Question 1

The estimated net present value (NPV) of this proposed investment (rounded to the nearest thousand) is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)

Accepted Answer

To calculate the NPV, we need to find the present value of the net cash inflows for 10 years and subtract the initial investment of $600,000.

Using the PV annuity factor of 6.145 from Table 2, we can find the present value of the net cash inflows as:

$144,000 x 6.145 = $883,080

Therefore, the NPV is:

NPV = $883,080 - $600,000 = $283,080

Rounding to the nearest thousand, the estimated NPV is $285,000. Since the NPV is positive, the investment is expected to generate a return greater than the required rate of return of 10%. Therefore, Olsen should undertake the investment.

Question 2

If a company must choose between two mutually exclusive investment projects, the best general method to employ for decision-making purposes is:

Accepted Answer

Net present value (NPV) is the best general method for decision-making purposes when choosing between mutually exclusive investment projects. NPV calculates the present value of future cash flows discounted at a required rate of return, taking into account the time value of money. The project with the highest positive NPV should be chosen as it will generate the most value for the company.

Question 3

Assume that cash inflows occur evenly throughout the year. The estimated payback period for this proposed investment, in years, is (rounded to two decimal places):

Accepted Answer

The payback period is defined as the length of time it takes for the cash inflows from a capital investment to equal the initial investment. To calculate the payback period, we need to determine in which year the cumulative net cash inflows will equal the initial investment of $600,000.

Since the net cash inflow is $144,000 each year, we can divide the initial investment by the annual net cash inflow to get the payback period:

Payback period = Initial investment / Annual net cash inflow
Payback period = $600,000 / $144,000
Payback period = 4.17 years (rounded to two decimal places)

Therefore, the best choice is A) 4.17 years, since this represents the time it will take for the firm to recoup its initial investment.

Question 4

Which of the following is not one of the four general classes of real options?

Accepted Answer

The four general classes of real options are expansion option, abandonment option, investment-timing option, and flexibility option. Exercise option is not a class of real options.

Question 5

The book (accounting) rate of return based on initial investment for this proposed investment is:

Accepted Answer

The accounting (book) rate of return (ARR) is calculated as the average annual profit divided by the initial investment. Since the machine has no salvage value and is depreciated over 10 years using straight-line depreciation, the annual depreciation is $600,000 / 10 = $60,000. The net cash inflow is $144,000, but for accounting purposes, we need to subtract the annual depreciation to find the profit. Thus, the annual profit is $144,000 - $60,000 = $84,000. The ARR is then ($84,000 / $600,000) * 100 = 14.00%.

Question 6

For dealing with uncertainty in the capital budgeting process, all of the following techniques can be used except which one?

Accepted Answer

Linear programming is a mathematical optimization technique used for determining the optimal solutions to a problem, given a set of constraints. It is not directly used for dealing with uncertainty in capital budgeting decisions. The other techniques, such as what-if analysis, Monte Carlo simulation, scenario analysis, and real options analysis, are specifically designed to handle uncertainty and risk in the capital budgeting process.

Question 7

Jasper Company has a payback goal of three years on acquisitions of new equipment. A new piece of equipment that costs $450,000 and a five-year life is being considered. Straight-line (SL) depreciation will be used, with zero salvage value. Jasper is subject to a 40% combined income tax rate. To meet the company's payback goal, the equipment must generate reductions in annual cash operating costs of:

Accepted Answer

The answer of Jasper Company has a payback goal of...

Question 8

The estimated internal rate of return (IRR) on this proposed investment is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)

Accepted Answer

To calculate the IRR, we need to set the present value of the investment's cash inflows equal to the initial cost of the investment and solve for the rate of return that makes this equation true. Using the PV annuity factor of 6.145 and the cash inflows provided, we get:
$400,000 + $150,000/1.1 + $150,000/(1.1)^2 + ... + $150,000/(1.1)^10 = $1,280,000
Simplifying this equation, we get:
$400,000 + $150,000(6.145) = $1,280,000
$1,313,175 = $1,280,000
This equation is not true with a 10% discount rate, as the left-hand side is larger than the right-hand side. However, if we try a higher discount rate, such as 12%, we get:
$400,000 + $150,000/1.12 + $150,000/(1.12)^2 + ... + $150,000/(1.12)^10 ≈ $1,283,447
This is very close to the initial cost of the investment, so the IRR is a little higher than 12%. Therefore, the best answer is D, "Greater than 12%."

Question 9

Amster Corporation has not yet decided on its discount rate for use in the evaluation of capital budgeting proposals. This lack of information will prohibit the company from calculating a proposed investment's:

Accepted Answer

The answer of Amster Corporation has not yet decided on...

Question 10

Which of the following statements regarding real options is true?

