Deck 7: Making Capital Investment Decisions: Further Issues

Question 1

Opportunity 1 calls for a $24,000 investment which will yield income before depreciation of $18,000 the first year and $20,000 the second year. Opportunity 2 calls for an investment of $36,000 resulting, over three years, in an expected income before depreciation of $15,000, $17,000, and $28,000, respectively. The investments are mutually exclusive. The company's hurdle rate is 12%. Using the equivalent-annual-annuity approach what can be concluded about the investments?

A) Opportunity 1 as it has the higher equivalent annuity of $4,743.
B) Opportunity 2 as it has the higher equivalent annuity of $5,643.
C) Opportunity 1 as its NPV is higher at $11,573.
D) Opportunity 2 as its NPV is higher at $10,875.
E) Opportunity 2 as its cash in flow is larger by $10,000.

Answer 1

A

Question 2

The current general purchasing power of cash flows is determined by

A) Applying a general rate of inflation to all cash flows
B) Including an inflation factor when determining the hurdle rate and then applying it to all cash flows
C) Ignoring inflation in the calculations as it affects various items differently and ultimately the effects cancel each other out
D) Determining and applying the specific rate of inflation for each item in a cash flow as well as specific rates of inflation to each type of cash flow
E) Determining the monetary cash flows from each item and deflating these amounts by the general rate of inflation

Answer 2

E

Question 3

Martin Rose Associates have included the cost of theft of their intangible assets in calculating the NPV of several biometric security scanning systems for the company's research facilities. A new generation of biometrics is likely to be unveiled within 12 to 18 months that could double the benefits that the current biometric system would deliver. The company should

A) Install the security system that achieves the highest NPV immediately
B) Wait until the technology is launched and costs are established before generating a NPV analysis on biometrics and selecting a system
C) Add the anticipated benefits from the new systems to the initial expenditures in the current NPV analysis
D) Install the security system that achieves the highest NPV immediately and reserve the cost of upgrades in a contingency fund
E) Re-open the investigation into improving security for the research facilities to determine if the benefits from the future of biometrics can be achieved in another way now

Answer 3

C

Question 4

Two or more investment opportunities score the same ENPV. What should the company do with respect to the projected cash flows on which the analysis is based?

A) Not consider the cash flows as risk has already been factored in the analysis and will be double counted.
B) Consider the cash flows on which ENPV was created as the option with the largest cash flow is the appropriate choice.
C) Always delay the project until more information resolves the tie.
D) Consider the cash flows as risk-adverse investors will choose the project with the lowest potential loss.
E) Not consider the cash flows and select the project on qualitative features alone.

Question 5

The Oakley-Brown, a frozen food processor, is considering buying a curly-fry extruder with potato preparation attachments for $90,000. It expects to sell 2,500 cases the first year and 4,500 cases for four years after that while the craze lasts. Price per case will be $30. Cost of goods, selling and administration expenses equal $62,500 in the first year and $100,500 in the subsequent years. What price drop will bring NPV to near zero if the company's hurdle rate is 14%?

A) $0.06
B) $0.15
C) $0.67
D) $1.00
E) $1.50

Question 6

An investment opportunity with identified risks and returns has been consistently rejected in competition with other opportunities. This is most likely because

A) The project is available over the next few years and so can be delayed
B) The project would require the hiring of new staff
C) The project is not offering sufficient compensation for its risks
D) A company cannot invest in all the opportunities it faces
E) The project is outside the usual business of the company

Question 7

Currently 90-day Treasury bills are trading at 7% per annum and inflation is running at 4.5%. A company is issuing bonds with a face value of $1,000 and an annual interest rate of 8% and maturity in 25 years. What can be concluded about the market's view of the company's level of riskiness?

A) It is risky because the term of the bond is 25 years.
B) It is not risky as the risk premium attached to the bond is 1%.
C) It is risky as the risk premium attached to the bond is 3.5%.
D) It is risky as the risk premium attached to the bond is 77% of the risk-free rate.
E) It is not risky as the risk premium attached to the bond is 14.3%.

Question 8

Sensitivity analysis provides a manager with

A) Clear decision rules about accepting or rejecting a project
B) A measure how much a project factor can change before the project becomes unprofitable
C) A dynamic picture of the interaction of risks involved with all the project factors
D) A single scenario modeling the projected values for all the project's factors
E) A net measure of the financial impact of the simultaneous change in the main project factors

Question 9

LaVerendrye Inc. has $20 million to invest and is looking at three projects. The company's hurdle rate is 14%. Project A's initial investment is $11 million and the cash flow over four years is $1 million, $2 million, $8 million, and $10 million, respectively. Project B's initial investment is $14 million and cash flow over the same period is $10 million, $7 million, $4 million and $4 million. Project C's initial investment is $18 million and its cash flow is $2 million, $5 million, $9 million, and $11 million, respectively. The projects are divisible. Because La Verendrye cannot undertake all three projects, what is their best investment decision?

