Capital Investments quiz Corporate Finance Quiz On Mar 10, 2024 Share /29 1234567891011121314151617181920212223242526272829 Capital Investments 30 questions in 30 minutes Answers at the end of the exam Pass Score 70% The questions change when you repeat the exam enter full-screen mode by pressing the icon located in the top- right comer of the exam 1 / 29 Should a company accept a project that has an IRR of 14% and an NPV of $2.8 million if the cost of capital is 12% ? Yes, based on the NPV and the IRR Yes, based only on the NPV No, based on the NPV and the IRR The project should be accepted on the basis of its positive NPV and its IRR, which exceeds the cost of capital. 2 / 29 The financial manager at Genesis Company is looking into the purchase of an apartment complex for $550,000. Net after-tax cash flows are expected to be $65,000 for each of the next five years, then drop to $50,000 for four years. Genesis' required rate of return is 9% on projects of this nature. After nine years, Genesis Company expects to sell the property for after-tax proceeds of $300,000. What is the respective internal rate of return on this project ? 7.01% 13.99% 6.66% CF0 = –$550,000 ; CF1 = $65,000 ; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1 . CPT IRR = 7.0152. Note that the cash flows in year 9 have to be netted to calculate the IRR correctly. 3 / 29 A company is considering the purchase of a copier that costs $5,000. Assume a required rate of return of 10% and the following cash flow schedule : Year 1: $3,000 Year 2: $2,000 Year 3: $2,000 The project’s NPV is closest to: – $309 + $883 $1,523 CF0 = –5,000 ; CF1 = 3,000 ; CF2 = 2,000 ; CF3 = 2,000 ; I / Y = 10 ; NPV = $883 4 / 29 An investment of $ 100 generates after-tax cash flows of $ 40 in Year 1, $ 80 in Year 2, and $ 120 in Year 3. The required rate of return is 20 %. The NPV is closest to : $58.33 $42.22 $68.52 CFO = -100; CF1 = 40 ; CF2 = 80 ; CF3 = 120 ; I = 20 ; CPT → NPV = $ 58.33 or 5 / 29 Erin Chou is reviewing a profitable investment that has a conventional cash flow pattern. If the cash flows for the initial outlay and future after-tax cash flows all double, Chou would predict that the IRR would : increase and the NPV would increase stay the same and the NPV would increase stay the same and the NPV would stay the same 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 . 6 / 29 Polington Aircraft Co. just announced a sale of 30 aircraft to Cuba, a project with a net present value of $10 million. Investors did not anticipate the sale because government approval to sell to Cuba had never before been granted. The share price of Polington should theoretically : not necessarily change because new contract announcements are made all the time increase by the NPV × (1 – corporate tax rate) divided by the number of common shares outstanding increase by the project NPV divided by the number of common shares outstanding Since the sale was not anticipated by the market, the share price should rise by the NPV of the project per common share. NPV is already calculated using after-tax cash flows. 7 / 29 Which of the following is least relevant in determining project cash flow for a capital investment ? Opportunity costs Sunk costs Tax impacts 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. 8 / 29 One of the basic principles of capital allocation is that : opportunity costs should be excluded from the analysis of a project projects should be analyzed on a pre-tax basis decisions are based on cash flows Key principles of the capital allocation process are : 1. Decisions are based on cash flows, not accounting income . 2. Cash flows are based on opportunity costs . 3. The timing of cash flows is important . 4. Cash flows are analyzed on an after-tax basis . 5. Financing costs are reflected in the project's required rate of return . 9 / 29 Which of the following statements concerning the principles underlying the capital allocation process is most accurate ? Financing costs should be reflected in a project’s incremental cash flows The net income for a project is essential for making a correct capital allocation decision Cash flows should be based on opportunity costs 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 . 10 / 29 Fisher, Inc., is evaluating the benefits of investing in a new industrial printer. The printer will cost $28,000 and increase after-tax cash flows by $7,000 during each of the next four years and $6,000 in each of the two years after that. The internal rate of return (IRR) of the printer project is closest to: 11.8% 12.0% 11.6% CF0 = – $28,000 ; CF1 = $7,000 ; F1 = 4 ; CF2 = $6,000 ; F2 = 2 ; CPT → IRR = 11.6175% . 11 / 29 Garner Corporation is investing $30 million in new capital equipment. The present value of future after-tax cash flows generated by the equipment is estimated to be $50 million. Currently, Garner has a stock price of $28.00 per share with 8 million shares outstanding. Assuming that this project represents new information and is independent of other expectations about the company, what should the effect of the project theoretically be on the firm's stock price ? The stock price will remain unchanged The stock price will increase to $34.25 The stock price will increase to $30.50 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. 