Reference no: EM132182720

Principles of Finance Assignment -

1. Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after three years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of $900/year for three years; variable operating costs (excluding depreciation) will be 50 per cent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500, $300, and $200 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 from this project if the project's income is negative, and a 10 per cent required rate of return. Inflation is zero. What is the project's NPV?

2. Real Time Systems Inc. is considering the development of one of two mutually exclusive new computer models. Each will require a net investment of $5,000. 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 per cent. Which model you will choose to develop?

3. Tas Pulp Company (TPC) can control its environmental pollution using either 'Project Old Tech' or 'Project New Tech.' Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the expected cost levels. The cash outflows associated with Project Old Tech, which uses standard proven technology, are less risky--they are about as uncertain as the cash flows associated with an average project. TPC's required rate of return for average risk projects is normally set at 12 per cent, and the company adds 3 per cent for high risk projects but subtracts 3 per cent for low risk projects. The two projects in question meet the criteria for high and average risk, but the financial manager is concerned about applying the normal rule to such cost-only projects. You must decide which project to recommend, and you should recommend the one with the lower PV of costs. What is the PV of costs of the better project?

Self-study Practice Questions -

1. Which of the following is not a cash flow that results from the decision to accept a project?

a. Changes in working capital.

b. Shipping and installation costs.

c. Sunk costs.

d. Opportunity costs.

e. Externalities.

2. Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a fire insurance company. If the purchase is made, Carolina will be 50 per cent larger than before. Currently, Carolina's stock has a beta of 1.2 and the return required is 15.2 per cent. The fire insurance company is expected to generate a return of 20 per cent with a beta of 2.5. If the risk free rate is 8 per cent and the market risk premium is 6 per cent, should Carolina make the investment?

a. No; the expected return is less than the required return.

b. No; the IRR is less than the appropriate required rate of return.

c. Yes; the IRR is greater than the appropriate required rate of return.

d. Yes; the expected return is greater than the required return.

e. Yes; the project's risk/return combination lies above the SML.

3. Whitney Crane Inc. has the following independent investment opportunities for the coming year:

The IRRs for Project A and C, respectively, are:

a. 16 per cent and 14 per cent

b. 18 per cent and 10 per cent

c. 18 per cent and 20 per cent

d. 18 per cent and 13 per cent

e. 16 per cent and 13 per cent

4. An all-equity firm is analysing a potential project which will require an initial, after-tax cash outlay of $50,000 and after-tax cash inflows of $6,000 per year for 10 years. In addition, this project will have an after-tax salvage value of $10,000 at the end of Year 10. If the risk-free rate is 6 per cent, the return on an average stock is 10 per cent, and the beta of this project is 1.50, then what is the project's NPV?

a. $13,210

b. $4,905

c. $7,121

d. -$6,158

e. -$12,879

5. A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should:

a. increase the IRR of the asset to reflect the greater risk.

b. Increase the NPV of the asset to reflect the greater risk.

c. Reject the asset, since its acceptance would increase the risk of the firm.

d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.

e. Increase the required rate of return used to evaluate the project to reflect the higher risk of the project.

6. California Mining is evaluating the introduction of a new ore production process. Two alternatives are available. Production Process A has an initial cost of $25,000, a four-year life, and a $5,000 net salvage value, and the use of Process A will increase net cash flow by $13,000 per year for each of the four years that the equipment is in use. Production Process B also requires an initial investment of $25,000, will also last four years, and its expected net salvage value is zero, but Process B will increase net cash flow by $15,247 per year. Management believes that a risk adjusted discount rate of 12 per cent should be used for Process A. If California Mining is to be indifferent between the two processes, what risk-adjusted discount rate must be used to evaluate B?

a. 8 per cent

b. 10 per cent

c. 12 per cent

d. 14 per cent

e. 16 per cent