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Ch 11 Cash Flow Estimation and Risk Analysis
56. Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The company owns the
building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new warehouse. The
equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it
would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and
revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash
flows are constant in Years 1-3.)
Project cost of capital (r)
10.0%
Opportunity cost
$100,000
Net equipment cost (depreciable basis)
$65,000
Straight-line deprec. rate for equipment
33.333%
Sales revenues, each year
$123,000
Operating costs (excl. deprec.), each year
$25,000
Tax rate
35%
a.
$10,521
b.
$11,075
c.
$11,658
d.
$12,271
e.
$12,885
Ch 11 Cash Flow Estimation and Risk Analysis
57. Garden-Grow Products is considering a new investment whose data are shown below. The equipment would be
depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some
additional working capital that would be recovered at the end of the project's life. Revenues and other operating costs are
expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)
Project cost of capital (r)
10.0%
Net investment in fixed assets (basis)
$75,000
Required new working capital
$15,000
Straight-line deprec. rate
33.333%
Sales revenues, each year
$75,000
Operating costs (excl. deprec.), each year
$25,000
Tax rate
35.0%
a.
$23,852
b.
$25,045
c.
$26,297
d.
$27,612
e.
$28,993
Ch 11 Cash Flow Estimation and Risk Analysis
58. Sheridan Films is considering some new equipment whose data are shown below. The equipment has a 3-year tax life
and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value
at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it
would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the
project's 3-year life. What is the project's NPV?
Project cost of capital (r)
10.0%
Net investment in fixed assets (depreciable basis)
$70,000
Required new working capital
$10,000
Straight-line deprec. rate
33.333%
Sales revenues, each year
$75,000
Operating costs (excl. deprec.), each year
$30,000
Expected pretax salvage value
$5,000
Tax rate
35.0%
a.
$20,762
b.
$21,854
c.
$23,005
d.
$24,155
e.
$25,363
Ch 11 Cash Flow Estimation and Risk Analysis
59. Shultz Business Systems is analyzing an average-risk project, and the following data have been developed. Unit sales
will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs
should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will
be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm
projects. What is the project's expected NPV?
Project cost of capital (r)
10.0%
Net investment cost (depreciable basis)
$200,000
Units sold
50,000
Average price per unit, Year 1
$25.00
Fixed op. cost excl. deprec. (constant)
$150,000
Variable op. cost/unit, Year 1
$20.20
Ch 11 Cash Flow Estimation and Risk Analysis
Annual depreciation rate
33.333%
Expected inflation rate per year
5.00%
Tax rate
40.0%
a.
$15,925
b.
$16,764
c.
$17,646
d.
$18,528
e.
$19,455
Ch 11 Cash Flow Estimation and Risk Analysis
60. Sylvester Media is analyzing an average-risk project, and the following data have been developed. Unit sales will be
constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise
with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no
salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm
projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the
variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the
expected NPV if the inflation adjustment is made vs. if it is not made?
Project cost of capital (r)
10.0%
Net investment cost (depreciable basis)
$200,000
Units sold
50,000
Average price per unit, Year 1
$25.00
Fixed op. cost excl. deprec. (constant)
$150,000
Variable op. cost/unit, Year 1
$20.20
Annual depreciation rate
33.333%
Expected inflation
4.00%
Tax rate
35.0%
a.
$13,286
b.
$13,985
c.
$14,721
d.
$15,457
e.
$16,230
Ch 11 Cash Flow Estimation and Risk Analysis
61. If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate
risk-adjusted discount rate.
a.
True
b.
False
Ch 11 Cash Flow Estimation and Risk Analysis
62. Which of the following procedures best accounts for the relative risk of a proposed project?
a.
Adjusting the discount rate downward if the project is judged to have above-average risk.
b.
Reducing the NPV by 10% for risky projects.
c.
Picking a risk factor equal to the average discount rate.
d.
Ignoring risk because project risk cannot be measured accurately.
e.
Adjusting the discount rate upward if the project is judged to have above-average risk.
Ch 11 Cash Flow Estimation and Risk Analysis
63. Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a risk-adjusted project cost of capital of 8% for
below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the
following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing
projects?
a.
Project B, which has below-average risk and an IRR = 8.5%.
b.
Project C, which has above-average risk and an IRR = 11%.
c.
Without information about the projects' NPVs we cannot determine which project(s) should be accepted.
d.
All of these projects should be accepted.
e.
Project A, which has average risk and an IRR = 9%.
64. Tallant Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company
estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted
thorough scenario and simulation analyses. This research produced the following data:
Project X
Project Y
Expected NPV
$500,000
$500,000
Standard deviation (σNPV)
$200,000
$250,000
Project beta (vs. market)
1.4
0.8
Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with
the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.
Which of the following statements is CORRECT?
a.
Project X has more corporate (or within-firm) risk than Project Y.
b.
Project X has more market risk than Project Y.
c.
Project X has the same level of corporate risk as Project Y.
d.
Project X has less market risk than Project Y.
Ch 11 Cash Flow Estimation and Risk Analysis
e.
Project X has more stand-alone risk than Project Y.
65. Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are
positively correlated with the overall economy. The company estimates that the proposed new project would have a higher
standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be
countercyclical in the sense that they would be high when the overall economy is down and low when the overall
economy is strong. On the basis of this information, which of the following statements is CORRECT?
a.
The proposed new project would increase the firm's corporate risk.
b.
The proposed new project would increase the firm's market risk.
c.
The proposed new project would not affect the firm's risk at all.
d.
The proposed new project would have less stand-alone risk than the firm's typical project.
e.
The proposed new project would have more stand-alone risk than the firm's typical project.
Ch 11 Cash Flow Estimation and Risk Analysis
66. A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all
methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the
following?
a.
Increase the estimated NPV of the project to reflect its greater risk.
b.
Reject the project, since its acceptance would increase the firm's risk.
c.
Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
d.
Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
e.
Increase the estimated IRR of the project to reflect its greater risk.
