Deck 10: A: Capital Budgeting: Decision Criteria and Real Option Considerations

Question 1

Under most conditions the equivalent annual annuity method will give the same decision as:

A)the net present value method
B)linear programming
C)the replacement chain method
D)the internal rate of return

Answer 1

C

Question 2

Rollerblade, a maker of skating gear, is evaluating two alternative presses.Press A costs $88,000, has a 4 year life, and is expected to generate annual cash inflows of $30,100 in each of the 4 years.Press B costs $122,000, has an 8 year life, and is expected to generate annual cash inflows of $24,600 in each of 8 years.The cost of replacement for A is $96,000 and the replacement press will generate cash inflows of $30,100 for another 4 years.Rollerblade uses a 12% cost of capital.Which press should be chosen?

A)A
B)B
C)both A and B
D)neither A or B

Answer 2

A
Explanation: NPVᴀ = -$88,000 - $96,000(0.636) + $30,100(4.968) = $480.80
NPVʙ = -$122,000 + $24,600(4.968) = $212.80
Choose A

Question 3

Toy Manufacturers (TM) is considering two mutually exclusive machines to use in its manufacturing process.The net cash flows for each are given below:

If the cost of capital for TM is 13%, which machine should they purchase?

A)Beta: has the highest total net cash flows
B)Beta: it has the highest NPV
C)Axa: it has the highest NPV using infinite replacement
D)Beta: it has the highest NPV using infinite replacement

Answer 3

C
Explanation: NPVᴀ = -$90,000 + $45,000(2.361) = $16,245 NPVʙ = -$105,000 + $35,000(3.517) = $18,095
EAAA = $16,245/2.361 = $6,881 EAAB = $18,095/3.517 = $5,145 NPVᴀ = $6,881/0.13 = $52,931 NPVʙ = $5,145/0.13 = $39,577

Question 4

What is the equal annual annuity for Scorch & Burn Fire Extinguishers if their cost of capital is 8% and the initial investment is $75,000 (rounded)?

A)$5,304
B)$6,271
C)$2,058
D)$4,157

Question 5

Quorex is evaluating two mutually exclusive projects.Project A has a net investment of $48,000 and net cash flows over a six year period of $12,500 per year.Project B also has a net investment of $48,000 but its net cash flows of $8,640 per year will occur over a 12 year period.If Quorex has a cost of capital of 14% for these projects, which project, if either, should be chosen and what is its NPV?

A)A, $862
B)A, $1,800
C)B, $2,475
D)B, $902

Question 6

Lakeland Ramblers is considering two mutually exclusive projects to boost their tourist revenue.Project A costs $60,000 and would produce net cash flows of $25,000 for 5 years.Project B cost $100,000 and will produce annual net cash flows of $25,000 for 10 years.If Lakeland's cost of capital is 12%, which project should be chosen using the equivalent annual annuity method?

A)Project A, NPV is $17,941 higher
B)Project B, NPV is $11,125 higher
C)Project A, NPV is $28,383 higher
D)Project B, NPV is $21,567 higher

Question 7

The best way to measure projects with unequal lives is:

A)the Gordon Model
B)the payback period
C)the net present value method
D)equivalent annual annuity approach

Question 8

The advantage(s) of the equivalent annual annuity method over the replacement chain technique in evaluating mutually exclusive investments having unequal lives include

A)the equivalent annual annuity method is often computationally simpler
B)the equivalent annual annuity method simplifies the handling of the time discrepancies that frequently arise in the replacement chain method
C)the equivalent annual annuity method is theoretically superior
D)a and b only

Question 9

Kaneb is evaluating two alternative pipeline welders.Welder A costs $310,000, has a 7 year life, and is expected to generate net cash inflows of $78,000 in each of the 7 years.Welder B costs $320,000, has a 5 year life, and is expected to generate annual net cash inflows of $68,900 in each of the 5 years.Kaneb's cost of capital is 16%.Using the equivalent annual annuity method, which alternative should be chosen and what is its NPV?

A)B, $4,920
B)A, $7,111
C)B, $10,650
D)A, $7,800

Question 10

What does a firm ignore if it chooses the longer-lived project based solely on the net present value or internal rate of return data?

Question 11

Creative Furniture is considering two mutually exclusive projects that would automate part of their production facilities.Project A costs $120,000 and would produce net cash flows of $37,000 annually for 5 years.Project B also costs $120,000 and will produce annual net cash flows of $25,000 for 10 years.Creative's cost of capital is 11 percent.Using a replacement chain, which project should be chosen? Assume that in 5 years, Project A will still cost $120,000 and produce 5 more years of $37,000 annual net cash flows.

A)Project B.NPV of A is negative
B)Project A.NPV of B is negative
C)Project B.NPV is $492 higher
D)Project A.NPV is $6,468 higher

Question 12

What would be the equal annual annuity for Wallflowers Florist, Inc.if the cost of capital is 10% and the initial investment is $50,000 (rounded)?

A)$2,024
B)$5,033
C)$1,257
D)$8,358

Question 13

Marvec needs to replace an extruder and two replacements look good.Extruder A costs $102,000 and has a 10 year life.Extruder B costs only $56,000 but its expected life is 6 years.Extruder A will generate net cash flows of $17,600 per year for 10 years and B will generate net cash flows of $13,800 per year for 6 years.If Marvec's cost of capital is 11%, which extruder should be chosen and what is its NPV? Use equivalent annual annuities.

A)B, $564
B)B, $2,388
C)A, $1,646
D)A, $280

Question 14

Casa Chica is considering replacing a piece of equipment.Alternative A costs $80,000, has an eight year life and would produce net cash flows of $18,000 in each of the eight years.Alternative B costs $65,000, has a six year life and would produce net cash flows of $18,000 in each of the six years.If Chica's cost of capital is 13 percent, which alternative should be chosen using the equivalent annual annuity method?

A)Project A
B)Project B
C)Indifferent between the two projects
D)Neither, because both projects have a negative NPV

Question 15

is (are) used when evaluating mutually exclusive investments having unequal lives.

A)Equivalent annual annuities
B)Replacement chains
C)Linear programming
D)a and b only

Question 16

Using the equivalent annual annuity method, which project should be chosen?

A)Project B, NPV is approximately $823 higher
B)Project A, NPVʙ is negative
C)Project B, NPV is $10,473 approximately higher
D)Project B, NPV is $90.56 approximately higher

Question 17

When two or more mutually exclusive alternative investments have , neither the net present value nor the internal rate of return method yields reliable accept-reject information unless the projects are evaluated for an equal period of time.

A)unequal lives
B)unequal net cash flows
C)unequal net investments
D)a and b

Question 18

The importance of time discrepancies depends on several items when making capital budgeting decisions.State those items:

Question 19

Dorati Inc.is considering two mutually exclusive projects.Dorati used a 15% required rate of return to evaluate capital expenditure projects.If the two projects have the costs and cash flows shown below, using a replacement chain determine the NPV for each.

Assume in two years Project S will still cost $70,000 and produce the same two years of cash flows.

A)NPVs = $8,860: NPVᴛ = $109,240
B)NPVs = $14,690: NPVᴛ = $109,240
C)NPVs = $40,020: NPVᴛ = $109,240
D)None of these

Question 20

Boomerang Bungee Corp.is considering the following project.Determine the equal annual annuity for the project if the cost of capital is 14%.
Initial Investment: $75,000

Year

A)$5,527.89
B)$4,355.25
C)$7,768.67
D)$2,259.62

Question 21

How does the equivalent annual annuity approach solve the time discrepancy problem?