Week 6

Week 6 A company has only $40 million to spend on all its capital projects for the current year. However, based on management's analyses, the company would require $50 million to invest in all its positive net present value (NPV) projects. All the projects are independent (none are mutually exclusive). Which method should the company use to decide which projects should be invested in for the current year? a) Sensitivity analysis b) Profitability index c) Payback period analysis d) Net present value - Answer b) is correct. The profitability index ranks projects and takes relative performance into account. This method can assist the company in selecting which combination of projects it should invest in based on the profitability of each relative to their initial investment. Which of the following describes some of the types of cash flows included in the capital budget analysis? a) Incremental contribution margin, debt principal repayments, and operating cash flows after tax b) Interest costs, capital expenditures, and salvage values c) Tax shield on capital investments, working capital investments, and dividend payments d) Capital expenditures, cash-basis income taxes, and working capital investments - Answer d) is correct. Capital expenditures, cash-basis income taxes, and working capital investment cash flows are incorporated into the cash flows for a capital budget. Ryan Car Inc. (Ryan) is assessing the investment in a new machine that will cost $450,000 after taxes. Ryan has forecasted that with the new machine, annual before-tax cash inflows will increase by $125,000 per year for the next eight years. The company has an income tax rate of 15%. What is the payback period for this project? a) 3.18 years b)3.60 years c) 4.24 years d)8.0 years - Answer c) is correct. The payback period is: $450,000 / $125,000 × (1 - 0.15) = 4.24 years. York Inc. is reviewing an investment in a new product line and trying to determine which cash flows to include in the analysis. One of the cash flows relates to research and development costs that have been incurred over the past year and resulted in a prototype of this new product. These research and development costs represents an example of what type of cost? a) An opportunity cost b) A sunk cost c) An incremental cost d) A side effect - Answer b) is correct. A sunk cost is a cost incurred in the past that cannot be changed regardless of whether a project is accepted or rejected. Franceston Corp. is preparing an NPV analysis for a capital project. The initial investment will be for building additions of $1,350,000 in the current year that qualify for capital cost allowance (CCA) at 4% declining balance and fall under CCA Class 1. The building additions qualify for the Accelerated Investment Incentive. The company has an income tax rate of 25%. The company's current cost of capital is 11%, but this is a riskier project, with a hurdle rate of 15%. What is the amount of the net incremental cash flow related to this initial investment? a) $1,314,049 outflow b) $1,274,314 outflow c) $1,255,541 outflow d) $1,278,947 outflow - Answer b) is correct. The net incremental cash flow is $1,350,000 - $75,686 (present value of the tax shield on the CCA) = $1,274,314. The present value of the tax shield on CCA is calculated using the following formula: PV tax shield on CCA = $1,350,000 × 0.04 × 0.25 0.04 + 0.15 × 1 + 1.5(0.15) 1 + 0.15 = $75,686 Ghostion Inc. is preparing a net present value analysis for a project. The project has an initial investment outflow of $4,500,000 for new equipment (net of applicable taxes). In addition, an asset that the company currently owns will also be used for the project. The book value of this asset is $370,000, its original cost was $950,000, and its current value to the company (after tax) is $500,000. The company also incurred $125,000 for a consultant's report related to this project. Although the report is completed, it has not yet been paid for. Annual incremental after-tax cash flows for the project have been forecasted as follows: Amount Year 1 $400,000 Year 2 1,500,000 Year 3 1,600,000 Year 4 2,200,000 Year 5 800,000 This project is assessed as high risk at a discount rate of 12%. Currently, the company has an 8% cost of debt and a 15% cost of equity. What is the net present value of this project? a) Positive $8 - Answer c) is correct. The net present value is calculated as follows: NPV Amount Discounted amount at 12% Year 1 $ 400,000 $ 357,143 Year 2 1,500,000 1,195,791 Year 3 1,600,000 1,138,848 Year 4 2,200,000 1,398,140 Year 5 800,000 453,941 $4,543,863 Initial investment (5,000,000) Net present value $(456,137) Zanipul Inc. (Zanipul) is considering a major expenditure of $225,000 to improve its manufacturing technology, which will result in annual operating cost savings of $85,000 for the next three years. The initial outlay can be expensed immediately for tax purposes. Zanipul's income tax rate is 25%. What is the internal rate of return (IRR) of this investment? a) 6.53% b) 7.71% c) 14.3% d) 23.87% - Hide question 7 feedback Answer a) is correct, as follows: PV = -168,750; PMT = 85,000 (1 - 0.25) = 63,750; N = 3; CPT I = 6.53% Twoquest Inc. is considering a new investment that is similar in risk to the company's main business. The following table sets out information regarding the firm and the potential project: Annual cash inflows from revenues for the project $1,200,000 Annual cash outflows for operating expenses for the project $ 740,000 Initial investment