Deck 11: Investment, Strategy, and Economic Rents

Question 1

When you are using futures prices to estimate the cash flows of a project the discount rate used is:
I. The cost of capital for the firm
II. The cost of capital for the project
III. The risk free rate

A) I only
B) I and II only
C) III only
D) II only

Answer 1

III only

Question 2

Use of certainty-equivalent cash flows is advantageous in the following ways:
I. there is no need to estimate future prices
II. there is no need to estimate the discount rate
III. there may be large errors introduced because prices in a competitive market fluctuate randomly

A) I only
B) II only
C) I and II only
D) I, II and III

Answer 2

I and II only

Question 3

Suppose the current price of gold is $600 per ounce. The price of gold is expected to grow at 4% per year for the foreseeable future. If the appropriate discount rate is 10%, then the current value of gold per ounce is:

A) Less than $600 per ounce
B) $600 per ounce
C) Greater than $600 per ounce
D) Not enough information

Answer 3

$600 per ounce

Question 4

Suppose the current price of gold is $650 per ounce. The price of gold is expected to grow at 5 % per year for foreseeable future. If the appropriate discount rate is 8%, the present value of gold is:

A) Less than $650 per ounce
B) Greater than $650 per ounce
C) $650 per ounce
D) None of the above

Question 5

The following are some of the competitive advantages that can last longer:
I. patents
II. brand names
III. economies of scale

A) I only
B) II only
C) I and II only
D) I, II and III

Question 6

When futures prices are used to estimate cash flows, the estimates are:
I. Present value of future cash flows
II. Certainty equivalents
III. Same as the estimates using spot prices

A) I only
B) II only
C) III only
D) I and III only

Question 7

A new grocery store cost $50 million in initial investment. It is estimated that the store will generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be sold for $60 million. What is the NPV of the project at a discount rate of 10%?

A) $2.42 million
B) $10 million
C) $6.21 million
D) None of the above

Question 8

Investing in gold is like:
I. Investing in a stock that pays quarterly dividends
II. Investing in a stock that pays annual dividends
III. Investing in Treasury bonds
IV. Investing in a stock that pays no dividends

A) I only
B) II only
C) I,II, and III only
D) IV only

Question 9

A building is appraised at $1 million. This estimate is based on a forecast of net rent of
$100,000 per year discounted at 10% [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of repair and maintenance costs and taxes. Suppose the building is currently in disrepair and it takes one year and $250,000 to bring it into rent able condition. How much would you be willing to pay for the building today?

A) $1,000,000
B) $681,818
C) $750,000
D) None of the above

Question 10

A rental property is providing 13% rate of return. Next year's rent is expected to be $1.0 million and is expected to grow at 3% per year forever. What is the current value of the property?

A) $7.7 million
B) $10 million
C) $33.3 million
D) none of the above

Question 11

The formula Po = Pt/((1 + r)^t) holds good for assets which:
I. Pay no dividends
II. Are traded in a competitive market
III. Cost nothing to hold

A) I only
B) I and II only
C) I,II, and III
D) II and III only

Question 12

Goldsmith labs recover gold from printed circuit boards. It has developed new equipment for the purpose. The following data is given.
(1)) Equipment costs $250,000
(2)) It will cost $200,000 per year to run
(3)) It has an economic life of 5 years and is depreciated using straight-line method
(4)) It will recover 300 ounces of gold per year
(5)) The current price of gold is $600 per ounce and it expected to increase at a rate 4% per year for the foreseeable future
(6)) The tax rate is 30%
(7)) The cost of capital is 8% What is NPV of the equipment?

A) $430,400
B) $520,510
C) $470,400
D) None of the above

Question 13

A new grocery store cost $50 million in initial investment. It is estimated that the store will generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be sold for $55 million. What is the NPV of the project at a discount rate of 10%?

A) $2.42 million
B) $5 million
C) $3.1 million
D) None of the above

Question 14

Economic rents are:

A) Returns that are in excess of the opportunity cost of capital
B) Returns that are equal to the opportunity cost of the capital
C) Returns that are less than the opportunity cost of capital
D) None of the above

Question 15

Which of the following is an example of a strategic asset?