A) All of C and 14% of B
B) All of B and 55% of A
C) All of B and 33% of C
D) All of A and 64% of B
E) All of A and 50% of C

Question 10

A modeling process that uses equations to show the interrelationships among key factors influencing cash flows and helps managers understand the nature of the project and the issues that need to be resolved is called

A) Risk assessment
B) Expected value analysis
C) Scenario analysis
D) Simulations
E) Portfolio analysis

Question 11

A company uses the Profitability Index to assess investment opportunities when:

A) The flows from the investment alternatives are unequal.
B) The investment alternatives are mutually exclusive.
C) Insufficient funding exists to invest in all the non-divisible projects.
D) A company is subject to capital rationing.
E) Risks from inflation impact projects individually.

Question 12

A company looking for a return of 12% has capital available for projects equalling $100,000 and three projects under consideration. Each of the projects will last five years. While all the projects are divisible, if the company selects project B, it cannot do project C. Project A costs $54,000 and provides and income before amortization of $25,000, $25,000, $28,000, $26,000, and $22,000, respectively. Project B costs $63,000 and provides $12,000, $16,000, $20,000, $30,000 and $45,000 respectively. Project C costs $70,000 and provides $35,000 $24,000 $18,000 $19,000 and $10,000 respectively. The company should do

A) Project A and part of Project B as the NPV is highest for Project A and NPV is higher for Project B than Project C
B) Project A and part of Project C as profitability index is highest for Project A and is higher for Project C than for Project B
C) Project B and part of Project A as NPV is highest for Project B and higher for Project A than Project C
D) All of Project C and part of Project A as this maximizes cash flow according to the profitability index
E) All of Project B and part of Project A as this maximizes cash flow according to the profitability index

Question 13

A company faces a hurdle rate of 12%. It has three possible outcomes to an investment opportunity: a realistic NPV of $17,500, an optimistic NPV of $21,300 and a pessimistic NPV of $4,530. The probabilities associated with the outcomes are 55%, 22% and 23%. What is the company's ENPV?

A) $13,071
B) $13,708
C) $14,443
D) $14,879
E) $15,353

Question 14

Merton Distillers Ltd. has a discount rate of 10% and two possible projects. Both projects allow reinvestment at the end of the term. The first is three years long and has a NPV of $1.3 million. The second is four years long and has a NPV of $1.4 million. Merton Distillers Ltd. should undertake

A) The second project because it has a NPV of $1.4
B) The first project because it has a positive NPV and allows for more rapid reinvestment
C) The second project because it has a higher NPV when calculated by the shortest-common-period-of time approach
D) The first project because its annualized equivalent is higher than that for the second project
E) Neither project because the results from the analytical methods provide conflicting conclusions

Question 15

Mercury Metals has up to $100 million budgeted to purchase high efficiency smelters. The company has an 12% hurdle rate. A part of a smelter cannot be purchased. If Smelter A will cost $55 million and provide an expected income before depreciation of $16 million for each of 20 years and Smelter B will cost $90 million and provide an expected income before depreciation of $22 million in each of 20 years, which is the project Mercury Metals should undertake?

A) Project A with the higher profitability index at 2.2.
B) Project B has the higher profitability index at 1.8.
C) Project A has the higher NPV at $64.5 million.
D) Project A has the higher IRR at 29%.
E) Project B with the higher NPV at $74.3 million.

Question 16

The Oakley-Brown, a frozen food processor, requires an additional refrigeration unit. The company is considering a premium model at a cost of $52,000. Expected life for the unit is five years with a residual value of $18,500. The incremental income before depreciation is expected to be $14,500 a year. The company's cost of capital is 14%. Using 14% and 25% as trial values, what increase in the cost of capital will eliminate the unit from consideration?

A) 0.6%
B) 11%
C) 2.0%
D) 5.1%
E) 19.7%

Question 17

Kendle Knitting Mills is looking to purchase additional weaving looms of different sizes. One supplier has offered an appropriate configuration of machines valued at $175,000. Kendle projects incremental income from these looms before depreciation at $40,000 a year over an eight year period. Kendle can purchase similar used machines for $85,000 but the equipment is less efficient and will only last four years. Income from these is projected at $40,000, $37,000, $33,000, and $28,000 respectively. Both used and new machines will have no salvage value at the end of their useful lives. If Kendle is looking for a 14% return, determine if Kendle should buy new or used looms using common-shortest period of time approach. What should Kendle buy?