net of the present value of the tax shield for CCA $1,000,000 Weighted average cost of capital (WACC) 12% Corporate tax rate 40% Market value debt/equity ratio 1.0 Cost of debt 8% The project has an expected life of five years. There would be no salvage value at that time. Annual revenues and expenses would occur at the end of each year for the next five years. What is the net present value of the project? a) $(5,082) b) $101,988 c) $658,197 d) $994,918 - Answer a) is correct. NPV = PV of after-tax cash flows for five years at 12% - the initial investment Annual after-tax cash flows = ($1,200,000 - $740,000) × (1 - 0.4) = $276,000 PV of after-tax cash flows for five years at 12%: PMT = $276,000; N = 5; I/Y = 12; PV = $994,918 NPV = $994,918 - $1,000,000 = $(5,082) A company is considering investing in a machine costing $3,250,000 (net of tax shield). The machine would generate annual net after-tax cash inflows of the following amounts: Year 1 $ 500,000 Year 2 950,000 Year 3 1,200,000 Year 4 1,600,000 Year 5 800,000 These cash flows would occur at the end of the year. The discount rate appropriate for this project is 9% and the company has an income tax rate of 15%. What is the discounted payback period for this project? a) 3.06 years b) 3.38 years c) 3.94 years d) 4.97 years - Answer c) is correct because, as seen in the calculation below, the discounted payback period is calculated as 3 years + [($1,065,045) / $1,133,440] = 3.94 years. Amount PV factor PV at 9% Cumulative Year 0 ($3,250,000) ($3,250,000) Year 1 500,000 0.9174 $ 458,700 (2,791,300) Year 2 950,000 0.8417 799,615 (1,991,685) Year 3 1,200,000 0.7722 926,640 (1,065,045) Year 4 1,600,000 0.7084 1,133,440 68,395 Year 5 800,000 0.6499 519,920 588,315 JYP Inc. (JYP) is evaluating two projects and has gathered the following data about them. JYP has a 10% required rate of return for both projects. Assume all cash flows are after tax. Project A Project B Initial costs $16,000 $20,000 Project life 5 years 5 years Cash flows $7,000 per year $7,500 per year If the projects are mutually exclusive, the company should: a) Accept Project A and reject Project B. b) Reject Project A and accept Project B. c) Accept both projects. d) Reject both projects. - Answer a) is correct. Mutually exclusive means that only one project in a set of possible projects can be accepted and that the projects compete with each other. Therefore, the project with the highest NPV should be accepted. PV of Project A: ($7,000 × 3.791) = $26,537 (N = 5; I/Y = 10%; PMT = $7,000) NPV of Project A: $26,537 - $16,000 = $10,537 PV of Project B: ($7,500 × 3.791) = $28,433 (N = 5; I/Y = 10%; PMT = $7,500) NPV of Project B: $28,433 - $20,000 = $8,433 Notwithstanding its drawbacks, the payback period method is widely used as a project evaluation tool, as it can provide useful information. Which of the following statements about the payback period method is true? a) The payback period method gives an indication of how quickly the firm will recover its investment. b) The payback period method is helpful in evaluating how sensitive a net present value calculation is to small changes in assumptions. c) The payback period method accounts for all cash flows in the project under consideration. d) It is very easy to compare opportunity costs when the payback period method of project evaluation is used - Answer a) is correct. The payback period method gives an indication of how quickly the firm will recover its investment. Which of the following statements is the most accurate regarding a normal capital budgeting project? a) If the NPV of its future cash flows is greater than 0, then the IRR is equal to the discount rate. b) If the IRR is greater than 0, then it must have a positive NPV. c) If the profitability index (PI) is greater than 0, then the project must have a positive NPV. d) If the IRR is greater than the discount rate, then the project's profitability index will be greater than 1. - Hide question 12 feedbackAnswer d) is correct. If the IRR is greater than the discount rate, then the project has a positive NPV, which implies a profitability index that is greater than 1. A company is looking to replace a machine with a new unit that is more efficient. The controller asks one of his financial analysts to prepare a net present value (NPV) analysis of the project. In preparing the NPV, which of the following factors is least likely to be relevant to the decision? a) The purchase price of the old machine b) The salvage value of the old machine c) The cost of repairs that have to be made immediately on the old machine d) The annual operating cost of the new machine - Answer a) is correct. The purchase price of the old machine represents a past cash outflow that is no longer relevant in today's analysis. It is now considered a sunk cost. Which of the following capital budgeting methods is most helpful for evaluating three independent capital projects under capital rationing? a) Net present value b) Internal rate of return c) Discounted payback period d)Profitability index - Answer d) is correct. The profitability index is the ratio of the present value of expected cash inflows over the present value of the net initial investment. The higher the index value, the more attractive the opportunity. As a result, it can be used to choose which projects should be accepted when capital is rationed. Which of the following statements regarding capital markets is true? a) Secondary capital markets provide a source of liquidity for