12 / 29 Bouchard Industries is a Canadian company that manufactures gutters for residential houses. Its management believes it has developed a new process that produces a superior product. The company must make an initial investment of CAD190 million to begin production. If demand is high, cash flows are expected to be CAD40 million per year. If demand is low, cash flows will be only CAD20 million per year. Management believes there is an equal chance that demand will be high or low. The investment, which has an investment horizon of ten years, also gives the company a production-flexibility option allowing the company to add shifts at the end of the first year if demand turns out to be high. If the company exercises this option, net cash flows would increase by an additional CAD5 million in Years 2–10. Bouchard’s opportunity cost of funds is 10%. The internal auditor for Bouchard Industries has made two suggestions for improving capital allocation processes at the company. The internal auditor’s suggestions are as follows: Suggestion 1: “In order to treat all capital allocation proposals in a fair manner, the investments should all use the risk-free rate for the required rate of return.” Suggestion 2: “When rationing capital, it is better to choose the portfolio of investments that maximizes the company NPV than the portfolio that maximizes the company IRR ” . Should the capital allocation committee accept the internal auditor’s suggestions ? No for Suggestions 1 and 2 No for Suggestion 1 and yes for Suggestion 2 Yes for Suggestion 1 and no for Suggestion 2 In valuing investments, expected cash flows should be discounted at required rates of return that reflect their risk, not at a risk-free rate that ignores risk. NPV is superior to IRR. Choosing projects based on IRR might cause the company to concentrate on short-term investments that do not maximize the company’s NPV . 13 / 29 A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and promises to return the following irregular payments : Year 1: $100,000 Year 2: $82,000 Year 3: $76,000 Year 4: $111,000 Year 5: $142,000 If the required rate of return for the firm is 8%, what is the net present value of the investment ? $86,133 $99,860 $64,582 CF0 = – $336,875 CF1 = $100,000 CF2 = $ 82,000 CF3 = $ 76,000 CF4 = $ 111,000 CF5 = $ 142,000 I= 8 CPT → NPV = $64,582 or To determine the net present value of the investment, given the required rate of return, we can discount each cash flow to its present value, sum the present value, and subtract the required investment. PV of Cash flow at 8% Cash Flow Year – 336,875.00 – 336,875.00 0 92,592.59 100,000.00 1 70,301.78 82,000.00 2 60,331.25 76,000.00 3 81,588.31 111,000.00 4 96,642.81 142,000.00 5 64,581.74 Net Present Value 14 / 29 As the director of capital budgeting for Denver Corporation, an analyst is evaluating two mutually exclusive projects with the following net cash flows : Project Z Project X Year 100,000- 100,000- 0 10,000 50,000 1 30,000 40,000 2 40,000 30,000 3 60,000 10,000 4 If Denver's cost of capital is 15%, which project should be chosen ? Neither project Project X, since it has the higher IRR Project X, since it has the higher net present value (NPV) 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. 15 / 29 The post-audit performed as part of the capital budgeting process is least likely to include the : rescheduling and prioritizing of projects indication of systematic errors provision of future investment ideas Rescheduling and prioritizing projects is part of the planning stage of the capital budgeting process, not the post-audit. The post-audit’s purpose is to explain any differences between the actual and predicted results of a capital budgeting project. This process can aid in indicating systematic errors, improve business operations, and provide concrete ideas for future investment opportunities. 16 / 29 Which of the following steps is least likely to be a step in the capital allocation process ? Forecasting cash flows and analyzing project profitability Conducting a post-audit to identify errors in the forecasting process Arranging financing for capital projects 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 17 / 29 Financing costs for a capital project are : subtracted from estimates of a project’s future cash flows subtracted from the net present value of a project captured in the project’s required rate of return Financing costs are reflected in a project's required rate of return. Project specific financing costs should not be included as project cash flows. The firm's overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows. 18 / 29 An investment of $ 150,000 is expected to generate an after-tax cash flow of $ 100,000 in one year and another $ 120,000 in two years. The COC is 10 %. What is the IRR ? 28.39% 28.79% 28.59% Using a financial calculator or the trial and error method, the IRR is 28.79%. The COC, which is stated as 10%, is not used to solve the problem. 2 1 0 Year 120,000 100,000 150,000 - Cash flow Using a financial calculator: Cf0 = -150,000 ;C01 = 100,000 ; C02 = 120,000 ; CPT IRR = 28.7855 19 / 29 Investments 1 and 2 have similar outlays, although the patterns of future cash flows are different. The cash flows, as well as the NPV and IRR, for the two investments are shown below. For both investments, the required rate of return is 10% . Cash Flows IRR (%) NPV 4 3 2 1 0 Year 21.86 13.40 20 20 20 20 - 50 Investment 1 18.92 18.30 100 0 0 0 - 50 Investment 2 The two projects are mutually exclusive. What is the appropriate investment decision ? Invest in Investment 2 because it has the higher NPV Invest in Investment 1 because it has the higher IRR Invest in both investments When valuing mutually exclusive investments, the decision should be made with the NPV method because this method uses the most realistic discount rate—namely, the opportunity cost of funds. In this example, the reinvestment rate for the NPV method (here, 10%) is more realistic than the reinvestment rate for the IRR method (here, 21.86% or 18.92%) . 