Capital Investments quiz

Sunk costs should be excluded from cash flows, as they are costs that cannot be avoided even if the project is not undertaken. Externalities, such as positive or negative effects of accepting a project on sales of the company's existing products, should be included in the cash flows.

Arranging financing is not one of the administrative steps in the capital budgeting process. The four administrative steps in the capital budgeting process are:

1. Idea generation

2. Analyzing project proposals

3. Creating the firm-wide capital budget

4. Monitoring decisions and conducting a post-audit

The option to abandon the project and receive the market value of the facility if actual cash flows are less than expected over the first two years can be viewed as a valuable put option that should be included in the calculation of the project’s NPV. 

Expansion projects increase the scale of a firm’s existing activities and/or extend a firm’s reach into new product or service categories and markets, in the hopes of generating longer-term expected gains. Regulatory/compliance projects are required for the business to continue operations but otherwise might not be undertaken by a company. Going concern projects benefit the company through improved efficiencies and cost savings over time .

NPV for Project X ⇒ CF0 = – 100,000 ; C01 = 50,000; C02 = 40,000; C03 = 30,000; C04 = 10,000; I = 15; CPT NPV = -833

NPV for Project Z ⇒ CF0 = – 100,000 ; C01 = 10,000; C02 = 30,000; C03 = 40,000; C04 = 60,000; I = 15; CPT NPV = - 8,014

Reject both projects because neither has a positive NPV.

Stock prices reflect investor expectations for future investment and growth. A new positive-NPV project will increase stock price only if it was not previously anticipated by investors .

Project P ⇒ N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT → PV = 18,024;  NPV for Project A = 18,024 – 15,000 = 3,024.
Project Q ⇒ N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT → PV = 27,036;  NPV for Project B = 27,036 – 25,000 = 2,036.

For independent projects the NPV decision rule is to accept all projects with a positive NPV. Therefore, accept both projects.

or

Project P  ⇒ Cf0 = -15,000, C01 = 5,000, F01 = 5,  I = 12 ;  CPT NPV = 3,024.

Project Q  ⇒ Cf0 = -25,000, C01 = 7,500, F01 = 5,  I = 12 ;  CPT NPV = 2,036.

Externalities refer to the effects that the acceptance of a project may have on other firm cash flows. Cannibalization is one example of an externality.

he study is a sunk cost, and the possible increase in sales of a related product is an example of a positive externality.

CF0 = – $28,000 ; CF1 = $7,000 ; F1 = 4 ; CF2 = $6,000 ; F2 = 2 ; CPT → IRR = 11.6175% .

A new project reducing the cash flows of an existing project is an externality called cannibalization .

Sunk costs are not to be included in investment analysis. Opportunity costs and the project's impact on taxes are relevant variables in determining project cash flow for a capital investment.

CF0 = –5,000 ; CF1 = 3,000 ; CF2 = 2,000 ; CF3 = 2,000 ; I / Y = 10 ; NPV = $883 

Project X

CF0 = – 15,000 ; CF1 = 2,000 ;  CF2 = 5,000 ; CF3 = 8,000 ; CF4 = 8,000 ; I = 15 ; CPT NPV = 354.0046

IRR= 16 % (given)

Project Y

CF0 = – 13,250 ; CF1 = 200 ;  CF2 = 500 ; CF3 = 7,000 ; CF4 = 15,000 ; I = 15 ; CPT NPV = 480.8972

CF0 = – 13,250 ; CF1 = 200 ;  CF2 = 500 ; CF3 = 7,000 ; CF4 = 15,000 ;  CPT IRR = 16.1542

Because these projects are mutually exclusive, only one can be undertaken: It should be Project Y, which has the highest NPV and thus increases shareholder wealth the most. Both projects’ IRRs exceed the hurdle rate, and the IRR of Project Y exceeds that of Project X. The decision, however, should be based on the superior NPV of Project Y

(Both projects ) is incorrect. Both NPV_X and NPV_Y are positive, but because they are mutually exclusive projects, only the one with higher positive NPV will be chosen

A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations .

The IRR is the discount rate that makes the NPV = 0. Because the cash flow stream is in perpetuity, it can be solved as follows:

0 = –270 + (30/IRR)

IRR = 11.1%

The NPV rule’s assumption about reinvestment rates is more realistic and more economically relevant than the IRR rule because it incorporates the market-determined opportunity cost of capital as a discount rate. In contrast, the IRR calculation assumes reinvestment at the IRR, which sometimes cannot be achieved because it is too high. Time-weighted rate of return suffers similar shortcomings as IRR.

Discount rates of 0% and approximately 61.8% both give an NPV of zero

CF0 = – 50 ; CF1 = 100 ;  CF2 = 0 ; CF3 = - 50 ; I = 0 ; CPT NPV = 0

CF0 = – 50 ; CF1 = 100 ;  CF2 = 0 ; CF3 = - 50 ; I = 32 ; CPT NPV = 4.0181

CF0 = – 50 ; CF1 = 100 ;  CF2 = 0 ; CF3 = - 50 ; I = 62 ; CPT NPV = - 0.0321

Because all Bearing’s projects have a positive NPV, they are all providing a return that is greater than the opportunity COC. Therefore, the ROIC must be greater than the COC .

CFO = -100; CF1 = 40 ; CF2 = 80 ; CF3 = 120 ; I = 20 ; CPT → NPV = $ 58.33

or

For these investments, a discount rate of 13.16% would yield the same NPV for both (an NPV of 6.73).

We subtract the two investments from each other:

CF0 = – 100 - (– 100)  = 0

CF1 = 36 - 0 = 36   ; F1 = 3

CF2 = 36 - 175 = - 139   ; F1 = 1

CPT IRR = 13.159

CF0 = – 100 - (– 100)  = 0

CF1 = 36 - 0 = 36   ; F1 = 3

CF2 = 36 - 175 = - 139   ; F1 = 1

I= 13.159

CPT NPV = 6.7282

The IRR would stay the same because both the initial outlay and the after-tax cash flows double, so the return on each dollar invested would remain the same. All the cash flows and their present values double. The difference between the total present value of the future cash flows and the initial outlay (the NPV) also doubles .

Cash flows are based on opportunity costs. Financing costs are recognized in the project’s required rate of return. Accounting net income, which includes non-cash expenses, is irrelevant; incremental cash flows are essential for making correct capital allocation decisions .

The NPV sums the investment’s expected cash flows (CF) discounted at the opportunity COC. The NPV calculation is 

where

CFt = the expected net cash flow at time t

N = the investment’s projected life

r = the discount rate or opportunity COC

There are many factors that can affect the stock price, including whether Ms. Ndereba’s analysis indicates that the project is more or less profitable than investors expected .

Using either the IRR function in Excel or a financial calculator, IRR is determined by setting the NPV equal to zero for the cash flows shown in the following table

CFO = -1,000; CF1 = 200; CF2 = 200; CF3 = 900;  CPT →  IRR = 11.0258

It is quite possible that offering a matching dryer will increase sales of their washers, because some consumers will prefer a matching set. The increased sales of their washers is a positive externality, and those incremental sales should be considered in the analysis. Cannibalization would be a consideration if the introduction of dryers was expected to decrease washer sales. Sunk costs should not be considered in project analysis .

The cost of the marketing survey should not be included because it is a sunk cost; it will be incurred whether they decide to do the project or not. The decrease in sales of their current sauce if the spicier version is introduced (cannibalization) should be considered in the analysis. The cost of recipe development should be included because it will only be incurred if they decide to go ahead with the introduction of the new spicier sauce .

The project should be accepted on the basis of its positive NPV and its IRR, which exceeds the cost of capital.

In theory, a positive NPV project should provide an increase in the value of a firm's shares.

NPV of new capital equipment = $50 million - $30 million = $20 million

Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000

Value of company after new equipment project = $224 million + $20 million = $244 million

Price per share after new equipment project = $244 million / 8 million = $30.50

Note that in reality, changes in stock prices result from changes in expectations more than changes in NPV.