A) trucks
B) diesel engine
C) rail road containers
D) rail road lines

Question 16

The following are some of the competitive advantages that can last longer:
I. proprietary technology
II. protected markets with high barriers to entry by other firms
III. strategic assets that competitors cannot easily duplicate

A) I only
B) II only
C) I and II only
D) I, II and III

Question 17

The present value of risky cash flows is calculated as follows:
I. estimate the expected cash flows and discount these at a rate that is consistent with the risk of the cash flows
II. estimate the certainty-equivalent cash flows and discount these at the risk-free rate
III. estimate the expected cash flows and discount these at the risk-free rate

A) I only
B) II only
C) I and II only
D) III only

Question 18

One way to uncover forecasting errors in NPV estimates is by looking at:
I. Book values
II. Liquidating values
III. Market values

A) I only
B) II only
C) III only
D) I and II only

Question 19

USGOLD Company has an opportunity to invest in a gold mine. The initial investment is
$250 million. The mine is estimated to produce 100,000 ounces of gold per year for the next ten years. The extraction cost of gold per ounce is $150 and it is expected to remain at that level. The current price of gold is $600 per ounce and it is expected to increase by 4% per year for the next 10 years. What is the NPV of the project at a discount rate of 10%? (Ignore taxes.)

A) $ - 3.8 million.
B) $240.8 million.
C) $257.8 million.
D) None of the above.

Question 20

Suppose the current price of gold is $600 per ounce and the price of gold is expected to increase at a rate of 5% per year for the foreseeable future. What is the current value of 0.2 million ounces of gold to be produced each year for the next five years (the discount rate is
8% per year)?

A) $600 million
B) $521.64 million
C) $690.86 million
D) None of the above

Question 21

The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2:
$43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value at the end of year-2 is $60,000, would you scrap the plant at the end of year-2?

A) Yes
B) No
C) Don't know
D) Need more information

Question 22

The annual demand (in millions) for golf balls is given by the equation: Demand = 6 * (5- price). If the price of a golf ball is $3, what is the demand for golf balls?

A) 8 million
B) 12 million
C) 18 million
D) None of the above

Question 23

A positive NPV for a new project is reliable only if it is based on:

A) forecast of cash flows
B) Michael Porter's theories
C) identifiable sources of economic rents
D) none of the above

Question 24

You have inherited 100 acres of Iowa farmland. There is an active market in this type of land and other similar properties are selling for $10,000 per acre. If planted with corn, the net cash flows are expected to be $800 per acre forever. If the discount rate is 10%, how much is the land worth per acre?

A) $10,000
B) $8,000
C) $18,000
D) None of the above

Question 25

NPVs can be thought of as the present value of:

A) economic rents
B) profits
C) revenues
D) none of the above

Question 26

The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A
100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in three years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology?

A) $500,000
B) $210,648
C) +$250,000
D) None of the above

Question 27

The strategy of deliberately slowing down the rate at which new products are introduced by well established and technologically advanced firms is:

A) a good strategy that maximizes economic rents
B) a dangerous strategy as it provides opportunities for other firms to introduce new products
C) a good strategy because firms only have a limited number of good projects
D) all of the above

Question 28

The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A
100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.50. Assuming that the competition will never catch up and the market demand is sufficiently high, what is the net present value
Of building a new plant with new technology?

A) Zero
B) +$500,000
C) +$250,000
D) +$50,000

Question 29

The annual demand (in millions) for baseballs is given by the equation: Demand = 10 * (4-price). If the price of baseballs is $1.50, what is the demand for baseballs?

A) 10 million
B) 15 million
C) 25 million
D) None of the above

Question 30

The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2:
$43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year-1 is $80,000, would you scrap the plant at the end of year-1?

A) Yes
B) No
C) Need more information
D) Don't know

Question 31

The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2:
$43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value at the end of year-2 is $40,000, would you scrap the plant at the end of year-2?

A) Yes
B) No
C) Don't know
D) Need more information

Question 32

In order to better understand a proposed positive net present value project, managers should:

A) Recheck all calculations.
B) Assume there are no forecast errors.
C) Identify sources of economic rent.
D) Evaluate other similar projects the company has undertaken in the past.

Question 33

The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A
100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in five years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology?

A) $500,000
B) $210,648
C) $299,061
D) None of the above

Question 34

You have inherited a run-down house in Chicago. There is an active market in properties of this type, and similar properties are selling for $100,000. If rented out, the cash returns are expected to be $12,000 per year forever. If the appropriate discount rate is 15%, how much is the house worth?

A) $80,000
B) $100,000
C) $180,000
D) None of the above

Question 35

The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2:
$43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year is $66,700, would you scrap the plant at the end of year one?

