#THE T#P$C% $& CAP$TA' CHAPTE !" D*ET$&* (Difficulty: (Difficul ty: E = Easy, M = Medium, and T = Tough) Tough)
Multiple Choice: Conceptual Easy: Easy: Abando Abandonme nment nt option option 1
.
No impact impact on expected expected cash cash flow, !xpected !xpected cash flow flow increase increases s and !xpected !xpected cash flow flow increase increases s and !xpected !xpected cash flow flow decrease decreases s and !xpected !xpected cash flow flow decrease decreases s and
Investment timing option
.
Diff: Diff: E
Whic Which h of the the foll follow owin ing g stat statem emen ents ts bes best t desc descri ribe bes s the the like likely ly imp impac act t tha that t an an abandonment option will have on a project’s expected cash flow and risk? a. b. c. d. e.
"
Answer Answer: : b
bt bt risk will will increase. increase. risk risk decreases. decreases. risk risk increases. increases. risk risk decreases. decreases. risk risk increases. increases. Answer: e
Diff: E
#omm #ommod odor ore e #orp #orpor orat atio ion n is deci decidi ding ng whe wheth ther er it it make makes s sens sense e to inv inves est t in a project today, or to postpone this decision for one year. Which of the following statements best describes the isses that #ommodore faces when considering this investment timing option? a. $he investm investment ent timing timing option option does does not affect affect the expect expected ed cash flows and shold therefore have no impact on the project’s risk. b. $he more ncerta ncertaint inty y abot abot the projec project’s t’s ftre ftre cash flows the more likely it is that #ommodore will go ahead with the project today. c. %f the project project has a positive positive expected expected N&' N&' today, this this means that that its expected N&' will be even higher if it chooses to wait a year. d. (ll of of the above above statements statements are correc correct. t. e. None of the above statements statements is correct. correct.
Flexibility option )
.
Answer: c
Diff: E
N
Whic Which h of of the the foll follow owin ing g is is an an exa examp mple le of of a fle flexi xibi bili lity ty opti option on? ? a. ( company has the option option to invest invest in a project project today or to wait a year. year. b. ( company company has the option option to back ot ot of a project project that trns trns ot to be nprodctive. c. ( company company pays a higher higher cost today today in order order to be able to reconfig reconfigre re the project’s inpts or otpts at a later date. d. ( com company pany inv invests ests in a proje roject ct today oday that that may lead ead to enha enhanc nced ed techno technolog logica ical l improv improveme ements nts that that allow allow it to expand expand into into differ different ent markets at a later date. e. (ll of of the statem statements ents above above are are correct. correct.
Chapter 12 - Page 1
Real options *
.
Answer: c
Diff: E
Whic Which h of of the the foll follow owin ing g is is an an exa examp mple le of of a fle flexi xibi bili lity ty opti option on? ? a. ( comp compan any y has has the the opti option on to inve invest st in a proj projec ect t toda today y or to wait wait a year. b. ( company company has the option option to back ot ot of a project project that trns trns ot to be nprodctive. c. ( company company pays a higher higher cost today today in order order to be able to reconfig reconfigre re the project’s inpt or otpts at a later date. d. ( com company pany inv invests ests in a proje roject ct today oday that that may lead ead to enha enhanc nced ed techno technolog logica ical l improv improveme ements nts that that allow allow it to expand expand into into differ different ent markets at a later date. e. (ll of of the statem statements ents above above are are correct. correct.
Real options +
.
Answer: b
Diff: E
N
Whal Whalen en ar arit itim ime e -ese -esear arch ch %nc %nc. . reg regla larl rly y take takes s real real opt optio ions ns int into o acco accon nt t when evalating evalating its proposed proposed projects. pecifically, pecifically, Whalen Whalen considers considers the option to abandon a project whenever it trns ot to be nsccessfl /the abandonment abandonment option0. %n addition, addition, it sally evalates whether it it makes sense to invest in a project today or whether to wait to collect more informa information tion /the /the investmen investment t timing timing option0. option0. (ssme (ssme the proposed proposed projects projects can can be abandone abandoned d at any time time withot withot penalt penalty. y. Which Which of the following statements is most correct? a. $he abandonment abandonment option tends tends to redce a project’s project’s N&'. b. $he abandonment abandonment option tends tends to redce a project’s project’s risk. risk. c. %f there are important important firstmov firstmover er advantages advantages, , this tends to increase increase the the val vale e of wait waitin ing g a year year to coll collec ect t more more info inform rmat atio ion n befo before re proceeding with a proposed project. d. tatemen tatements ts a and b are corre correct. ct. e. (ll of the the stateme statements nts above above are are correct. correct.
