FIN 365 GRADED ASSIGNMENT 2

CHAPTERS 12, 13, AND 14

25 WRITTEN QUESTIONS WORTH 4 POINTS EACH
DUE: THURSDAY, OCTOBER 29TH BY 4 PM.
Chapter 12
1. Langton Inc. is considering Projects S and L, whose cash flows are shown below. These projects are
mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection
criterion, while the CFO advocates the MIRR. If the decision is made by choosing the project with the
higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone. In other
words, what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true
value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no
effect on the value lost.
WACC: 7.00%        
Year 0 1 2 3 4
CFS −$1,100 $550 $600 $100    $100
CFL −$2,750 $725 $725 $800 $1,400
  a. $185.90
  b. $197.01
  c. $208.11
  d. $219.22

2. Farmer Co. is considering Projects S and L, whose cash flows are shown below. These projects are
mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with
the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that
under some conditions choosing projects on the basis of the shorter payback will not cause value to be
lost.
WACC: 10.25%        
Year 0 1 2 3 4
CFS −$950 $500 $800     $0        $0
CFL −$2,100    $400 $800 $800 $1,000
  a. $24.14
  b. $26.82
  c. $29.80
  d. $33.11

3. Carolina Company is considering Projects S and L, whose cash flows are shown below. These projects
are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the

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project with the higher IRR, how much value will be forgone? Note that under some conditions choosing
projects on the basis of the IRR will cause $0.00 value to be lost.
WACC: 7.75%        
Year 0 1 2 3 4
CFS −$1,050 $675 $650    
CFL −$1,050 $360 $360 $360 $360
  a. $11.45
  b. $12.72
  c. $14.63
  d. $16.82

4. Suzanne's Cleaners is considering a project that has the following cash flow data. What is the project's
payback?
Year 0 1 2 3 4 5
Cash flows −$1,100 $300 $310 $320 $330 $340
  a. 2.31 years
  b. 2.56 years
  c. 2.85 years
  d. 3.52 years

5. Watts Co. is considering a project that has the following cash flow and WACC data. What is the
project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which
case it will be rejected.

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WACC: 10.00%        
Year 0 1 2 3 4
Cash flows −$850 $300 $320 $340 $360
  a. 14.08%
  b. 15.65%
  c. 17.21%
  d. 18.94%
 

6. Corner Jewelers, Inc. recently analyzed the project whose cash flows are shown below. However,
before the company decided to accept or reject the project, the Federal Reserve changed interest rates and
therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did
the change in the WACC affect the project's forecasted NPV? Note that a project's expected NPV can be
negative, in which case it should be rejected.
Old WACC: 8.00% New WACC: 11.25%  
Year 0 1 2 3
Cash flows −$1,000 $410 $410 $410
  a. −$59.03
  b. −$56.08
  c. −$53.27
  d. −$50.61

7. Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and
B's IRR is 20%. The company's WACC is 12%, and at that rate Project A has the higher NPV. Which of
the following statements is CORRECT?
  a. Assuming the timing pattern of the two projects' cash flows is the same, Project B probably
has a higher cost (and larger scale).

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  b. Assuming the two projects have the same scale, Project B probably has a faster payback than
Project A.
  c. The crossover rate for the two projects must be 12%.
  d. Since B has the higher IRR, then it must also have the higher NPV if the crossover rate is less
than the WACC of 12%.

8. Which of the following statements is CORRECT? Assume that all projects being considered have
normal cash flows and are equally risky.
  a. If a project's IRR is equal to its WACC, then under all reasonable conditions, the project's IRR
must be negative.
  b. If a project's IRR is equal to its WACC, then under all reasonable conditions the project's
NPV must be zero.
  c. There is no necessary relationship between a project's IRR, its WACC, and its NPV.
  d. When evaluating mutually exclusive projects, those projects with relatively long lives will
tend to have relatively high NPVs when the cost of capital is relatively high.

9. Which of the following statements is CORRECT? Assume that the project being considered has normal
cash flows, with one outflow followed by a series of inflows.
  a. A project's MIRR is always less than its regular IRR.
  b. If a project's IRR is greater than its WACC, then the MIRR will be less than the IRR.
  c. If a project's IRR is greater than its WACC, then the MIRR will be greater than the IRR.
  d. To find a project's MIRR, we compound cash inflows at the IRR and then discount the terminal
value back to t = 0 at the WACC.

10.  You are on the staff of O'Hara Inc. The CFO believes project acceptance should be based on the
NPV, but Andrew O'Hara, the president, insists that no project should be accepted unless its IRR exceeds
the project's risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of
$15,000 and two cash flows: $110,000 at the end of Year 1 and −$100,000 at the end of Year 2. The
president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is
$2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the
following statements best describes your optimal recommendation, i.e., the analysis and recommendation
that is best for the company and least likely to get you in trouble with either the CFO or the president?
  a. You should recommend that the project be rejected because, although its NPV is positive, it has an
IRR that is less than the WACC.
  b. You should recommend that the project be accepted because (1) its NPV is positive and (2)
although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the
WACC. You should explain this to the president and tell him that the firm's value will increase if
the project is accepted.
  c. You should recommend that the project be rejected. Although its NPV is positive it has two IRRs,
one of which is less than the WACC, which indicates that the firm's value will decline if the
project is accepted.
  d. You should recommend that the project be rejected because, although its NPV is positive, its
MIRR is less than the WACC, and that indicates that the firm's value will decline if it is accepted.

11. Which of the following statements is CORRECT?

  a. The discounted payback method eliminates all of the problems associated with the payback
method.

