Exam 10: Project Cash Flows and Risk

Depreciation must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project because

Hill Top Lumber Company is considering building a sawmill in the province of Limpopo because the company doesn't have such a facility to service its growing customer base that is located in the region.Hill Top's executives believe that future growth in the regions' customers will make the sawmill project a good investment.When evaluating the acceptability of the project, which of the following would not be considered a relevant cash flow that should be included when determining its initial investment outlay?

A key difference between replacement and expansion project analyses is that with replacement, the incremental cash flows are measured as the net difference between projected cash flows from the current productive assets and cash flows of the proposed new productive assets.

Topsider Inc.is considering the purchase of a new leather-cutting machine to replace an existing machine that has a book value of R3,000 and can be sold for R1,500.The old machine is being depreciated on a straight-line basis, and its estimated salvage value 3 years from now is zero.The new machine will reduce costs (before taxes) by R7,000 per year.The new machine has a 3-year life, it costs R14,000, and it can be sold for an expected R2,000 at the end of the third year.The new machine would be depreciated over its 3-year life using the MACRS method.Assuming a 40 percent tax rate and a required rate of return of 16 percent, find the new machine's NPV.

Mars Inc.is considering the purchase of a new machine which will reduce manufacturing costs by R5,000 annually.Mars will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for R10,000.The firm expects to be able to reduce net working capital by R15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 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 R60,000, what is the NPV of the project?

Table Rock, an all-equity firm, currently has a beta of 1.25, and rRF = 7 percent and rM = 14 percent.Suppose the firm sells 10 percent of its assets (beta = 1.25) and purchases the same proportion of new assets with a beta of 1.1.What will be the firm's new overall required rate of return, and what rate of return must the new assets produce in order to leave the share price unchanged?

Monte Carlo simulation

One problem with the Monte Carlo simulation analysis is that, while the simulation may provide some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus reject decision.

Quantification of risk is the easiest part of incorporating risk into capital budgeting; treatment of that calculated risk measure is more difficult.

If a typical S.A.company uses the same discount rate to evaluate all projects, the firm will most likely become

Your company is considering a machine which will cost R50,000 at Time 0 and which can be sold after 3 years for R10,000.R12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3.The facility will produce sales revenues of R50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales.No fixed costs will be incurred.Operating cash inflows will begin 1 year from today (at t = 1).By an act of Congress, the machine will have depreciation expenses of R40,000, R5,000, and R5,000 in Years 1, 2, and 3 respectively.The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent required rate of return.Inflation is zero.What is the project's NPV?

Mid-State Electric Company must clean up the water released from its generating plant.The company's required rate of return is 10 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects.Clean-up Plan A, which is of average risk, has an initial cost of -R1,000 at time 0, and its operating cost will be -R100 per year for its 10-year life.Plan B, which is a high-risk project, has an initial cost of -R300, and its annual operating cost over Years 1 to 10 will be -R200.What is the proper PV of costs for the better project?

Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables, such as sales.Other things held constant, with the independent variable graphed on the horizontal axis, the steeper the graph of the relationship line, the less risky the project.

It is possible with a replacement project that the incremental depreciation cash flows will be negative even if the actual depreciation on the new asset is positive.

Which of the following statements is correct?

Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash flows are riskier.

In theory, the decision maker should view market risk as being of primary importance.However, within-firm, or corporate, risk is relevant to a firm's

Sensitivity analysis is a risk analysis technique in which key variables are changed and the resulting changes in the NPV and IRR are observed.

Exhibit 10-1 You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck.The truck's basic price is R50,000, and it will cost another R10,000 to modify it for special use by your firm.The truck falls into the MACRS three-year class, and it will be sold after three years for R20,000.Use of the truck will require an increase in net working capital (spare parts inventory) of R2,000.The truck will have no effect on revenues, but it is expected to save the firm R20,000 per year in before-tax operating costs, mainly labor.The firm's marginal tax rate is 40 percent. [MACRS table required] -Refer to Exhibit 10-1.What is the initial investment outlay for the truck? (That is, what is the Year 0 net cash flow?)

Real Time Systems Inc.is considering the development of one of two mutually exclusive new computer models.Each will require a net investment of R5,000.The cash flow figures for each project are shown below: Model B, which will use a new type of laser disk drive, is considered a high-risk project, while Model A is of average risk.Real Time adds 2 percentage points to arrive at a risk-adjusted discount rate when evaluating a high-risk project.The rate used for average risk projects is 12 percent.Which of the following statements regarding the NPVs for Models A and B is most correct?