Chapter 12 - Page 2
Real options 2
.
Answer: b
Diff: E
N
3arm 3armon on %nd %ndst stri ries es is cons consid ider erin ing g add addin ing g a new new sto store re. . (s a fin final al step step in reviewing the proposed project, the #45 wants to take into accont two real options that are attached to the proposed project. 4irst, there is a timing timing option. 5ne year from now, the company will have a mch better idea of whether the conty will raise or lower its property taxes. taxes. $he firm firm might might want want to wait a year to decide decide wheth whether er it makes makes sense sense to procee proceed d with with their their propos proposed ed projec project t becas becase e the conty conty taxes taxes cold significantly affect the project’s cash flows. econd, there is an abandonment abandonment option. (fter two years, the company will have the option to sht down the store if it is determined that the store is losing money and will contine to lose money. Which of the following statements is most correct? a. $he greater greater the ncerta ncertaint inty y regard regarding ing the conty conty tax rates, rates, the less less valable is the option to delay the project. b. $he abandon abandonmen ment t option option is likely likely to increa increase se the project project’s ’s expect expected ed cash flows. c. $he abandonme abandonment nt option option is likely to increase increase the the project’s project’s risk. risk. d. tatem tatement ents s a and b are are correc correct. t. e. (ll of of the statem statements ents above above are are correct. correct.
Real options 6
.
Answer: a
Diff: E
N
Whic Which h of of the the foll follow owin ing g stat statem emen ents ts is most most corr correc ect? t? a. %n general, general, the more ncerta ncertainty inty there there is abot market market conditions, conditions, the the more attractive it may be to wait before making an investment. b. %n general, general, the greater greater the strate strategic gic advanta advantages ges of being being the first first competitor to enter a given market, the more attractive it may be to wait before making an investment. c. %n general, general, the higher higher the discont discont rate, rate, the more attractiv attractive e it may be to wait before making an investment. d. tatem tatement ents s b and c are are correc correct. t. e. (ll of of the statem statements ents above above are are correct. correct.
Real options 7
.
Answer: d
Diff: E
N
eav eaver er !lec !lectr tron onic ics s is is con consi side deri ring ng inve invest stin ing g in in 3on 3ong g 8on 8ong. g. Whic Which h of of the the following factors wold make the company more likely to proceed with the investment? a. $he company company wold wold have the option option to withdraw withdraw from the the investment investment after after " years, if it trns ot to be nprofitable. b. $he investm investment ent wold wold increase increase the odds of the compan company y being being able to sbse9ently make a sccessfl entry into the #hina market. c. $he investm investment ent wold wold preclde preclde the company company from being being able to make make a profitable investment in :apan. d. tatem tatement ents s a and b are are correc correct. t. e. (ll of of the statem statements ents above above are are correct. correct.
Chapter 12 - Page 3
Miscel Miscellan laneou eous s capi capital tal budget budgeting ing topics topics ;
.
Answer Answer: : d
Diff: Diff: E
N
Whic Which h of of the the foll follow owin ing g sta state teme ment nts s is is mos most t cor corre rect ct? ? a. %f yo have have an optio option n to aband abandon on a proj projec ect t at increases the likelihood that yo will select the b. When When evala evalatin ting g potent potential ial projec projects ts yo always always costs in the estimated cash flows. c. When When evala evalatin ting g potent potential ial projec projects ts yo shold shold costs in the estimated cash flows. d. tatemen tatements ts a and b are corre correct. ct. e. (ll of the the stateme statements nts above above are are correct. correct.
a late later r date date, , this this project today. incld inclde e opport opportni nity ty always always
incld inclde e
snk snk
Medium: Medium: Real options 1<
.
Answer: b
$he $he $he $he $he
option option option option option option option option option option
to expand expand prodction prodction if the prodct prodct is sccess sccessfl. fl. to by additional additional shares shares of stock stock if the stock stock price goes goes p. to expand expand into a new new geographi geographic c region. region. to abandon abandon a project. project. to switch switch sorces sorces of fel sed in an indstri indstrial al frnace. frnace.
Real options
.
Answer: d
Diff: M
Whic Which h of of the the foll follow owin ing g wil will l not not incr increa ease se the the val vale e of a rea real l opt optio ion? n? a. (n incr increa ease se in the the time time rema remain inin ing g nti ntil l the the real real opti option on mst mst exercised. b. (n increase increase in the volatili volatility ty of the nderlyin nderlying g sorce of risk. risk. c. (n increas increase e in the riskf riskfree ree rate. rate. d. (n increase increase in the the cost of exercis exercising ing the real real option. option. e. tat tatem emen ents ts b and and d. d.