A) Yes
B) No
C) Depends on the net present value
D) Need more information

Question 36

The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2:
$43,300 and Year-3 = 58,300. (Assume there is no tax.) If the discount rate is 20%, what is the value of the plant at the end of year-2?

A) $48,600
B) $-51,600
C) Zero
D) None of the above

Question 37

As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows: Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (
III)
Each vessel has a life of 15 years, (
IV) current salvage value of either ship (sailing or steam) is
$114,091, and (v) Cost of capital is 10%, (
VI) no taxes. What is the annual revenue from a cargo ship? (Assume that salvage values are independent of use and there are no taxes.) If the cost of carrying cargo by sailing ship were $70,000 per year, what would be the present value of a steamship?

A) $114,091
B) $152,814
C) $215,000
D) None of the above

Question 38

The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2:
$43,300 and Year-3 = 58,300. (Assume there is no tax.) If the discount rate is 20%, what is the value of the plant at the end of year-1?

A) $76,569
B) -23,400
C) 48,600
D) None of the above

Question 39

Allen Technology Company is currently valued at $400 million. It is proposing a new plant with a net present value of $200 million. But the new plant will reduce the value of the existing plant by $50 million. What is the value of the company if it takes up the new plant?

A) $600 million.
B) $200 million.
C) $550 million.
D) None of the above.

Question 40

When the markets become competitive, economic rents:

A) Increase
B) Decrease
C) Remain the same
D) Tend to be zero

Question 41

Price cutting in a competitive market will never lead to the creation of economic rents.

Question 42

Frequently the financial manager can observe market values for real assets e.g. real estate values, values of precious metals etc. However, they have no place in the capital budgeting analysis. For that purpose discounted cash flow is the only proper tool.

Question 43

What is the NPV of a project in a perfectly competitive environment?

A) Positive
B) Negative
C) Zero
D) Cannot be determined

Question 44

Since gold is held as an investment but pays no cash dividends, today's price equals the present value of its forecasted future price.

Question 45

For a stock that pays no dividends, today's price is the present value of next year's price.

Question 46

Sometimes the losses on existing plants may completely offset the gains from new technology.

Question 47

In a highly competitive market, how will a firm most likely produce positive economic rents?

A) A new marketing plan that will gain market share from competitors
B) Renegotiation of financing terms with the firm's funding sources
C) The introduction of new technology that creates manufacturing efficiencies
D) All of the above

Question 48

Briefly explain how investing in gold is like investing in a stock that pays no dividends?

Question 49

In order to generate a positive NPV project, a firm must have competitive advantage.

Question 50

In a competitive market, a firm can earn high economic rents.

Question 51

According to Michael Porter, managers can secure a competitive advantage for their firm within its industry in three ways. They are: by cost leadership, by product differentiation, and by focusing on a particular market niche.

Question 52

The total NPV of a new plant is equal to the NPV of the new plant plus the change in the present value of the existing plant.

Question 53

If a firm expects long-run economic rents from a particular project, the company is considering the effects of competition.

Question 54

Briefly explain the concept of "economic rent."

Question 55

The expected rise in the price of a mineral less extraction costs should equal the cost of capital.

Question 56

The cash forecasts for positive NPV projects are more reliable, if the managers of the firm are able to identify the economic rents associated with the projects.

Question 57

Stealing market share is the best way to create economic rents in a competitive market.

Question 58

The NPV of an investment is the discounted value of the economic rents that it is expected to produce.

Question 59

If an asset is worth more to others than it is to you, you should always attempt to buy it from them.

Question 60

In evaluating a project, it is necessary to consider its effect upon the sales of the firm's existing products.

Question 61

Why are economic rents important to a manager?

Question 62

Briefly explain the two ways in which PVs of cash flows can be estimated.

Question 63

Briefly explain the effect of competition on economic rents

Question 64

Explain the economic concept that prevents economic rents from occurring.

Question 65

Briefly explain the advantage and the disadvantage of a high salvage value for a project.

Question 66

Briefly explain the effect of building new manufacturing plants on the existing plants.

Question 67

State the difference between capital budgeting and strategic planning.

Question 68

What is the total net present value (NPV) of an expansion plan?

Question 69

Briefly explain the main difference between the capital budgeting process and the strategic planning process.

Question 70

Discuss how you would react if you were presented with a project that had a high positive
NPV.