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  b. When evaluating independent projects, the NPV and IRR methods often yield conflicting
results regarding a project's acceptability.
  c. To find the MIRR, we discount the TV at the IRR.
  d. The IRR method appeals to some managers because it gives an estimate of the rate of return
on projects rather than a dollar amount, which the NPV method provides.

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 Chapter 13
12. 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?
WACC 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 rate per year 5.00%
Tax rate 40.0%
  a. $15,925
  b. $16,764
  c. $17,646
  d. $18,528

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13. 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.)
WACC 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

14. McPherson Company must purchase a new milling machine. The purchase price is $50,000, including
installation. The machine has a tax life of 5 years, and it can be depreciated according to the following

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rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal
tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?
Year Depreciation Rate
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
  a.  $8,878
  b.  $9,345
  c.  $9,837
  d. $10,900

15. Whitestone Products is considering a new project whose data are shown below. The required
equipment has a 3-year tax life, and the accelerated rates for such property are 33.33%, 44.45%, 14.81%,
and 7.41% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the
project's 10-year expected operating life. What is the project's Year 4 cash flow?
Equipment cost (depreciable basis) $70,000
Sales revenues, each year $42,500
Operating costs (excl. deprec.) $25,000
Tax rate 35.0%
  a. $11,904
  b. $12,531
  c. $13,190
  d. $13,850

16. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation
of 10%. What is the investment's coefficient of variation?
  a. 0.67

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  b. 0.73
  c. 0.81
  d. 0.89
 

17. Which of the following statements is CORRECT?

  a. Only incremental cash flows are relevant in project analysis, the proper incremental cash
flows are the reported accounting profits, and thus reported accounting income should be used
as the basis for investor and managerial decisions.
  b. It is unrealistic to believe that any increases in net working capital required at the start of an
expansion project can be recovered at the project's completion. Working capital like inventory
is almost always used up in operations. Thus, cash flows associated with working capital
should be included only at the start of a project's life.
  c. If equipment is expected to be sold for more than its book value at the end of a project's life,
this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow
will be greater than if the asset had been sold at book value, other things held constant.
  d. Changes in net working capital refer to changes in current assets and current liabilities, not to
changes in long-term assets and liabilities. Therefore, changes in net working capital should
not be considered in a capital budgeting analysis.
  e. If an asset is sold for less than its book value at the end of a project's life, it will generate a
loss for the firm, hence its terminal cash flow will be negative.

18. Which of the following statements is CORRECT?

  a. In comparing two projects using sensitivity analysis, the one with the steeper lines would be
considered less risky, because a small error in estimating a variable such as unit sales would
produce only a small error in the project's NPV.
  b. The primary advantage of simulation analysis over scenario analysis is that scenario analysis
requires a relatively powerful computer, coupled with an efficient financial planning software
package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet
program or even with just a calculator.
  c. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to
changes in key input variables and the probability of occurrence of these variables' values.
  d. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the
probability of occurrence of the key input variables.

19. Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite)
WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and
Laramie evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk

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projects at 12%. The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low   9%

Which set of projects would maximize shareholder wealth?

  a. A and B.
  b. A, B, and C.
  c. A, B, and D.
  d. A, B, C, and D.

20. 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 more stand-alone risk than the firm's typical project.

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 Chapter14
Exhibit 14.4
The Z−90 project being considered by Steppingstone Inc. (SI) has an up-front cost of $250,000. The
project's subsequent cash flows are critically dependent on whether another of its products, Z−45,
becomes an industry standard. There is a 50% chance that the Z−45 will become the industry standard, in
which case the Z−90's expected cash flows will be $110,000 at the end of each of the next 5 years. There
is a 50% chance that the Z−45 will not become the industry standard, in which case the Z−90's expected
cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

21. Refer to Exhibit 14.4. Based on the above information, what is the Z−90's expected net present value?
  a. −$6,678
  b. −$3,251
  c. $15,303
  d. $20,004

22. Refer to Exhibit 14.4. Now assume that one year from now SI will know if the Z−45 has become the
industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon
the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1.
Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?
  a. $2,075
  b. $4,067
  c. $8,945
  d. $10,745

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23. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of
estimating projects' sales and costs. However, it never considers real options that might be associated with
projects. Which of the following statements is most likely to describe its situation?
  a. Its estimated capital budget is probably too large due to its failure to consider abandonment
and growth options.
  b. Failing to consider abandonment and flexibility options probably makes the optimal capital
budget too large, but failing to consider growth and timing options probably makes the
optimal capital budget too small, so it is unclear what impact not considering real options has
on the overall capital budget.
  c. Failing to consider abandonment and flexibility options probably makes the optimal capital
budget too small, but failing to consider growth and timing options probably makes the
optimal capital budget too large, so it is unclear what impact not considering real options has
on the overall capital budget.
  d. Its estimated capital budget is probably too small, because projects' NPVs are often larger
when real options are taken into account.

24. Which of the following will NOT increase the value of a real option?
  a. An increase in the volatility of the underlying source of risk.
  b. An increase in the risk-free rate.
  c. An increase in the cost of obtaining the real option.
  d. A decrease in the probability that a competitor will enter the market of the project in
question.

25. Whether to invest in a project today or to postpone the decision until next year is a decision facing the
CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than
expected, in which case the NPV could be negative. No competitors are likely to invest in a similar
project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron
faces when considering this investment timing option?
  a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead
with this project today.
  b. Since the project has a positive expected NPV today, this means that its expected NPV will be
even higher if it chooses to wait a year.
  c. Since the project has a positive expected NPV today, this means that it should be accepted in
order to lock in that NPV.
  d. Waiting would probably reduce the project's risk.

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