FIN3403 Ch9 11 Practice Problems Consider the following cash flows for two mutually exclusive capital investment projects The required rate of return is 12 Use this information for the next 5 questions Year 0 1 2 3 4 5 6 Project A Cash Flow 32 400 9 600 9 600 9 600 8 400 8 400 6 000 Project B Cash Flow 14 400 4 200 4 200 4 200 3 600 3 600 3 600 1 What is the IRR of project A Use CF function CF0 32 400 CF1 9 600 CF2 9 600 CF3 9 600 CF4 8 400 CF5 8 400 CF6 6 000 Answer CPT IRR 16 32 2 What is the payback period of project A one year 32 400 9 600 22 800 two years 22 800 9 600 13 200 three years 13 200 9 600 3 600 3 600 8 400 0 43 Answer Payback period is 3 43 years 3 What is the profitability index of project A Use CF function CF0 32 400 CF1 9 600 CF2 9 600 CF3 9 600 CF4 8 400 CF5 8 400 CF6 6 000 CPT NPV 3802 10 Profitability Index NPV CF0 CF0 Answer PI 1 117 3802 10 32 400 32 400 4 Calculate the net present value of project B Use CF function CF0 14 400 CF1 4 200 CF2 4 200 CF3 4 200 CF4 3 600 CF5 3 600 CF6 3 600 I Y 12 Answer CPT NPV 1 842 5 Which of the following statements is true concerning projects A and B a Both NPV and IRR lead to the same investment decision b Due to time disparity IRR indicates that project A should be accepted and NPV indicates that project B should be accepted c Due to time disparity IRR indicates that project B should be accepted and NPV indicates that project A should be accepted d Due to size disparity IRR indicates that project A should be accepted and NPV indicates that project B should be accepted e Due to size disparity IRR indicates that project B should be accepted and NPV indicates that project A should be accepted NPV 1842 IRR 16 58 NPV 3802 IRR 16 32 Project A Project B B should be accepted and NPV indicates that project A should be accepted Answer e Due to size disparity IRR indicates that project 6 Metro Corporation will spend 1 million for special manufacturing equipment Shipping and installation charges will amount to 175 000 and an initial increase in net working capital of 50 000 will be required The equipment will replace an existing machine that has a salvage value of 85 000 and a book value of 140 000 If Metro has a current marginal tax rate of 34 what is the amount of the initial outlay for this project Cost of equipment Shipping Install Total NWC BV SV xT Total 1 000 000 175 000 1 175 000 50 000 85 000 18 700 1 121 300 Answer 1 121 300 7 Shell Biotech Corporation is considering two mutually exclusive capital investment projects Project 1 costs 75 000 and would produce differential cash flows of 16 200 for each of the next 9 years Project 2 also costs 75 000 but would produce differential cash flows of 14 000 for each of the next 12 years If Shell s cost of capital is 11 which alternative should be chosen Use CF Function Project 1 CF0 75 000 CF1 16 200 CF2 16 200 CF3 16 200 CF4 16 200 CF5 16 200 CF6 16 200 CF7 16 200 CF8 16 200 CF9 16 200 Project 2 CF0 75 000 CF1 14 000 CF2 14 000 CF3 14 000 CF4 14 000 CF5 14 000 CF6 14 000 CF7 14 000 CF8 14 000 CF9 14 000 CF10 14 000 CF11 14 000 CF12 14 000 NPV 13592 NPV 2908 Answer Project 1 should be accepted 8 Jefferson Corporation is purchasing equipment with a 10 year life which will increase revenue by 38 000 per year and increase expenses by 21 000 per year The cost of the project is 24 000 and the equipment has a salvage value of 9 000 at the end of the tenth year The project will require a 6 000 investment in net working capital immediately The equipment will be depreciated for 10 years using simplified straight line Jefferson s marginal tax rate is 35 Calculate the total year 10 net cash flow including both the last annual cash flow and the project s terminal cash flow Increase in revenue Expenses Cost Depreciation Terminal Cash Flow Total year 10 CF 38 000 21 000 24 000 14 600 5110 9490 2400 11890 11850 23 740 Answer 23 740 9 The approach is used by corporations that attempt to consider differential project risk in their capital budgeting procedures Answer Risk adjusted discount rate 10 Windsor Corporation is considering an investment which will require the purchase of a machine The machine costs 800 000 has a class life of 5 years and will be depreciated using simplified straight line depreciation The firm s marginal tax rate is 35 The incremental cash inflows expected over the 5 year life of the project are 240 000 per year and cash expenses are 80 000 per year In addition the new machine will reduce defects by 15 000 per year The new machine will require a one time increase in net working capital of 25 000 at the time of installation At the end of 5 years the machine will be worthless and the firm will not replace it Calculate the annual cash flow resulting from this project 240 000 80 000 Annual Cash Flows Revenue Expenses Reduced Defects 15 000 Depreciation EBT Tax EBIT Depreciation Total 160 000 15 000 5250 9750 160 000 169 750 Answer 169 750 11 Heron Corporation is planning to add manufacturing capacity by installing new high tech machines The machines would increase revenues by 180 000 per year and increase costs by 50 000 per year The new machines cost 560 000 and would be depreciated over 5 years using simplified straight line Investment in net working capital of 30 000 would be required at the time of installation The firm is planning to keep the machines for 7 years and then sell them for 80 000 The firm has a required rate of return on investment projects of 13 and a marginal tax rate of 34 What is the net present value of this project Initial Outlay Cost NWC Total 560 000 30 000 590 000 Years 6 7 180 000 50 000 130 000 44 200 85 880 Annual Cash Flow Years 1 5 Revenue 180 000 50 000 Cost Depreciation 112 000 EBT Tax EBIT Depreciation112 000 Cash Flow 123 880 18 000 6120 11880 Terminal Cash Flow 80 000 Salvage 27 200 Tax 30 000 NWC 82 800 TCF Use CF Function CF0 590 000 CF1 123 880 CF2 123 880 CF3 123 880 CF4 123 880 I Y 13 CF5 123 880 CF6 85 880 CF7 85 880 82 …