BUSFIN 4220 Study Guide - Final Guide: Net Present Value

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mauvepug886

30 Oct 2014

School

Ohio State University

Department

Business Admin : Finance

Course

BUSFIN 4220

Professor

All

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Document Summary

One year from today, with the project"s initial cost ,000 lower, project npv will rise to ,000. Two years from today, with the project"s initial cost ,000 lower, project npv will rise to ,000. Three years from today, with the project"s initial cost ,000 lower, project npv will rise to ,000. The objective is to compare the 4 npv values to determine when to start the project (which year has the highest npv). However, to make this comparison, all the npvs must be in today"s dollars. Pv of npv 1 year from today is ,283 ( = 550000 / 1. 095) Pv of npv 2 years from today is ,406 ( = 600000 / 1. 095^2) Pv of npv 3 years from today is ,075 ( = 650000 / 1. 095^3) Waiting 1 year to launch the project has the highest npv in today"s dollars. Waiting 1 year to launch the project has the highest npv in today s dollars.

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Your company Portfolio Manager is convening a review board in the first calendar quarter to consider three projects. You have been asked to provide recommendations with respect to the capital budgeting aspects of these projects. Your recommendations will be considered by the review board along with other non-financial aspects of the projects. Initial (year 0) funding will be provided in the current year for the single project selected.

Project sponsors have provided the following estimated cash flow projections:

Project A				Project B			Project C
Year	Outflow	Inflow	Netflow	Outflow	Inflow	Netflow	Outflow	Inflow	Netflow
0	15000		-150000	15000		-150000	20000		-200000
1		20000	20000	130000	40000	-9000	150000		-150000
2		30000	30000		50000	50000		90000	90000
3		40000	40000		60000	60000		100000	100000
4		40000	40000		90000	90000		110000	110000
5		50000	50000		90000	90000		120000	120000

The company has not yet decided how the selected project will be financed. The cost of capital or hurdle rate will vary depending upon how the company decides to finance the project. You decide to compare projects in three areas: (1) payback period (not considering the cost of capital); NPV sensitivity (see note 1 below); and (3) Internal Rate of Return (IRR). Conduct each analysis and interpret the results.

Based on your analysis, which project would you recommend and why? Your recommendation must be based on the combination of all three factors.

Show all calculations supporting your recommendation. Calculate NPV to the nearest dollar, IRR to three decimal places, and payback period to one decimal place.

Note 1: Project NPV varies inversely with the cost of funds to perform the project (expressed as the hurdle rate or k in the NPV discount factor formula). Some project NPVs are more sensitive to changes in k than others. See the NPV Profile discussion in Gallagher, Chapter 10, pages 278-279 for information on determining NPV sensitivity.

Aluminum Building Products Company (ABPC) is considering investing in either of the two mutually exclusive projects described as follows:

Project 1. Buying a new set of roll-forming tools for its existing roll forming line to introduce a new cladding product. After its introduction, the product will need to be promoted. This means that cash inflows from additional production will start sometime after and will gradually pick up in subsequent periods.

Project 2. Modifying its existing roll-forming line to increase productivity of its available range of cladding products. Cash inflows from additional production will start immediately and will reduce over time as the products move through their life cycle. Sarah Brown, project manager of ABPC, has requested that you do the necessary financial analysis and give your opinion about which project ABPC should select.

The projects have the following net cash flow estimates:

Year project 1 project 2

0 (200,000) (200,000)

1 0 90,000

2 0 70,000

3 20,000 50,000

4 30,000 30,000

5 40,000 10,000

6 60,000 10,000

7 90,000 10,000

8 100,000 10,000

Both these projects have the same economic life of eight years and average risk characteristics. ABPCâs weighted average cost of capital, or hurdle rate, is 7.2 percent.

a ) Which project would you recommend Ms. Brown accept to maximize value of the firm? (Hint: Calculate and compare NPVs of both projects.)

b) What are the IRRs of each project? Which project should be chosen using IRR as the selection criterion?

c) Draw the NPV profiles of both projects. What is the approximate discount rate at which both projects would have the same NPC? what is that NPV?

d) Does the selection remain unaffected for i) WACC> 5.4 percent; ii) WACC > 8.81 percent; and iii) WACC > 14.39 percent?

e) Further market survey research indicates that both projects have lower- than- average risk and, hence, the risk- adjusted discount rate should be 5 percent. What happens to the ranking of the projects using NPV and IRR as the selection criteria? Explain the conflict in ranking, if any.

f) Answer questions a, d, e, assuming the projects are independent of each other.

Question 13 Your firm has bonds outstanding with 18 years remaining until maturity. The bonds are trading for $1127 and pay a 8.5% coupon rate. Your firm faces a 32% tax rate. Based on this, the after-tax cost of debt financing is

None of the other answers are correct

Question 14 You have estimated the following values for dividends over the next four years.

D1 = $1.50

D2 = $2.50

D3 = $3.50

D4 = $4.50

In addition, you anticipate that you can sell the stock four years from today (immediately after you receive the year four dividend) for $50. Assuming a 9% required return, the value of the stock today is

Question 15 Developed equity markets have seen higher returns than emerging equity markets over the the Nov. 2004 to June 2012 time frame.

True

False

Question 16 You are evaluating a capital budgeting project that will cost $25,000

Year 1 ==> $12,000

Year 2 ==> $20,000

Year 3 ==> $9,000

The required return is 13% and the critical acceptance level is 1.9 years. Calculate the Internal Rate of Return and determine whether or not the project should be accepted based solely on the Internal Rate of Return.

The IRR is 21.33% and we should reject the project

The IRR is 17.27% and we should accept the project

The IRR is 17.27% and we should reject the project

The IRR is 21.33% and we should accept the project

None of the other answers is correct

Question 17 Linda is saving for retirement and would like to accumulate $800,000 at her retirement. She currently has $30,000 saved and would like to work for another 25 years. She plans to save $3500 at the end of each year over the next 25 years. What rate of return must she earn on her investments over the next 25 years?

Question 18 Consider two projects:

Project A Project B

PP 2.8 years 3.0 years

IRR 12.5% 13.3%

NPV -$15,500 -$16,900

Assume that the projects both have a required return of 15% and a critical acceptance level (T) of 3.25 years. If these are independent projects we should

Take both projects A and B

Take project B and reject project A

Take neither project

Take project A and reject project B

Question 20 Your firm wants to raise $4924796 by issuing preferred stock. The stock has a par value of $50 and pays a 6% dividend, how many shares must be issued if the required return is 10% (ignore costs associated with issuing the shares known as floatation costs -- round to the nearest share)?

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BUSFIN 4220 Study Guide - Final Guide: Net Present Value

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