision Criteria Comparison
9-56
Technique
Units
1. Payback
Time
Payback < Mgt’s #
2. Discounted Payback
Time
Payback < Mgt’s #
Financial Integration, LLC
Accept if:
56
NET PRESENT VALUE AND OTHER CRITERIA
3. Net Present Value
⚫ Example 1: $30,000 investment, $6,000 net cash flow, R 15%
New factor
salvage
The PV of an Annuity
6,000 PMT
15i
8n
PV -26,923.92
+
Total = 26,923.92
+
Financial Integration, LLC
the PV of the salvage
2,000 FV
15i
8n
PV -653.80
652.80 = $27,576.72 a loser
60
NET PRESENT VALUE AND OTHER CRITERIA
SUPPLEMENTARY 1:
HP12C REGISTORS
IRREGULAR RECEIPTS
Financial Integration, LLC
61
NET PRESENT VALUE AND OTHER CRITERIA
3. Net Present Value
⚫ Summary table:
NPV: investment acceptable if Net Present Value
from DCF is positive and rejected if is negative
Advantages
Disadvantages
Considers time value of Money,
and risk as reflected in the
discount rate
More difficult to compute:
Determine correct discount rate
and cash flows
Considers all payments/cash
flows i.e. time to build-
Project that differ in order of
magnitude are not obvious in the
NPV final figure: SIZE COUNTS
negative cash flow -registers
SHOWS VALUE CREATED
SHOWS VALUE CREATED
(ORDER OF MAGNITUDE:
SOMETHING WITH LOWER NPV
MIGHT BE STRATEGICALLY
MORE IMPORTANT)
Answer usually similar to IRR
(note reservations about IRR)
SIMPLE POSITVE / NEGATIVE
DCF process is very mechanical
Financial Integration, LLC
71
NET PRESENT VALUE AND OTHER CRITERIA
3. Net Present Value
● Class exercise
a. Cost: 50
b. Yearly Inflows: 30
c. Yearly Outflows: 15
Net Flow: 15
Salvage: 10
6 year
R 6%
Financial Integration, LLC
Remember
PV of an
annuity and
PV of salvage
This could
also be done
for irregular
amounts
72
NET PRESENT VALUE AND OTHER CRITERIA
3. Net Present Value
⚫ Capital Budgeting Decision Criteria Comparison
Technique
Units
Accept if:
1. Payback
Time
Payback < Mgt’s #
Time
Payback < Mgt’s #
Regular or irregular amounts
2. Discounted Payback
Regular or irregular amounts
3. Net Present Value
$
NPV > $0 (creates value)

Regular or irregular amounts

9-73

Financial Integration, LLC

73

NET PRESENT VALUE AND OTHER CRITERIA

END EXCEL

(OPTIONAL)

Financial Integration, LLC

77

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

⚫ Profitability Index (also known as cost/benefit ratio)

‒

‒

PV future cash flows, $220, divided by investment, $200

Computation: PI = PV of cash Inflows

Initial Investment

PI = $220 (PV of future flows) = 1.1

$200 (cost)

‒

9-79

RULE: Positive NPV if greater than 1

(every dollar invested above returns 1.10 of NPV)

Financial Integration, LLC

79

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

⚫ Example 1: (previous discounted payback example)

1R = 12%2

$ -165,000

PVs as before

CF1 =

63,120

CF2 =

70,800

3

CF3 =

91,080

56,357

56,441

64,829

$177,62

7

9-80

Financial Integration, LLC

80

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

⚫ Example 1

‒ Calculation

PI = PV of Inflows

Initial Investment

$177,627 = 1.0765

$165,000

9-81

■

PI >1: Accept, firm is increasing NPV results,

■

$.0765, abut 8 cents for each dollar in excess of NPV

results, every $1 invested

Financial Integration, LLC

81

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

● What the profitability index tells us

‒ If index is greater than 1, the project creates value — it

generates a return greater than our required return.

‒ If Index is less than 1, the project destroys value — it

generates a return less than our required return.

‒ If it is equal to 1, the profitability index tells us the

project generates a return equal to the discount rate.

Financial Integration, LLC

82

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

⚫ Example 1

9-83

■

“Bang for the Buck” in TVM terms

■

Provides prioritization / ranking where there are

limitations that prevent taking all such projects i.e.

“Capital Rationing”

■

Useful for multiple projects of hugely different costs

and or capital is scarce

■

WARNING: DO NOT USE FOR MUTUALLY EXCLUSIVE

Financial Integration, LLC

83

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

PQR, Inc. has $40 million at its disposal and the management is considering

the following projects for investment. The CFO prepared the following table fo

Project A

Project B

Project C

Initial investment

$10,000,000

$15,000,000

$15,000,000

Net present value

$20,000,000

$15,000,000

$21,000,000

25%

15%

20%

IRR

If the project are mutually exclusive, it means the company can select any

one of the projects. For example three candy factories of equivalent

technical capabilities. It can’t invest simultaneously in all the three

projects. Don’t need three factories

In such situation, the company should opt for projects generating the

maximum net present value i.e. Project C.

If these were independent projects, PQR would invest in all of these

projects because they all have positive NPVs.

9-84

Financial Integration, LLC

84

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index Capital Rationing

● Example for Capital Rationing

cash

flows

Project

C0

C1

C2

[email protected]

%

A

-10

30

5

21

B

-5

5

20

16

C

-5

5

15

12

‒

Firm limited to $10million, Capital Rationing

‒

Invest in A or B & C, but not all three

‒

B and C have lower NPV individually than A

‒

B and C together the have higher NPV than A

Financial Integration, LLC

85

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index Capital Rationing

● Take B and C rather than A

Proje Inve

ct

stme

nt

C1

C2

NPV

@10

%

Profita

bility

Index

A

-10

30

5

21

2.1

B

-5

5

20

16

3.2

C

-5

5

15

12

2.4

● Bigger bang for the buck in each

Financial Integration, LLC

86

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

● MUTUALLY EXCLUSIVE PROBLEM – but not capital rationing

‒

project costs $50,000 and has NPV of $100,000 PI = 2

‒

project costs $100,000 and has NPV $150,000 PI =1.5

‒

Choose first, Wrong!!!!

‒

If “Mutually Exclusive” one or the other

‒

Because the second brings in more cash or absolute NPV

‒

Useful for first cut of numerous similar sized projects

‒Profitability complementary to NPV

Financial Integration, LLC

87

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

● Class exercise

– “estimated” the following cash flows for a project:

■

■

■

■

–

Year 0:

Year 1:

Year 2:

Year 3:

CF = -250,000

CF = 100,000

CF = 125,000

CF = 100,000

Required rate is 10%

– Profitability Index?

Financial Integration, LLC

88

NET PRESENT VALUE AND OTHER CRITERIA

4. Profitability Index

⚫ Capital Budgeting Decision Criteria Comparison

Technique

Units

Accept if:

1. Payback

Time

Payback < Mgt’s #
Time
Payback < Mgt’s #
Regular or irregular amounts
2. Discounted Payback
Regular or irregular amounts
3. Net Present Value
$
4. Profitability ...
Purchase answer to see full
attachment