investors. b) Companies and governments use the secondary capital market to raise funds for their operations. c) Offering memorandums are used to provide details of new public issues in the capital market. d) The primary market is only for shares and the secondary market is only for bonds. - Hide question 15 feedback Answer a) is correct. The secondary market provides a mechanism for liquidity by allowing investors to sell stocks to investors wishing to purchase stocks. Over the past couple of months, share prices have been steadily increasing for Sanjay Co. (Sanjay). Today, Sanjay announced its earnings for the last quarter, which were lower than anticipated by the market. Internally, management was already aware that earnings would be lower. In a semi-strong-form efficient market, what will be the immediate impact on Sanjay's share price? Incorrect Response a) The share price will remain unchanged since this information was already known by insiders and has been incorporated into the market price. b) The share price will increase as the share price has been steadily trending upward. c) The impact on the share price cannot be predicted. d) The share price will decrease because lower future cash flows will now be expected. - Answer a) is incorrect. This response reflects a strong-form efficient market where all information is reflected in the share price, including insider knowledge. Answer d) is correct. In a semi-strong-form efficient market, the share price will change with new publicly available information. Lower earnings may imply lower future cash flows, which will reduce the intrinsic value of the share and its current market price. Quintesse Corp. recently issued shares to the public through an initial public offering (IPO). The initial issue price was $20 per share. By the end of the first day, the shares were trading at $32 per share. Which of the following statements best describes what happened to the share price? a) The share price was underpriced in the IPO. b) The Green Shoe provision in the IPO caused the share price to rise. c)The increase in value is a result of the lockup period in the IPO. d)The red herring in the IPO priced the shares incorrectly. - Answer a) is correct. The increase in price of a new share issue on its first day of trading is an example of the common occurrence known as underpricing. Lemonica Inc. (Lemonica) is a public company that is considering a secondary equity offering to raise $10,000,000. Lemonica has been in discussions with its underwriter about the type of underwriting deal that should be used. Which of the following correctly describes a bought deal? a) The underwriter has the right to purchase additional shares within a specified time after the initial trade date. The underwriter may buy these shares from Lemonica for an agreed-upon price less commissions and fees. b) The underwriter sets up an auction for the shares. Shares will be sold for a price determined by the auction bids and the underwriter makes a commission based on a percentage of the funds raised. In this case, Lemonica bears the price risk. c) The underwriter purchases the entire issue of shares for an agreed-upon price from Lemonica and has the responsibility to sell all the shares for what it believes the market will - Answer c) is correct. In a bought deal, the underwriter buys all of the shares to be issued by Lemonica and takes on the price risk. Bolder Co. (Bolder) is considering a bond issue for $5,000,000 that will mature in five years time, and is convertible into common shares at the investor's option. The bonds are redeemable at the company's option any time after the first year, at a price of $103. Bolder is required to deposit $1,000,000 annually with a trustee. Bolder must also maintain an EBITDA (earnings before interest, tax, depreciation, and amortization) to interest coverage ratio of at least 4. Which of the following statements correctly explains the sinking fund provision related to this bond? a) Bolder must maintain an EBITDA-to-interest coverage ratio of at least 4. b) Bolder may repurchase the bonds at any time after the first year, at a price of $103. c) Bolder must convert the bonds into shares upon the investor's request. d) Bolder must deposit $1,000,000 each year with a trustee. - Answer d) is correct. The requirement to deposit money annually with a trustee is a sinking fund provision that ensures there will be enough cash to pay off the bond when it comes due. AI Airlines Corp. (AI) is a Canadian domestic airline. Today, the company announced its annual earnings to be $0.75 per share, which is $0.20 per share above what analysts had been expecting. Assuming the market is strong-form efficient, how you would expect AI's share price to react to this information? a) The price will be unaffected as only insider information impacts prices. b)The price will increase immediately to a price that incorporates the new information. c) The price will remain unchanged because prices only react to past price trends in markets. d) The price will initially increase above an appropriate price as demand for the shares responds in an exaggerated way, but it will eventually fall to the correct price. - Answer b) is correct. In a strong-form efficient market, the price will react to the announcement immediately, and in this case, since earnings are higher than expected, the price will increase. Big Construction Projects Inc. (BCP) is considering building a toll road. A separate joint venture has been organized for