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 Kim Corporation is considering an investment of 750 million with expected after-tax cash inflows of 175 million per year for seven years. The required rate of return is 10 %. What is the investment’s : NPV (102 million) . IRR (14.0%) NPV (193 million) . IRR (10.0%) NPV (157 million) . IRR (23.3%) Using a financial calculator : CF0 = – 750 ; CF1 = 175 ; F1 = 7; CPT IRR = 14.0198 CF0 = – 750 ; CF1 = 175 ; F1 = 7; I = 10 ; CPT NPV = 101.9733 2 / 29 With regard to capital allocation, an appropriate estimate of the incremental cash flows from an investment is least likely to include : interest costs externalities opportunity 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 . 3 / 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 analysis should include the value of a put option the analysis should include the value of a call option the assumed investment horizon is too long 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. 4 / 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 stay the same stay the same and the NPV would increase 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 . 5 / 29 A project has the following annual cash flows : Which of the following discount rates most likely produces the highest net present value (NPV) ? 8% 10% 15% 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 6 / 29 Which of the following types of capital investments are most likely to generate little to no revenue? Going concern projects New product or market development 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 . 7 / 29 The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as : sunk cost; externality opportunity cost; externality externality; cannibalization he study is a sunk cost, and the possible increase in sales of a related product is an example of a positive externality. 8 / 29 An investment is purchased at a cost of $775,000 and returns $300,000 at the end of years 2 and 3. At the end of year 4 the investment receives a final payment of $400,000. The IRR of this investment is closest to : 9.45% 8.65% 13.20% Cf0 = -775,000 , C01 = 0, F01 = 1, C02 = 300,000, F02 = 2, C03 = 400,000, F03 = 1; IRR = 8.6534 or Cf0 = -775,000 , C01 = 0, C02 = 300,000, C03 = 300,000, C04 = 400,000 ; IRR = 8.6534 9 / 29 Given the following cash flows for a capital investment, calculate the NPV and IRR. The required rate of return is 8 % . 5 4 3 2 1 0 Year 5,000 10,000 20,000 15,000 15,000 - 50,000 Cash flow NPV (USD 1,905) . IRR (26.0%) NPV (USD 3,379) . IRR (10.9%) NPV (USD 1,905) . IRR (10.9%) Using either the IRR function in Excel or a financial calculator CFO = -50,000; CF1 = 15,000; CF2 = 15,000; CF3 = 20,000; CF4 = 10,000 ; CF5 = 5,000 I = 8; CPT → NPV = $3,378.83 CFO = -50,000; CF1 = 15,000; CF2 = 15,000; CF3 = 20,000; CF4 = 10,000 ; CF5 = 5,000 CPT → IRR = 10.8795 or NPV = -50, 000 + 13, 888.89 + 12, 860.08 + 15, 876.64 + 7, 350.30 + 3, 402.92 NPV = -50, 000 + 53, 378.83 = 3, 378.83 10 / 29 Given a discount rate of 10%, the net present value (NPV) of the following investment is closest to : 6 5 4 3 2 1 0 time 300 500 200 1,000 600 300 1,500 - Cash flow 578 636 605 he given cash flows are inserted into a financial calculator along with the 10% discount rate: CF0 = −1,500, CF1 = 300, CF2 = 600, CF3 = 1,000, CF4 = 200, CF5 = 500, CF6 = 300, I = 10. Computing NPV the result is 636.32 ~ 636 . 11 / 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 remain where it is because Ms. Ndereba’s analysis confirms that the recent run-up was justified 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 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 . 12 / 29 A three-year investment requires an initial outlay of GBP1,000. It is expected to provide three year-end cash flows of GBP200 plus a net salvage value of GBP700 at the end of three years. Its IRR is closest to : 11% 20% 10% 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 3 2 1 0 Year 900 200 200 - 1,000 Cash flow (GBP) CFO = -1,000; CF1 = 200; CF2 = 200; CF3 = 900; CPT → IRR = 11.0258 13 / 29 The effects that the acceptance of a project may have on other firm cash flows are best described as: opportunity costs pure plays externalities 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. 14 / 29 The incremental after-tax cash flows (in € thousands) and information on two mutually exclusive projects are as follows: IRR (%) NPV 4 3 2 1 0 Year 16.0 354.0 8,000 8,000 5,000 2,000 15,000 - Project X ? ? 