20 / 29 Which of the following types of capital investments are most likely to generate little to no revenue? New product or market development Going concern projects Regulatory projects Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating . 21 / 29 With regard to capital allocation, an appropriate estimate of the incremental cash flows from an investment is least likely to include : opportunity costs externalities interest costs Costs to finance the investment are taken into account when the cash flows are discounted at the appropriate COC; including interest costs in the cash flows would result in double-counting the cost of debt . 22 / 29 Catherine Ndereba is an energy analyst tasked with evaluating a crude oil exploration and production company. The company previously announced that it plans to embark on a new project to drill for oil offshore. As a result of this announcement, the stock price increased by 10%. After conducting her analysis, Ms. Ndereba concludes that the project does indeed have a positive NPV. Which statement is true ? The stock price should go even higher now that an independent source has confirmed that the NPV is positive The stock price could remain steady, move higher, or move lower The stock price should remain where it is because Ms. Ndereba’s analysis confirms that the recent run-up was justified 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 . 23 / 29 A company is considering a $10,000 project that will last 5 years. Annual after tax cash flows are expected to be $3,000 Cost of capital = 9.7% What is the project's net present value (NPV)? - $1,460 + $11,460 + $1,460 Calculate the PV of the project cash flows N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460 Calculate the project NPV by subtracting out the initial cash flow NPV = $11,460 – $10,000 = $1,460 or CF0 = –$10,000 ; CF1 = $3,000 ; F1 = 5 ; I= 9.7 CPT → NPV = $1,460 or CF0 = –$10,000 CF1 = $3,000 CF2 = $3,000 CF3 = $3,000 CF4 = $3,000 CF5 = $3,000 I= 9.7 CPT → NPV = $1,460 24 / 29 The Bearing Corp. invests only in positive NPV projects. Which of the following statements is true ? Bearing’s ROIC is greater than its COC Bearing’s COC is greater than its ROIC We cannot reach any conclusions about the relationship between the company’s ROIC and COC 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 . 25 / 29 A company is considering building a distribution center that will allow it to expand sales into a new region comprising three provinces. John Parker, a firm analyst, has argued that the current analysis fails to incorporate the amount they could get from selling the distribution center at the end of year 2, rather than operating it to the end of the project’s assumed economic life. Parker is suggesting that : the assumed investment horizon is too long the analysis should include the value of a put option the analysis should include the value of a call option 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. 26 / 29 Lincoln Coal is planning a new coal mine, which will cost $430,000 to build. The mine will bring cash inflows of $200,000 annually over the next seven years. It will then cost $170,000 to close down the mine in the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. If Lincoln has a 16% required rate of return, the minimum price they should accept for the property is closest to : $310,000 $326,000 $318,000 The key is first identifying this as a NPV problem. The minimum price the company should accept for selling the property is the net present value of the mine if the company built and operated it. Next, the year of each cash flow must be property identified; specifically: CF0 = –430,000 ; CF1-7 = +$200,000 ; CF8 = –$170,000. Entering these values into the cash flow worksheet: CF0 = –430,000 ; C01 = 200,000; F01 = 7 ; C02 = –170,000 ; F02 = 1 ; I = 16 ; CPT NPV = 325,858.76 27 / 29 The estimated annual after-tax cash flows of a proposed investment are shown below : Year 1: $10,000 Year 2: $15,000 Year 3: $18,000 After-tax cash flow from sale of investment at the end of year 3 is $120,000 The initial cost of the investment is $100,000, and the required rate of return is 12%. The net present value (NPV) of the project is closest to : -$66,301 $19,113 $63,000 CFO = -100,000; CF1 = 10,000; CF2 = 15,000; CF3 = 138,000; I = 12; CPT → NPV = $19,112. 28 / 29 An analyst is estimating the NPV of a project to introduce a new spicier version of its wellknown barbeque sauce into its product line. A cost that should most likely be excluded from his analysis is : $100,000 for a marketing survey that was conducted to determine demand for a spicier sauce $200,000 to develop a recipe for the new sauce a $150,000 decrease in sales of its current sauce as some current customers switch to the spicier sauce 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 . 29 / 29 A project has the following annual cash flows : Which of the following discount rates most likely produces the highest net present value (NPV) ? 15% 8% 10% CF0 = – 4,662,005 ; CF1 = 22,610,723 ; CF2 = ‒ 41,072,261 ; CF3 = 33,116,550 ;CF4 = ‒ 10,000,000 ; I = 8 ; CPT NPV = ‒ 307.7589 CF0 = – 4,662,005 ; CF1 = 22,610,723 ; CF2 = ‒ 41,072,261 ; CF3 = 33,116,550 ;CF4 = ‒ 10,000,000 ; I = 15 ; CPT NPV = 99.9354 CF0 = – 4,662,005 ; CF1 = 22,610,723 ; CF2 = ‒ 41,072,261 ; CF3 = 33,116,550 ;CF4 = ‒ 10,000,000 ; I = 8 ; CPT NPV = ‒ 0.0120 Your score is LinkedIn Facebook Twitter VKontakte 0% Send feedback types of capital investments made by companies Principles of Capital Allocation Net Present Value (NPV) Internal Rate of Return (IRR) relations among a company’s investments, company value, and share price calculate net present valueCapital Investmentscapital investments examples