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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
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NET PRESENT VALUE AND OTHER CRITERIA
Review NPV: 80,000, uneven and/or negative cash flow
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NET PRESENT VALUE AND OTHER CRITERIA
What about IRR for irregular amounts, but no
second negative, which would invalidate IRR
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NET PRESENT VALUE AND OTHER CRITERIA
IRR IRREGULAR AMOUNTS
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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
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NET PRESENT VALUE AND OTHER CRITERIA
WHERE DO WE GET THE MONEY
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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.
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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
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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
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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
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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
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NET PRESENT VALUE AND OTHER CRITERIA
END EXCEL
(OPTIONAL)
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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)
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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
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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
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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.
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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
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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
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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
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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
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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
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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?
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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

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