Abando Abandonme nment nt and growt growt option options s 1"
.
Whic Which h of the the foll follow owin ing g are are not not real real opti option ons? s? a. b. c. d. e.
11
Diff: M
Answer Answer: : a
be
Diff: Diff: M
#le #lele less ss #orp #orpor orat atio ion n never never cons consid ider ers s aband abandon onme ment nt opti option ons s or growt growth h optio options ns when estimating estimating its optimal capital capital bdget. What impact impact does this policy have on the company’s optimal capital bdget? a. %ts estimated estimated capital capital bdget bdget is too small small becase becase it fails fails to consider consider abandonment and growth options. b. %ts estimated estimated capital capital bdget bdget is too large large becase becase it fails fails to consider consider abandonment and growth options. c. 4ail 4ailin ing g to cons consid ider er aban abando donm nmen ent t opti option ons s make makes s the the opti optima mal l capi capita tal l bdget bdget too large, large, bt failin failing g to consid consider er growth growth option options s makes makes the optimal capital bdget too small, so it is nclear what impact this policy has on the overall capital bdget. d. 4ail 4ailin ing g to cons consid ider er aban abando donm nmen ent t opti option ons s make makes s the the opti optima mal l capi capita tal l bdget bdget too small, small, bt failin failing g to consid consider er growth growth option options s makes makes the optimal capital bdget too large, so it is nclear what impact this policy has on the overall capital bdget. e. Neithe Neither r abando abandonme nment nt nor growth growth options options shold shold have an effect effect on the
Chapter 12 - Page 4
company’s optimal capital bdget.
Chapter 12 - Page 5
Multiple Multip le Choice: P+olems Easy: Easy: !ptimal capital budget and divisional ris" 1)
.
Answer: c
Diff: E
han hanah ahan an %nc %nc. . has has two two divi divisi sion ons= s= >iv >ivis isio ion n ( makes makes p p +< perc percen ent t of the the company, while >ivision makes p the other +< percent. hanahan’s beta is 1.". @ooking at standalone competitors, hanahan’s #45 estimates that >ivision (’s beta is 1.+, while >ivision ’s beta is <.;. $he riskfree rate is + percent and the market risk premim is + percent. $he company is 1<< percent e9ityfinanced. /W(## A ks, the cost of e9ity0. >ivision is considering the following projects given below. !ach of the projects has the same risk and all have the same risk as a BtypicalC >ivision project. &roject 1 " ) * +
#apital -e9ired D*<< million )<< million "+< million )"< million ")< million
%-1*.
$he company is debating which cost of capital they shold se to evalate >ivision ’s projects. :ohn Freen arges that hanahan shold se the same cost of capital for each of its divisions, and believes it shold base the cost of e9ity on hanahan’s overall beta. ecky White arges that the cost of capital shold vary for each division, and that >ivision ’s beta shold be sed to estimate the cost of e9ity for >ivision ’s projects. %f the company ses White’s approach, how mch larger will the capital bdget be than if it ses Freen’s approach? a. b. c. d. e.
#apital #apital bdget bdget is D)"< million million larger larger sing White’s White’s approach. approach. #apital #apital bdget bdget is D++< million million larger larger sing White’s White’s approach. approach. #apital #apital bdget bdget is D76< million million larger larger sing White’s White’s approach. approach. #apital #apital bdget is D1,"<< D1,"<< million million larger sing sing White’s approach approach. . $he capital capital bdget bdget is the the same sing sing the two two approaches approaches. .
Chapter 12 - Page 6
Replacement cain 1*
.
D)*,*"+ D)<,"7) D";,;2* D";,"*< D"*,+)6
Replacement cain
.
Diff: E
:ayhawk :ets mst choose one of two mtally exclsive projects. &roject ( has an pfront cost /t A <0 of D1"<,<<<, and it is expected to prodce cash inflows of D7<,<<< per year at the end of each of the next two years. $wo years from now, the project can be repeated at a higher pfront cost of D1"+,<<<, bt the cash inflows will remain the same. &roject has an pfront cost of D1<<,<<<, and it is expected to prodce cash inflows of D*1,<<< per year at the end of each of the next for years. &roject cannot be repeated. oth projects have a cost of capital of 1< percent. :ayhawk wants to select the project that provides the most vale over the next for years. What is the net present vale /N&'0 of the project that creates the most vale for :ayhawk? a. b. c. d. e.