15,000 7,000 500 200 13,250 - Project Y The appropriate hurdle rate to use in evaluating the projects is 15%. Which of the following statements is most accurate? The company should accept: Both projects Project Y only Project X only 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 NPVX and NPVY are positive, but because they are mutually exclusive projects, only the one with higher positive NPV will be chosen 15 / 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 16 / 29 An analyst has gathered the following data about a company with a 12% cost of capital : Project Q Project P 25,000 15,000 Cost 5 years 5 years Life $7,500/year $5,000/year Cash inflows If the projects are independent, what should the company do? Accept Project P and reject Project Q Reject both Project P and Project Q Accept both Project P and Project Q 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. 17 / 29 The effect of a company announcement that they have begun a project with a current cost of $10 million that will generate future cash flows with a present value of $20 million is most likely to : increase value of the firm’s common shares by $10 million increase the value of the firm’s common shares by $20 million only affect value of the firm’s common shares if the project was unexpected 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 . 18 / 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 CAD 190 million to begin production. If demand is high, cash flows are expected to be CAD 40 million per year. If demand is low, cash flows will be only CAD 20 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 CAD 5 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.” What is the NPV (CAD millions) of the original project for Bouchard Industries without considering the production-flexibility option ? CAD 2.33 million - CAD 6.11 million - CAD 5.66 million - If demand is “high,” the NPV is as follows: CF0 = – 190 ; CF1 = 40 ; F1 = 10; I = 10 ; CPT NPV = 55.78 If demand is “low,” the NPV is CF0 = – 190 ; CF1 = 20 ; F1 = 10; I = 10 ; CPT NPV = - 67.11 The expected NPV is 0.50 (55.78) + 0.50 (–67.11) = – 5.66 or (40+20)÷ 2 = 30 CF0 = – 190 ; CF1 = 30 ; F1 = 10; I = 10 ; CPT NPV = - 5.663 19 / 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 : $19,113 -$66,301 $63,000 CFO = -100,000; CF1 = 10,000; CF2 = 15,000; CF3 = 138,000; I = 12; CPT → NPV = $19,112. 20 / 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 $68.52 $42.22 CFO = -100; CF1 = 40 ; CF2 = 80 ; CF3 = 120 ; I = 20 ; CPT → NPV = $ 58.33 or 21 / 29 When dealing with mutually exclusive projects, the most reliable decision rule is : IRR time weighted rate of return NPV 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. 22 / 29 What type of project is most likely to yield new revenues for a company ? Going concern Regulatory/compliance Expansion 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 . 23 / 29 If two projects are mutually exclusive, a company : can accept either project, but not both projects can accept one of the projects, both projects, or neither project must accept both projects or reject both projects Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects . 24 / 29 In the capital allocation process, a post-audit is used to : stimulate management to improve operations, bring results into line with forecasts, and eliminate potentially profitable but risky projects improve cash flow forecasts and eliminate potentially profitable but risky projects improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations . 25 / 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. 26 / 29 Financing costs for a capital project are : subtracted from the net present value of a project subtracted from estimates of a project’s future cash flows 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. 27 / 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 : $326,000 $318,000 $310,000 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 28 / 29 Consider the two investments below. The cash flows, as well as the NPV and IRR, for the two investments are given. For both investments, the required rate of return is 10% . Cash Flows IRR (%) NPV 4 3 2 1 0 Year 16.37 14.12 36 36 36 36 - 100 Investment 1 15.02 19.53 175 0 0 0 - 100 Investment 2 What discount rate would result in the same NPV for both investments ? A rate between 10.00% and 15.02% A rate between 15.02% and 16.37% A rate between 0.00% and 10.00% 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 29 / 29 The post-audit performed as part of the capital budgeting process is least likely to include the : provision of future investment ideas rescheduling and prioritizing of projects indication of systematic errors 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. 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