A) Neither new looms nor old as the NPV for both is negative.
B) Used looms as they have a NPV that is $17,164 higher than new.
C) Used looms as they have a NPV that is $67,494 higher than new.
D) New looms as they have a NPV that is $90,568 higher than old.
E) New looms as they have a NPV that is $3,324 higher than old.

Question 18

Li'l Lucy's Fried Chicken would like to invest $2 million to buy land and build a a restaurant in an area that has been rezoned from agricultural to residential. The company expects a 9% return. The company believes there is a 15% probability that the neighbouring land will be fully developed into family homes resulting in income before depreciation of $800,000 a year. It also believes in a 60% chance that the neighbouring land will be gradually developed resulting in Year 1 income of $150,000, Year 2 income of $200,000, Years 3, 4 and 5 income of $500,000 and Years 6 and 7 income of $800,000. There exists a 25% chance that there will be no development resulting in an income of $150,000 a year from an alternative use of the land. Based on ENPV, should Li'l Lucy's Fried Chicken build the restaurant?

A) Yes, ENPV equals $164,207
B) Yes, ENPV equals $250,654
C) Yes, ENPV equals $452,170
D) No, ENPV equals ($5)
E) No, ENPV equals ($483,899)

Question 19

Which of the following may bias the NPV calculation upward?

A) Failure to adjust cash flows but not the discount rate for inflation.
B) Adjusting lease rates where there are long term agreements.
C) Increasing the income tax rate by the inflation rate.
D) Failure to expand working capital.
E) Adjusting wage expense if a union contract with a lower rate is in effect.

Question 20

When measuring satisfaction on a 20 point scale, an individual receives $500 and registers a satisfaction rating of 3. An additional $500 rates a 7 in satisfaction and yet another $500, increases the individual's satisfaction rating to 12. A reduction in wealth of $1000 would bring about a dissatisfaction rating of 5. It could be concluded that the individual is

A) Risk-seeking
B) Risk-avoiding
C) Risk-adverse
D) Risk neutral
E) Risk-attracting

Question 21

What does the expected value-standard deviation rule fail to provide?

A) The size of the return on investment.
B) The risk associated with undertaking the investment.
C) A decision rule that always distinguishes between two investment opportunities.
D) The expected value of the returns of an investment if standard deviations are known.
E) A rule for investments whose returns are distributed along the normal curve.

Question 22

Which of the following is a type of diversifiable risk?

A) Rate of inflation
B) General level of interest rates
C) Weather
D) Exchange rate movements
E) Degree of competition

Question 23

Approximately 20,000 businesses use 350,000 cases of a particular kind of metal fastener. An average case sells for $15. If Flex Bolt Ltd. sells 200,000 cases to 8,000 businesses, what is Flex Bolt's market share?

A) 10 turns
B) 57%
C) 40%
D) 25 turns
E) $3,000,000

Question 24

Smith Inc. of Montreal sells 75% of two million dollars of sales in the United States. Smith expects the Canadian dollar to strengthen vis-a-vis the U.S. dollar over the next year. Which of the following represents Smith's best course of action to limit its risk of currency losses.

A) Hedge the Canadian dollar depreciation risk by buying a forward contract to deliver 1.5 million U.S. dollars at today's exchange rate.
B) Hedge the Canadian dollar appreciation risk by buying a forward contract to deliver 1.5 million Canadian dollars at today's exchange rate.
C) Hedge the U.S. dollar appreciation risk by buying a forward contract to deliver 1.5 million Canadian dollars at today's exchange rate.
D) Hedge the U.S. dollar depreciation risk by buying a forward contract to deliver 1.5 million U.S. dollars at today's exchange rate.
E) Hedge the U.S. dollar appreciation risk by selling a forward contract to deliver 1.5 million U.S. dollars at today's exchange rate.

Question 25

Perminder Ltd. buys raw (green) coffee beans, roasts, packages and distributes premium coffee nationally. Green bean prices, like oil, currency and gold, are set on international markets. Which of the following does Perminder Ltd. face?

A) Non-diversifiable risk that can be reduced by purchasing long-term future contracts.
B) Non-diversifiable risk that can be reduced through changes in processing or investment.
C) Diversifiable risk that can be reduced by purchasing green beans from different growers or different countries.
D) Diversifiable risk that can be reduced by purchasing long term future contracts.
E) Diversifiable risk that can be reduced through changes in processing or investment strategy.