1+
Answer: b
Answer: d
Diff: E
'and 'ander erhe heid iden en %nc. %nc. is consi conside deri ring ng two two aver averag age eri risk sk alte altern rnat ativ ive e ways ways of prodcing its patented polo shirts. &rocess has a cost of D7,<<< and will prodce net cash flows of D+,<<< per year for " years. &rocess @ will cost D11,+<< and will prodce cash flows of D*,<<< per year for * years. $he company has a contract that re9ires it to prodce the shirts for * years, bt the patent will expire after * years, so the shirts will not be prodced after * years. %nflation is expected to be Gero dring the next * years. %f cash inflows occr at the end of each year, and if 'anderheiden’s cost of capital is 1< percent, by what amont will the better project increase 'anderheiden’s vale? a. b. c. d. e.
D 26 266.2; D1,< D1,<; ;7.7; 7.7; D1,1 D1,16 6;.*2 ;.*2 D1," D1,") )6.62 6.62 D1,) D1,)1 1".)1 ".)1
Chapter 12 - Page 7
Investment timing option 12
.
Answer: d
Diff: E
N
ari arich chal al ot otor ors s is con consi side deri ring ng an an inve invest stme ment nt in in a prop propos osed ed proj projec ect. t. -at -athe her r than making the investment today, the company wants to wait a year to collect collect additiona additional l informati information on abot abot the project. project. %f arichal arichal waits waits a year, it will not have to invest any cash flows nless it decides to make the investment. investment. %f it waits, there there is a "+ percent chance chance the project’s expected N&' one year from today will be D1< million, a +< percent chance that the project’s expected N&' one year from now will be D* million, and a "+ percent chance that the project’s expected N&' one year from now will be D1< million million. . (ll expected expected cash cash flows flows are disconte disconted d at 1< percent. percent. What is the expected N&' /in today’s dollars0 if the company chooses to wait a year before deciding whether to make the investment? a. b. c. d. e.
D".; D".;77 77; ; D).1 D).1*; *;2 2 D).2 D).276 76+ + D*.< D*.<;< ;<; ; D*.+ D*.+<< <<< <
mill millio ion n mill millio ion n mill millio ion n mill millio ion n mill millio ion n
Medium: Medium: Replacement cain 16
.
Answer: c
Diff: M
ord orden en oo ooks ks is is inte intere rest sted ed in in prc prcha hasi sing ng a com comp pte ter r syst system em to to se se for for the the next 1< years. years. #rrently, #rrently, orden is considerin considering g two mtally exclsive exclsive systems, ystem and ystem @. ystem has an pfront cost of D) million at t A < and will prodce positive cash flows of D".+ million per year for two years /at t A 1 and "0. $his system can be repeated forever. %n other words, every two years the company can reprchase the system nder exactly the same terms. ystem @ has an pfront cost of D+ million at t A < and will prodce positive cash flows of D" million per year for five years /at t A 1, ", ), *, and +0. $his system can be replaced at a cost of D* million at t A +, after which time it will prodce positive cash flows of D1.+ million per year for the sbse9ent five years /at t A 2, 6, 7, ;, and 1<0. orden’s #45 has determined that the compa company’s ny’s W(## is 1 1" " percent. 5ver a 1< year extended basis, which system is the better system and what is its N&'? a. b. c. d. e.
ystem ystem ystem ystem ystem ystem ystem ystem ystem ystem
Chapter 12 - Page 8
@H @H H @H H
D"." D"."1 1 D).< D).<1 1 D*.1 D*.1< < D*.* D*.*1 1 D2.1 D2.1) )
milli million on milli million on milli million on milli million on milli million on
Replacement cain 17
.
Answer: c
Diff: M
>ohe >ohert rty y %nd %ndst stri ries es wan wants ts to to inve invest st in in a new new comp compt ter er sys syste tem. m. $he $he com compa pany ny only wants to invest in one system, and has narrowed the choice down to ystem ( and ystem . ystem ( re9ires an pfront cost of D1<<,<<< and then generates positive aftertax cash flows of D2<,<<< at the end of each of the next two years. $he system system can be replac replaced ed every every two years years with with the cash inflows inflows and otflows remaining the same. ystem ystem also also re9ir re9ires es an pfro pfront nt cost cost of D1<<,< D1<<,<<< << and then then genera generates tes positive aftertax cash flows of D*7,<<< at the end of each of the next three years. ystem can be replaced every three years, bt each time the system is replaced, both the cash inflows and otflows increase by 1< percent. $he company needs a compter system for the 2year period, after which time the crrent owners plan on retiring and li9idating the firm. $he company’s cost of capital is 11 percent. What is the N&' /on a 2year extended basis0 of the system that creates the most vale to the company? a. b. c. d. e.