this project. The project will be financed by government grants, equity from BCP and three other sponsors, and a loan from a lending syndicate. All four sponsors are parties to the joint venture. Which of the following best describes a disadvantage of using project financing for this project? a) BCP will have to include all the debt related to the project on its balance sheet. b) BCP's debt capacity will decrease. c)BCP will bear all the risk relating to the construction for the project being completed on time and within budget. d) The interest cost charged by the lender may be higher than the interest cost that BCP normally pays. Hide question 21 feedback - Answer d) is correct. This financing arrangement may require the lender to take more risk than normal when lending directly to BCP because the debt is only supported by the project's cash flows. In these cases, lenders will demand a premium and the cost of financing the project will be higher Which of the following statements best describes project financing? a) The lender will assess the value of the assets at the time the lending agreement is signed to determine the amount of funds to advance. b) In addition to collateral, the lender will require covenants be met. c) The lender assesses the cash flow stream related to the completed project to determine the repayment terms and interest rate. d)The lender will provide a loan for the refinancing of an established office building owned by a company. - Answer c) is correct. Lenders will be paid back from the cash flows generated from the completed project. Accordingly, lenders will review the forecasted cash flows to determine the repayment terms and interest rate. Electric Co. (EC) is planning to build a new hydroelectric plant. The capital required for the project will come from EC and three other equity investors (sponsors), and banks will lend the remaining amount. The project will be set up as a separate legal entity and the project's free cash flows used to repay the interest and principal loan payments and provide the required return to the equity investors. In this case, the other three sponsors are customers who have committed to guaranteeing future purchases of electricity from this new plant for the first 10 years of operation at agreed-upon prices. Which of the following best describes an advantage of project financing for EC? a) Although project financing will reduce EC's debt capacity, the equity return on the project will be higher and so will compensate for this. b) The financing arrangements for project financing are quite simple and usually have lower overa - Hide question 23 feedback Answer d) is correct. Since there is a purchase agreement in place that guarantees a certain level of sales, the risk of financial distress for the project is lower and lenders may be willing to finance the project at a lower interest rate. Gold Mining Inc. (GMI) is considering the construction of a mine in Peru. The Peruvian government (PG) has agreed to be a sponsor in this project. A syndicate of lenders will provide the rest of the funds required to construct the mine. The lenders require all sponsors to agree to a cash flow arrangement prior to finalizing the loan amount and terms. Which of the following best describes a cash flow arrangement related to project financing? a) GMI and PG will be required to purchase a specified amount of the gold that is produced by the mine on an annual basis. b)If there are insufficient funds to make the interest and principal obligations as they come due, GMI and PG will be required to pay the amounts not covered by the cash flows of the project. c) The lenders will be able to stop advancing any further amounts on the loan if construction does not proceed on schedule. d) GMI and PG will be required to ensure that - Answer b) is correct. Under a cash flow arrangement, the sponsors are required to put in cash to cover any deficiency in cash flows required to service the debt. Oil Co. (OC) is reviewing the analysis of a project to build a new oil pipeline. OC has decided to use project financing. Equity will be contributed by OC and four other sponsors, and a syndicate of lenders will provide the debt. OC and other sponsors will sign purchase arrangements to guarantee 50% of the forecasted revenue from the pipeline. Which of the following best describes the risks that are reduced for the lender when the sponsors agree to a purchase arrangement? a) The risk that the project will not be completed on time and that operations will not commence on time. b) The risk that a product or service may not be saleable in the future at a price that ensures demand. c) The risk that there will be insufficient oil to transport through the pipeline in order to generate revenue. d) The risk that the project will generate insufficient cash flows to finance all the project's debt obligations. - Hide question 25 feedback Answer b) is correct. With this purchase agreement, the sponsors have guaranteed 50% of the revenue for the project. Failure to purchase as agreed obligates the sponsors to pay the debt Payback Period - 1) cost after tax and cash inflow after tax 2)if the inflow is same amount for all years than cost after tax/ cash inflow after tax = payback period. IRR calculation - 1) you need the expense and revenue amount after tax. 2. Use the rate formula to calculate IRR. 3) the pv should be negative. When we are going to accept the IRR? - We are going to accept the IRR when the IRR rate is exceed the discount rate.