AGEC 424 Exam 3 Spring 2015 (100 points)

Name______

To receive credit you must show all work including calculator inputs and outputs and distinguish the output.

1.  (2 points) The cost of capital is the appropriate discount rate in capital budgeting when:

a. / all the projects are equally risky.
b. / all the projects have the same risk as the current firm.
c. / the projects can be ranked from riskiest to least risky.
d. / all the projects have less risk than the risk of the current firm.

2.  (2 points) The technique for incorporating risk into capital budgeting that involves the use of numbers drawn randomly from probability distributions is called a:

a. / probability simulation.
b. / scenario analysis.
c. / sensitivity analysis.
d. / Monte Carlo simulation.

3.  (5 points) Sanville Quarries is considering acquiring a new drilling machine which is expected to be more efficient than their current machine. The project is to be evaluated over four years. The initial outlay required to get the new machine operating is $675,000. Incremental cash flows associated with the machine are uncertain, so management developed the following probabilistic forecast of cash flows by year ($000). Sanville’s cost of capital is 10%.

Year1 Prob Year2 Prob Year3 Prob Year4 Prob

$150 .30 $200 .35 $350 .30 $300 .25

$175 .40 $210 .45 $370 .25 $360 .35

$300 .30 $250 .20 $400 .45 $375 .40

a. What is the NPV of the expected (mean) cash flows? Show Work.

b. Calculate the project’s best and worst NPVs. Show Work.

4.  (6 points) Provide the missing information for the following projects. Show calculator inputs and output in the space provided.

Project Initial Length Annual Cost of NPV

Investment (in years) Cash Flow Capital

A $100,000 5 $35,000 8% “a”

B $200,000 4 “b” 13% $35,000

C $300,000 7 $50,000 “c” $15,000

a. b. c.

5.  Projected cash flows for two projects are as follows (again, show work, clearly identify all calculator inputs and outputs):

Year / Project A / Project B / a. (4 points) Compute the payback of each investment
0 / ($150,000) / ($200,000)
1 / 80,000 / 50,000
2 / 60,000 / 50,000
3 / 50,000 / 50,000
4 / 60,000
5 / 60,000

b. (7 points) If the firm’s cost of capital is 10% compute the NPV and IRR. If the projects are independent, which would be chosen?

c. (4 points) If the projects are mutually exclusive and the equivalent annual annuity method is used to eliminate the disparity between the projects’ lives, which project should be undertaken? Why?

Questions 6 and 7 are on the back page and that page may be removed from the exam.

Question 6

Initial Outlay / Depreciation [initial basis = / ]
Operating Cash flow
minus
deprec.
EBT
less taxes
EAT
Dep. add-back
OCF
Terminal CF / Calculator inputs/outputs and investment decision
TCF workspace

Question 7

Initial Outlay / Depreciation [initial basis = / ]
Work space
Operating Cash flow
minus
deprec.
EBT
less taxes
EAT
Dep. add-back
OCF
Terminal CF / Calculator inputs/outputs and investment decision
TCF workspace

The previous sheets are for these two problems. You may detach this page.

New Investment

6.  (30 points) You have been asked by the president of your company to evaluate the proposed acquisition of a spectrometer for the firm’s R&D department. The equipment’s base price is $70,000, and it would cost another $30,000 to modify it for special use by your firm. The spectrometer, which falls into the MACRS three-year class, would be sold after three years for $40,000 (percentages: 33%, 45%, 15% and 7%). Use of the equipment would require an increase in net working capital (spare parts inventory) of $10,000. The spectrometer would have no effect on revenues, but it is expected to save the firm $100,000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax rate is 40 percent and cost of capital is 12 percent. Determine the cash flows, payback, NPV, and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

Replacement Problem:

7.  (40 points) Two years ago our company bought equipment for $2 million that has been depreciated straight line over a five-year life. The existing equipment has a current market value of $500,000 (but would be worth only $200,000 if kept 3 more years). More efficient equipment can be purchased today for $3 million and is expected to last 3 years (economic life), at which time its anticipated salvage value would be $300,000. The new machine will be depreciated using 3-year MACRS (percentages: 33%, 45%, 15% and 7%). Our company would realize a $2,000,000 per year operating cost savings by replacing the old equipment with the new equipment. Also, our Net Working Capital requirement would decrease by $50,000 as soon as we bought the equipment, but would increase again when it is sold at the end of its economic life (3 years). Our marginal tax rate is 40% and the firm’s WACC is 10%. Identify the relevant cash flows for this project, NPV, IRR, and should the company make this replacement investment (state why)?

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