D 16, 16,"; ";7. 7.)< )< D "", "",2) 2)*. *.66 66 D )1, )1,"1 "11. 1.+" +" D )7, )7,+" +"). ).*) *) D1<) D1<),< ,<2+ 2+.7 .7" "
Replacement cain 1;
.
Answer: e
Diff: M
:ohn :ohnso son n :ets :ets is is cons consid ider erin ing g two two mt mtal ally ly exc excl lsi sive ve mac machi hine nes. s. ac achi hine ne ( has has an pfront cost of D1<<,<<< /#4< A 1<<,<<<0 and prodces positive after tax cash inflows of D*<,<<< a year at the end of each of the next six years. achine has an pfront cost of D+<,<<
D"),;+< D*1,2+2 D+2,")7 D2",*+2 D61,276
Chapter 12 - Page 9
Replacement cain "<
.
D)*6 D)*6,7 ,7<" <".< .<< < D*+1 D*+1,6 ,66+ 6+." ."1 1 D2)) D2)),* ,*71 71.1 .1; ; D6;" D6;"," ,"72 72.+ .+* * D711 D711,) ,)+6 +6.2 .22 2
Replacement cain
.
Diff: M
( sma small ll man manfa fact ctr rer er is cons consid ider erin ing g two two alte altern rnat ativ ive e mac machi hine nes. s. ach achin ine e ( costs D1 million, has an expected life of + years, and generates aftertax cash flows of D)+<,<<< per year. (t the end of + years, the salvage vale of the original machine is Gero, bt the company will be able to prchase another achine ( at a cost of D1." million. $he second achine ( will generate aftertax cash flows of D)6+,<<< a year for another + years at whic which h time time its its salv salvag age e val vale e will will agai again n be Gero Gero. . (lte (ltern rnat ativ ivel ely, y, the the company can by achine at a cost of D1.+ million today. achine will prodce aftertax cash flows of D*<<,<<< a year for 1< years, and after 1< years it will have an aftertax salvage vale of D1<<,<<<. (ssme that the cost of capital is 1" percent. %f the company chooses the machine that adds the most vale to the firm, by how mch will the company’s vale increase? a. b. c. d. e.
"1
Answer: d
Answer: c
Diff: M
Fai Fainesv nesvil ille le s s @ine @ines s /F /F@0 is consi onside deri ring ng two two alte altern rnat ativ ive e bss bsses es to transport people from the commter lot to the main camps. s has a cost of D+<,<<< and will prodce endofyear net cash flows of D"+,<<< per year for ) years. s @ will cost D6+,<<< and will prodce cash flows of D"),<<< per year for 2 years. $he company mst provide bs service for 2 year years, s, afte after r whic which h it plan plans s to give give p its its fran franch chis ise e and and to ceas cease e operating the rote. %nflation is not expected to affect either costs or revenes dring the next 2 years. %f F@’s cost of capital is 1+ percent, by what amont will the better project change the company’s vale? a. b. c. d. e.
D1<, D1<,"" ""+. +.17 17 D11, D11,6) 6)2. 2."2 "2 D1", D1",<* <*). ).1< 1< D1), D1),*" *"*. *.22 22 D1*, D1*,<7 <71. 1.1; 1;
Chapter 12 - Page 10
Replacement cain ""
.
Answer: e
Diff: M
N
&roj &rojec ects ts I and and J hav have e the the foll follow owin ing g exp expec ecte ted d net net cash cash flow flows= s=
$ime < 1 " )
&roject I #ash 4low D+<<,<<< "+<,<<< "+<,<<< "+<,<<<
&roject J #ash 4low D+<<,<<< )+<,<<< )+<,<<<
(ssme that both projects have a 1< percent cost of capital, and each of the projects can be indefinitely repeated with the same net cash flows. What What is the 2year 2year extended extended N&' of the project project that that create creates s the most vale? a. b. c. d. e.
D17* D17*,* ,*2" 2".2 .2" " D"<* D"<*,7 ,7** **.2 .21 1 D"1) D"1),1 ,1+6 +6.6 .66 6 D"*7 D"*7,7 ,7<) <).6 .6+ + D"2; D"2;,2 ,211 11.) .)7 7
Replacement cain ")
.