Question 26

There are three projects to consider. Project A and B both have an expected return of $1,000,000. Project C has an expected return of $800,000. Which of the following statements best describes a risk-neutral investor?

A) An investor who would choose to do Project A because it is closer to home, even though it has a lower risk.
B) An investor who would choose to do Project B because it is closer to home, even though it has a lower risk.
C) An investor who would choose to do Project B because it is closer to home, even though it has a higher risk.
D) An investor who would choose to do Project C because it is closer to home, even though it has a lower risk.
E) An investor who would choose to do Project C because it is closer to home, even though it has a higher risk.

Question 27

Which of the following projects would a risk-averse investor choose?

A) an ENPV of $2 million and a standard deviation of $50,000.
B) an ENPV of $2 million and a standard deviation of $200,000.
C) an ENPV of $2 million and a standard deviation of $400,000.
D) an ENPV of $1 million and a standard deviation of $200,000.
E) an ENPV of $3 million and a standard deviation of $2,500,000.

Question 28

In an effort to update its pro forma budget, Morningside Deliveries is attempting to determine the level of service, and therefore income, which will come from a new four-year contract. Morningside assigns a probability of 25% that the customer will require minimum service and provide a NPV of $28,000. The company estimates a 50% probability that medium service will be required and will generate at NPV of $32,000. There is only a likelihood of 25% that the customer will need maximum servicing and produce an NPV of $36,000. What is the standard deviation of the income from the contract?

A) $1,280
B) $4,040
C) $5,657
D) $6,428
E) $3,200

Question 29

Norris Gears Inc. owns land with two vacant warehouses which it could sell as is or be rezoned from commercial to light industrial and the buildings upgraded for manufacturing at a cost of $2,450,000 and used for 15 years. There is a 30% chance the rezoning application will be rejected and then Norris will sell the land after one year to make it saleable. If the property is re-zoned Norris estimates a 25% probability that its sales will be $400,000 per year after expenses and before depreciation, a 65% probability that sales will be $300,000 and a 10% that sales will be low at $200,000. If the property is not rezoned and Norris Gears sells the land, there is a 10% probability that the land will be sold this year at $145,000, an 85% probability that the land will go for $115,000 and a 5% probability it goes for $95,000. What is the net present value to Norris of land with warehouses if the company's hurdle rate is 8%?

A) $204,865
B) $157,228
C) $136,955
D) $131,778
E) $97,311

Question 30

Which of the following business groupings is likely to have the highest negative correlation?

A) An ice cream company and a winter coat company.
B) A cattle farming company and a tractor company.
C) A pleasure boat company and an outboard engine company.
D) A clothing store in Winnipeg and a clothing store in New York.
E) A suntanning company and an ice skating manufacturer.

Question 31

Mountain Water Inc. has $20 million to invest and is looking at three projects. The company's hurdle rate is 14%. Project A's initial investment is $13 million and the cash flow over four years is $1 million, $2 million, $8 million, and $10 million, respectively. Project B's initial investment is $17 million and cash flow over the same period is $10 million, $7 million, $4 million and $4 million. Project C's initial investment is $18 million and its cash flow is $2 million, $10 million, $9 million, and $7 million, respectively. The projects are indivisible and the internal rate of returns of the three projects are 15.99%, 19.83%, and 17.91%. Idle cash earns no return. Because La Verendrye cannot undertake all three projects, what is their best investment decision?

A) A
B) B
C) C
D) None
E) B and 17% of C

Question 32

Etienne Electronics is appraising three projects. Project 1 has a NPV of $64,000 with a 40% probability of occurrence; $78,000 with a 40% probability; and $95,000 with a 20% probability. Project 2 has an NPV of $55,000 and probability of 30%; $105,000 with a probability of 60% and $110,000 with a probability of 10%. Project 3 has an NPV of $75,000 and probability of 20%; $90,000 and probability of 50%, and $105,000 with a probability of occurrence of 30%. Which project should Etienne Electronics undertake?

A) Project 1 as it has the highest return with an ENPV of $94.5 million and a similar risk as the other two projects.
B) Project 3 as it has the highest return, $91.5 million and lowest risk, a standard deviation of $21.4 million.
C) Project 1 as it has the highest return $85.4 and lowest risk, a standard deviation of $24.5 million.
D) No decision can be made as Project 3 has the highest return and a higher risk than the other two projects.
E) Project 2 as it has the highest return $98 million, and lowest risk, a standard deviation of $45.6 million.

