Deck 3: Opportunity Cost of Capital and Capital Budgeting

Question 1

Gorgeous George is evaluating a three-year investment in an oil-change franchise, which costs $25,000 paid up front. Projected net operating cash flows are $40,000 per year. If Gorgeous George buys shares instead of the franchise, he expects an annual return of 15%. Which is true?

A)The future value of the franchise is $95,000
B)The net present value of the franchise is $91,329
C)The future value of the franchise is $138,900
D)The net present value of the franchise is $66,329
E)None of the above

Answer 1

D

Question 2

A lump sum of $5,000 is invested at 10% per year for five years. The company's cost of capital is 8%. Which is true?

A)The investment has a future value of $7,347
B)The investment has a future value of $8,053
C)The investment has a present value of $5,000
D)The investment has a net present value of $5,000
E)None of the above

Answer 2

B

Question 3

Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. What is the issue price of the Treasury bond?

A)$100,000
B)$108,110
C)$92,278
D)$125,000
E)None of the above

Answer 3

B

Question 4

The Baltic Company is considering the purchase of a new machine tool to replace an obsolete one. The machine being used for the operation has a tax book value of $80,000, with an annual depreciation expense of $8,000. It has a salvage value (resale value) of $40,000, is in good working order, and will last, physically, for at least 10 more years. The proposed machine will perform the operation so much more efficiently that Baltic engineers estimate that labor, material, and other direct costs of the operation will be reduced $60,000 a year, if it is installed. The proposed machine costs $240,000 delivered and installed, and its economic life is estimated at 10 years, with zero salvage value. The company expects to earn 14 percent on its investment after taxes (14 percent is the firm's cost of capital). The tax rate is 40 percent, and the firm uses straight-line depreciation. Any gain or loss on the machine is subject to tax at 40 percent.
Should Baltic buy the new machine?

Question 5

Peter Pontificator is proposing to purchase a paddle machine, which will cost $1 million, last eight years and have a salvage value of 20%. Given a tax rate of 35%, and a cost of capital of 6%: If double-declining balance depreciation is used, and PP switches to straight-line depreciation in year 6, the present value of the depreciation tax shield is:

A)$287,506
B)$230,005
C)$286,513
D)$229,211
E)none of the above

Question 6

Financing Charges and Net Present Value
The president of the company is not convinced that the interest expense should be excluded from the calculation of the net present value. He points out that, "Interest is a cash flow. You are supposed to discount cash flows. We borrowed money to completely finance this project. Why not discount interest expenditures?" The president is so convinced that he asks you, the controller, to calculate the net present value including the interest expense.
How can you adjust the net present value analysis to compensate for the inclusion of the interest expense?

Question 7

Suppose the opportunity cost of capital is 10 percent and you have just won a $1 million lottery that entitles you to $100,000 at the end of each of the next ten years.
Required:
a. What is the minimum lump sum cash payment you would be willing to take now in lieu of the ten-year annuity?
b. What is the minimum lump sum you would be willing to accept at the end of the ten years in lieu of the annuity?
c. Suppose three years have passed and you have just received the third payment and you have seven left when the lottery promoters approach you with an offer to "settle-up for cash." What is the minimum you would accept (the end of year three)?
d. How would your answer to part (a) change if the first payment came immediately (at t = 0) and the remaining payments were at the beginning instead of at the end of each year?

Question 8

Identifying the Opportunity Cost of Capital
Don Phelps recently started a dry cleaning business. He would like to expand the business and have a coin-operated laundry also. The expansion of the building and the washing and drying machines will cost $100,000. The bank will lend the business $100,000 at 12 percent interest rate. Don could get a 10 percent interest rate loan if he uses his personal house as collateral. The lower interest rate reflects the increased security of the loan to the bank, because the bank could take Don's home if he doesn't pay back the loan. Don currently can put money in the bank and receive 6 percent interest.
Required:
Provide arguments for using 12 percent, 10 percent, and 6 percent as the opportunity cost of capital for evaluating the investment.

Question 9

Peter Pontificator is proposing to purchase a paddle machine, which will cost $1 million, last eight years and have a salvage value of 20%. Given a tax rate of 35%, and a cost of capital of 6%: What is the present value of the tax shield if straight-line depreciation is used?

A)$261,261
B)$271,679
C)$240,700
D)$217,343
E)None of the above

Question 10

How much must Samuel Survivor save each year to accumulate the lump sum found in Q 7, assuming the same annual return?

A)$893
B)$4,062
C)$1,339
D)$937
E)None of the above

Question 11

Harriet Harvester (HH) plans to buy a haymaker. It costs $17,500 and is expected to last for five years. She presently hires 6 workers at $1,000 per month for each of the three harvesting months each year. The equipment would eliminate the need for two workers. HH uses straight-line depreciation and projects a salvage value of $2,500. Her tax rate is 25% and opportunity cost of funds is 3.3%. Which is true?

A)The present value of cash flows in year 5 is $4,463
B)NPV is $8,464
C)NPV is $6,339
D)NPV is $5,058
E)None of the above

Question 12

Assuming Mirtha purchased the risky bond above for $105,000 and the market rate is 6%, which is false?

A)Net present value is $17,080
B)Payback occurs at the end of year 10
C)IRR is 8.25%
D)Present value of the cash flows is $122,080
E)None of the above

Question 13

Cash of $12,000 will be received in year 6. Assuming an opportunity cost of capital of 7.2%, which of the following is true?

A)The future value is $18,212
B)The present value is $7,996
C)The present value is $7,907
D)Provide data for tax purposes
E)None of the above

Question 14

Samuel Survivor is planning to save for retirement 35 years from now. He expects to live 25 years beyond that, and would like an annual retirement income of $38,500 after tax of 30%. What is the lump sum needed to fund retirement, at an expected annual return of 11.2%?

A)$357,888
B)$319,561
C)$456,515
D)$479,118
E)None of the above

Question 15

Furious Fred expects cash flows from an investment as follows: Yr 1 $3,000, Yr 2 $5,000, Yr 3 $8,000
Using an opportunity cost of capital of 5.6%, the present value is:

A)$14,118
B)$14,523
C)$14,361
D)$14,909
E)none of the above

Question 16

Which is true?

A)The present value of a 20-year annuity of $1,900 at 8% is $16,854
B)A $100,000 bond with a 5% coupon will sell at a premium when the market rate of interest is 6%
C)The issue price of a $150,000 zero coupon bond that matures in 6 years when the market rate of interest is 6% is $105,744
D)The present value of a perpetual income stream of $4,000 when the market rate of interest is 8% is $50,000
E)None of the above

Question 17

Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. What is the risk premium that makes Mirtha indifferent between the two investments?

A)7.80%
B)5.66%
C)3.80%
D)5.00%
E)None of the above