Answer: a
Diff: M
Whit Whitma man n ot otor ors s is is con consi side deri ring ng two two pro proje ject cts, s, &roj &rojec ect t ( and and &ro &roje ject ct . projects have the following cash flows=
Jear < 1 " )
&roject ( #ash 4low D)<< 1+< 1+< 1+<
N
$he $he
&roject #ash 4low D)<< "<< "<<
(ssme that each project has a 1< percent cost of capital, and assme that the company is not capital constrained. constrained. Which of the following statements is most correct? a. %f the two projec projects ts are indepe independe ndent nt /stand /standal alone one0 0 projec projects, ts, then the company wold select both projects. b. %f the two projects projects are mtall mtally y exclsive exclsive and cannot cannot be repeated, repeated, then the company wold select &roject . c. %f the two projec projects ts are mtal mtally ly exclsiv exclsive, e, and each can be repeated repeated indefinitely with the same expected cash flows, then the company wold select &roject . d. tatem tatement ents s a and c are are correc correct. t. e. (ll of of the statem statements ents above above are are correct. correct.
Chapter 12 - Page 11
Investment timing option "*
.
Answer: b
Diff: M
Nebr Nebras aska ka %nst %nstr rme ment nts s /N%0 /N%0 is cons consid ider erin ing g a proj projec ect t that that has an pf pfro ront nt cost cost at t A < of D1,+ D1,+<< <<,< ,<<< <<. . $he $he proj projec ect’ t’s s sbs sbse9 e9e ent nt cash cash flow flows s critically depend on whether its prodcts become the indstry standard. $here is a 6+ percent chance that the prodcts will become the indstry standard, in which case the project’s expected cash flows will be D+<<,<<< at the end of each of the next seven years /t A 1 ... 60. $here is a "+ percent chance that the prodcts will not become the indstry standard, in which case the expected cash flows from the project will be D+<,<<< at the end of each of the next seven years /t A 1 ... 60. N% will know for sre one year from today whether its prodcts will have become the indstry standard. %t is considering whether to make the investment today or to wait a year ntil after it finds ot if the prodcts have become the indstry standard. %f it waits a year, the project’s pfront cost at t A 1 will remain at D1,+<<,<<<. %f it chooses to wait, the sbse9ent cash flows will remain at D+<<,<<< per year if the prodct becomes the indstry standard, and D+<,<<< per year if the prodct does not become the indstry standard. 3owever, if it decides to wait, the sbse9ent cash flows will be received only for six years /t A 1 ... 60. (ssme that all cash flows are are disc disco ont nted ed at 1< perc percen ent. t. %f N% choo choose ses s to wait wait a year year befo before re proceeding, how mch will this increase or decrease the project’s expected N&' N&' in toda today’ y’s s doll dollar ars s /t A <0, <0, rela relati tive ve to the the proj projec ect’ t’s s N&' N&' if it proceeds today? a. b. c. d. e.
D1)+ D1)+, ,*6" *6" D""; D"";, ,+12 +12 D)72 D)72, ,+1" +1" D*;* D*;*, ,))6 ))6 D212 D212, ,<"7 <"7
Chapter 12 - Page 12
Investment timing option "+
.
Answer: a
Diff: M
N
Fibs Fibson on Froc Frocer ers s is is con consi side deri ring ng a pro propo pose sed d pro proje ject ct. . $he $he com compa pany ny esti estima mate tes s that if it invests in the project today, the project’s estimated N&' is D1< million, bt there remains a lot of ncertainty abot the project’s profitability. (s an alte altern rnat ativ ive e to maki making ng the the inve invest stme ment nt toda today, y, the the comp compan any y is considerin considering g waiting waiting a year. year. %n particla particlar, r, it is consider considering ing spending spending some money today to collect additional information, which wold enable the firm to make a better assessment of the project’s vale one year from now. Fibson believes that if it waits a year, there is a +< percent chance the information collected will be positive and the project’s expected N&' one year from now /not inclding the cost of obtaining the information0 will be D"+ milli million on. . $her $here e is also also a +< perce percent nt chanc chance e the the inform informat atio ion n collected will be negative and the project’s expected N&' one year from now /not inclding the cost of obtaining the information0 will be D1+ million. %f the company chooses to collect additional information, the costs of collecting collecting this this informat information ion will will be incrred incrred today. today. oreover, oreover, if the company chooses to wait a year, it has the option to invest or not invest in the the proj projec ect t afte after r rece receiv ivin ing g the the info inform rmat atio ion n abo abot t the the proj projec ect’ t’s s prospects. (ssme that all cash flows are disconted at 1" percent. What is the maximm amont of money the company wold be willing to spend to collect this information? a. b. c d. e.