Question 33

A company is facing a .45 probability that a competitive product may enter the market at the same time as their own product launch. This would cut their projected demand in half. The company estimates a .35 high market acceptance for that type of product, .45 for medium acceptance. What is the probability of the company's worst possible outcome?

A) 45%
B) 20%
C) 13%
D) 9%
E) 5%

Question 34

Granular Sugar Company is considering buying a new fork lift truck that will improve warehousing efficiency. the cost is $100,000 and it will last two years producing additional cash inflows of $61,500 each year. Granular's cost of capital is 10%. What is the net present value, internal rate of return, percentage margin of safety on the cost and margin of safety on the additional cash inflow?

A) $6,736, 15%, 6.7%, $3,881
B) $6,736, 14%, 7.6%, $6,358
C) $17,409, 59.7%, 45.2%, $10,031
D) $17,409, 19.7%, 9.2%, 45,329
E) $23,000, 10%, 23%, $13,253

Question 35

The validity of the data on which objective probabilities are based always suffers from the situation that

A) The data is historical and may not describe the future
B) The expert input being used can be, in reality, wrong
C) Opinions can be biased by irrelevant factors
D) The data was recorded for other purposes
E) The data required is not available

Question 36

If the coefficient of correlation between two projects is 0, it would indicate that

A) One project is cyclical and the other is somewhat less so
B) Both projects react in a similar manner to a change in interest rates
C) The factors that impact one project's success have no impact on the other project's success
D) The projects are not well diversified
E) The revenue from one project will equally offset the losses in the other

Question 37

Alternative A and Alternative B have the same ENPV. When graphing possible results from the alternative projects, Alternative A has fewer values clustered around the ENPV and has a greater number of lower and higher possible values than Alternative B. What can be concluded when comparing Alternative A to Alternative B?

A) A is not as risky as B because its value distribution indicates a higher upside probability.
B) A is not as risky as B because its value distribution indicates lower overall variability.
C) A is riskier than B because its value distribution indicates a lower overall variability.
D) A is not as risky as B because its values are more equally spread over the entire value range.
E) A is riskier than b because its value distribution indicates a higher downside probability.

Question 38

The Maritime Cannery Company is considering a new machine that costs $100,000. It will last three years and management feels there are two possible cash flow possibilities each year, depending on whether the country is in recession or not. Year 1: 70% chance of $40,000 and 30% chance of $20,000; Year 2: 60% chance of $50,000 and 40% chance of $30,000; Year 3: 80% chance of $60,000 and 20% chance of $20,000. What is the expected net present value of the new machine if the company's discount rate is 6%?

A) ($78,000)
B) ($6,583)
C) $6,000
D) $13,116
E) $28,000

Question 39

Which of the following terms is also used to describe diversifiable risk?

A) Avoidable risk.
B) Macroeconomic Risk.
C) Microeconomic Risk.
D) Entrenched Risk.
E) Systematic Risk.

Question 40

Why are most investors risk averse?

A) Most investors are risk averse because it is the fashionable thing to do when one is investing one's own money.
B) Most investors are risk averse because the idea of making an investment that has a larger standard deviation of investment returns is a good way to earn excess returns.
C) Most investors are risk averse because the idea of making good gains with a small chance of a loss is more important that the idea of making a larger gain with a bigger chance of a loss.
D) Most investors are risk averse because the idea of utility theory is that the richer one becomes, the less chance one wants to take to earn even more money.
E) Most investors are risk averse because the risk-adjusted discount rate takes into account the current inflation rate and hopes to earn a return that beats inflation.

Question 41

Little Air Ltd. is considering two different projects of unequal length. Which two approaches to this problem should result in the same decision?

A) Using the equivalent-interest-rate approach and the shortest-common-period-of-time approach.
B) Using the equivalent-annual-annuity approach and the shortest-common-period-of-time approach.
C) Using the equivalent-annual-annuity approach and the smallest-discount-rate approach.
D) Using the equivalent-internal-rate-of-return approach and the shortest-common-period-of-time approach.
E) Using the equivalent-annual-cost approach and the shortest-common-discount approach.

Question 42

The City of Edmonton is trying to decide whether to build a base facility or an Olympic swimming pool at a new park. For budget reasons, the city cannot afford to build both. Each project is expected to result in a public facility that can be used for twenty years. which of the following best describes the two projects.

A) They are unequal duration, divisible, not mutually exclusive investment projects.
B) They are equal duration, divisible, not mutually exclusive investment projects.
C) They are unequal duration, non-divisible, not mutually exclusive investment projects.
D) They are unequal duration, divisible, mutually exclusive investment projects.
E) They are equal duration, non-divisible, mutually exclusive investment projects.