Accepted Answer

Real options can be incorporated into the capital budgeting decision process through the use of decision trees, allowing decision makers to consider the value of waiting to make an investment decision and react to changing market conditions or future information. The value of a real option generally increases with the length of time before expiration, making statement A false. Real options can provide value with both favorable and unfavorable future information, making statement C false. Conventional DCF decision models can incorporate the effects of real options, making statement D false. Capital budgeting models can handle multiple options embedded in an investment project, making statement E false.

Question 11

The hurdle rate for accepting new capital investment projects is 4%, after-tax. (Note: To answer this question, students will have to be provided with the Tables provided in Appendix C, Chapter 12. Alternatively, the instructor can provide students with the following PV $1 factors for 4%: for 1 year = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) The estimated internal rate of return (IRR) on this investment is:

Accepted Answer

To determine the IRR, we need to compare the present value of cash inflows with the initial investment. If the present value of cash inflows is greater than the initial investment, then the IRR is greater than the hurdle rate of 4%. If the present value of cash inflows is less than the initial investment, then the IRR is less than the hurdle rate of 4%.

Without any specific data or values, we cannot calculate the exact IRR. However, we can make an educated guess based on the given information. Since the hurdle rate is 4%, we can assume that the cash inflows from the investment are discounted at a rate of 4%. Based on the provided PV factors, the present value of cash inflows from the investment is likely to be slightly above the initial investment. Therefore, the IRR is likely to be slightly above 4%. The best choice, therefore, is C: Slightly above 4%.

Question 12

The estimated value of a real option:

Accepted Answer

The answer of The estimated value of a real option:
...

Question 13

A widely used approach that managers use to recognize uncertainty about individual items and to obtain an immediate financial estimate of the financial consequences of possible prediction errors is:

Accepted Answer

Sensitivity analysis is a widely used approach that helps managers to recognize uncertainty about individual items and obtain an immediate financial estimate of the financial consequences of possible prediction errors. It involves systematically varying key assumptions or inputs in a financial model to assess the overall impact of changes in these variables on the results. This helps managers to understand the level of risk associated with different scenarios and to develop contingency plans to deal with unexpected outcomes. The other options may also be useful in financial analysis, but they are not specifically designed to address uncertainty or the risk of prediction errors.

Question 14

The hurdle rate for accepting new capital investment projects is 4%, after-tax. The estimated book (accounting) rate of return on this project (rounded to two decimal points), based on the initial investment is:

Accepted Answer

The estimated book rate of return is calculated as the average annual income after taxes divided by the initial investment. We don't have any information on income, so we can't calculate this directly. However, we can use the hurdle rate as a benchmark. If the estimated book rate of return is less than 4%, the investment should not be undertaken. If it is greater than 4%, the investment should be considered. 
So, if the hurdle rate is 4% and the estimated book rate of return is less than 4%, we should not undertake the investment. 
The only answer choice that meets this criteria is A) 2.67%.

Question 15

The hurdle rate for accepting new capital investment projects is 4%, after-tax. (Note: PV $1 factors for 4%: for 1 year = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) At a discount rate of 4%, the PV payback period, in years (rounded to two decimal places) is:

Accepted Answer

The answer of The hurdle rate for accepting new capital...

Question 16

Flex Corporation is studying a capital investment proposal in which newly acquired assets will be depreciated using the straight-line (SL) method. Which one of the following statements about the proposal would be incorrect if, instead of SL, the Modified Accelerated Cost Recovery System (MACRS) is used for determining depreciation for income tax purposes?

Accepted Answer

The answer of Flex Corporation is studying a capital investment...

Question 17

Which of the following statements regarding real options is not true?

Accepted Answer

Real options are not traded on an open exchange like financial options. Instead, they are embedded in investment opportunities and can be exercised at a later time to potentially enhance the value of the investment.

Question 18

If a company is faced with limited capital funds for investment (i.e., the company faces capital rationing), the best general method to employ to assess individual project profitability is:

Accepted Answer

The answer of If a company is faced with limited...

Question 19

The accounting (book) rate of return based on average investment (rounded to two decimal places) for this proposed investment is:

Accepted Answer

The answer of The accounting (book) rate of return based...

Question 20

The hurdle rate for accepting new capital investment projects is 4%, after-tax. (Note: the following PV $1 factors for 4%: for 1 year = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) At a discount rate of 4%, the net present value is (rounded to the nearest hundred):

Accepted Answer

To calculate the NPV, we first find the present value (PV) of each year's after-tax cash inflow using the given PV factors, then subtract the initial investment. The calculation is as follows:- Year 1: $18,000 * 0.962 = $17,316- Year 2: $15,000 * 0.925 = $13,875- Year 3: $9,000 * 0.889 = $8,001- Year 4: $6,000 * 0.855 = $5,130- Year 5: $3,000 * 0.822 = $2,466Total PV of cash inflows = $17,316 + $13,875 + $8,001 + $5,130 + $2,466 = $46,788NPV = Total PV of cash inflows - Initial investment = $46,788 - $45,000 = $1,788, rounded to the nearest hundred dollars is $1,800.

Quiz 12: Strategy and the Analysis of Capital Investments