D 1.1 1.12< 2<6 6 D ".+ ".+<< <<< < D +.7;)7 D1<. D1<.<< <<<< << D11. D11.12 12<6 <6
mil milli lion on mil milli lion on million mill millio ion n mill millio ion n
Chapter 12 - Page 13
Abando Abandonme nment nt option option "2
.
Answer Answer: : e
Diff: Diff: M
3olm 3olmes es #or #orpo pora rati tion on rec recen entl tly y prc prcha hase sed d a new new deli delive very ry tr trck ck. . $he $he new new trc trck k costs D"+,<<< D"+,<<< and is expected expected to generate generate net aftertax aftertax operating operating cash flows, inclding depreciation, of D6,<<< at the end of each year. $he trck has a +year expected life. $he expected abandonment vales /salvage vales after tax adjstments0 at different points in time are given below. /Note that these abandonment vale estimates assme that the trck is sold after receiving the project’s cash flow for the year.0 $he firm’s cost of capital is 1< percent. Jear 1 " ) * +
(bandonment vale D"<,<<< 1+,<<< 1<,<<< +,<<< <
(t what point in time wold the company choose to sell /abandon0 the trck in order to maximiGe its N&'? a. b. c. d. e.
(fte (fter r one one year year (fte (fter r two two year years s (fte (fter r thre three e year years s (fte (fter r fo for r year years s %t wold wold never never choose choose to to sell the trck. trck.
Tough: !ptimal pro#ect selection "6
.
:ackson #orporation is investment opportnities= &roject ( # >
Answer: a
evalating
#ost D)<<,<<< 1+<,<<< "<<,<<< *<<,<<<
the
following
for
Diff: $
independent,
-ate of -etrn 1*E 1< 1) 11
:ackso :ackson’s n’s target target capita capital l strct strctre re is 2< percen percent t debt debt and *< percen percent t e9ity e9ity. . $he yield yield to matri matrity ty on the compan company’s y’s debt debt is 1< percent percent. . :ack :ackso son n will will inc incr r flot flotat atio ion n cost costs s for for a new new e9i e9ity ty iss issan ance ce of 1" percent. percent. $he growth growth rate rate is a constan constant t 2 percent. percent. $he stock price is crrently D)+ per share for each of the 1<,<<< shares otstanding. :ackson expects to earn net income of D1<<,<<< this coming year and the dividend payot ratio will be +< percent. %f the company’s company’s tax rate is )< )< percent, which of the projects will be accepted? a. b. c. d. e.
&roj &roje ect ( &roj &rojec ects ts ( and and # &rojec &rojects ts (, #, #, and and > (ll of the the investme investment nt projects projects will will be taken. taken. None of of the investm investment ent project projects s will be be taken. taken.
Chapter 12 - Page 14
!ptimal capital budget "7
.
Answer: b
Diff: $
Fibs Fibson on %nc %nc. . is con consi side deri ring ng the the fol follo lowi wing ng fiv five e inde indepe pend nden ent t proj projec ects ts= = &roject ( # > !
#ost D"<<,<<< 2<<,<<< *<<,<<< *<<,<<< *<<,<<<
%-"
$he company has a target capital strctre that consists of *< percent debt and 2< 2< percent percent common common e9ity. e9ity. $he company company can isse isse bonds bonds with a yield to to matrity matrity of 11 percent percent. . $he company company has has D2<<,<<< D2<<,<<< in retaine retained d earnings, earnings, and and the crrent crrent stock stock price price is D*" per per share. share. $he flotati flotation on costs costs associa associated ted with with issing issing new e9ity e9ity are D" per share. share. Fibson Fibson’s ’s earnings earnings are expecte expected d to contine contine to grow grow at 2 percent percent per year. year. Next year’s year’s dividend dividend />10 is forec forecas aste ted d to be D*.<< D*.<<. . $he $he firm firm faces faces a *< percent tax rate. What is the siGe of Fibson’s optimal capital capital bdget? a. b. c. d. e.
D "< "<<,<< <,<<< < D 7< 7<<,<< <,<<< < D1," D1,"<< <<,< ,<<< << D1,2 D1,2<< <<,< ,<<< << D",< D",<<< <<,< ,<<< <<
!ptimal capital budget ";
.
