AGEC 424 Third Hour Exam Spring2013 (100 points)

Name______

You must show logically correct work, including calculator inputs and outputs for all problems to receive credit. Show signs on calculator inputs. Differentiate calculator outputs from inputs.

  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.
  1. (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.
  1. (2 points) Which of the following is/are included in the list of drawbacks to using the Monte Carlo simulation for dealing with risk in capital budgeting?

a. / Cash flows still have to be estimated subjectively.
b. / Individual cash flows generally don’t behave independently. If one cash flow turns out to be less than expected, several other may behave the same way.
c. / Even after creating a distribution of probably outcomes, it is difficult to know exactly how to interpret the data.
d. / Both a & c are drawbacks.
e. / All of the above are drawbacks.
  1. (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 ProbYear2 ProbYear3 ProbYear4 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.

  1. (2 points) The appropriate interest rate to use in capital budgeting is:

a. / always the company’s cost of capital.
b. / the company’s cost of capital if the project’s risk is about the same as the company’s.
c. / the cost of capital plus any additional risk premium required to compensate for the project’s higher risk.
d. / both b & c
  1. (17 points)Bagel Pantry Inc. is considering two mutually exclusive projects with widely differing lives. The company's cost of capital is 12%. The project cash flows are summarized as follows:

Project AProject B
C0($25,000) ($23,000)
C1$14,742 $ 6,641
C2$14,742 $ 6,641
C3$14,742 $ 6,641
C4$ 6,641
C5$ 6,641
C6$ 6,641
C7$ 6,641
C8$ 6,641
C9$ 6,641 / a. Compute NPV and IRR for the projects (clearly mark all inputs and outputs). Which project(s) would you select, why?

1

b. Compare the projects by using Payback.Which project(s) has the best payback, why?

c. Based on the EAA method (show EAA calculation), which project(s) would you select, why?

d. If the projects were independent instead of mutually exclusive, which would you chose and why?

Questions 7 and 8 are on the last page and you may remove that page from the exam.

Question 7

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

Question 8

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

New Investment

  1. (30 points) Mars Inc. is considering the purchase of a new machine, which will reduce manufacturing costs by $15,000 annually. Mars will use 3-year MACRS (percentages: 33, 45, 15, 7) to depreciate the machine, and it expects to sell the machine at the end of its 3year operating life for $10,000. The firm expects to be able to reduce net working capital by $5,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 3 years. Mars' marginal tax rate is 40 percent, and it uses a 12 percent required rate of return to evaluate projects of this nature. If the machine costs $100,000, determine the cash flows, payback, NPV, and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

Replacement Problem:

  1. (40 points) Meals on Wings Inc. supplies prepared meals for corporate aircraft (as opposed to public commercial airlines), and it needs to purchase new broilers. If the broilers are purchased, they will replace old broilers purchased 10 years ago for $105,000 and which are being depreciated on a straight line basis to a zero salvage value (15year depreciable life). The old broilers can be sold today for $60,000, but will have onlya $10,000 market value in 3 years. The new broilers will cost $100,000 installed and will be depreciated using MACRS over their 3year class life (percentages in problem above); they will be sold at twice their book value at the end of the 3rdyear. The firm expects to increase its revenues by $33,000 per year if the new broilers are purchased, but cash expenses will also increase by $3,000 per year. The firm's required rate of return is 10 percent and its tax rate is 40 percent. Determine the cash flows, NPV, and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

1