Answer: b
Diff: $
&ho &hoton ton #orpo orpora rati tion on has has a targ target et capi capit tal str strct ctre re tha that cons consis ists ts of 2< percen percent t e9ity e9ity and *< percen percent t debt. debt. $he firm firm can raise raise an nlimit nlimited ed amont of debt at a beforetax cost of ; percent. percent. $he company expects to retain earnings of D)<<,<<< in the coming year and to face a tax rate of )+ percen percent. t. $he last dividend dividend /><0 was D" per share and the growth rate of the company company is constan constant t at 2 percent. percent. %f the company company needs needs to isse isse new e9ity, e9ity, then then the flotation flotation cost cost will will be D+ per share. share. $he crrent crrent stock pric price e /&<0 &<0 is D)< D)<. &ho &hoton ton has has the the foll follow owin ing g inv invest estment ment opportnities= &roject 1 " ) * +
#ost D1<<,<<< "<<,<<< 1<<,<<< 1+<,<<< 6+,<<<
%-1<.+E 1).< 1".< 1*.< ;.<
What is the company’s optimal capital bdget? a. b. c. d. e.
D2"+ D2"+, ,<<< <<< D*+< D*+<, ,<<< <<< D)+< D)+<, ,<<< <<< D++< D++<, ,<<< <<< D1+< D1+<, ,<<< <<<
Chapter 12 - Page 15
!ptimal capital budget )<
.
Answer: b
Diff: $
(tle (tlee e (sso (ssoci ciat ates es has has a cap capit ital al str strc ct tre re tha that t cons consis ists ts of of *< per perce cent nt deb debt t and 2< percent common stock. $he yield to matrity on the company’s debt is 7 percent, the cost of retained earnings is 1" percent, and the cost of issing new e9ity is 1) percent. $he company expects its net income to be D+<<,<<<, the dividend payot is expected to be *< percent, and its tax rate is *< percent. $he company is considering five projects, all with the same risk. $he siGe and estimated retrns of the proposed projects are listed below= &roject ( # > !
#ost D"<<,<<< 1<<,<<< 1<<,<<< "<<,<<< "<<,<<<
%-11.<
5n the basis of this information, what is (tlee’s optimal capital bdget? a. b. c. d. e.
D7<< D7<<, ,<<< <<< D2<< D2<<, ,<<< <<< D*<< D*<<, ,<<< <<< D)<< D)<<, ,<<< <<< D"<< D"<<, ,<<< <<<
Real options )1
.
Answer: e
Diff: $
N
ch chol olG G ran rands ds is con consi side deri ring ng the the devel develop opme ment nt of of a new ket ketch chp p pro prod dct ct. . $he ketchp will be sold in a variety of different colors and will be marketed marketed to yong yong children children. . %n evalati evalating ng the propose proposed d project, project, the company has collected the following information= • •
• •
•
•
•
• •
$he company estimates that the project will last for for years. $he company will need to prchase new machinery that has an pfront cost of D)<< D)<< million million /incrred /incrred at t A <0. <0. (t t A *, the machiner machinery y has an estimated salvage vale of D+< million. $he machinery will be depreciated on a *year straightline basis. &rodction on the new ketchp prodct will take place in a recently vacated vacated facility facility that that the company company owns. owns. $he facility facility is empty empty and cholG does not intend to lease the facility. $he project will re9ire a D2< million increase in inventory at t A <. $he company expects that its acconts payable will rise by D1< mill millio ion n at t A <. (fte (fter r t A <, ther there e will will be no chang changes es in net net operating working capital, ntil t A * when the project is completed, and the net operating working capital is completely recovered. $he company estimates that sales of the new ketchp will be D"<< million each of the next for years. $he operating costs, exclding depreciation, are expected to be D1<< million each year. $he company’s tax rate is *< percent. $he project’s W(## is 1< percent.
Chapter 12 - Page 16
%f cholG goes ahead with the project, they will have the option to prse a second stage stage project project at t A *. $his secondst secondstage age project project will involve involve a fll line of mlticolored condiments. $his second stage project cannot be ndert ndertake aken, n, nless nless the first firststa stage ge projec project t /the /the new ketch ketchp p prodc prodct0 t0 is ndert ndertake aken n today. today. $he compan company y estimate estimates s today, today, that if they want want to go ahead with the second stage project that this will re9ire a significant expenditre at t A *. 3owever, the company does not have to decide whether to prse the second stage project or to spend any fnds on the second stage project ntil t A *. #rrently, the company’s analysts estimate that there is a "+ percent chance that demand will be high and the second stage will have an estimated N&' /at t A *0 of D*< million, and there is a 6+ percent chance that demand will be weak and the second stage will have an esti estima mate ted d N&' N&' /at /at t A *0 of D6+ D6+ milli million on. . 4rt 4rthe herm rmor ore, e, the analy analyst sts s beli believ eve e that that, , by the the for forth th year year /at /at t A *0, *0, cons consm mer er pref prefer eren ence ces s and and demands demands for the second second stage project project will be known known with certaint certainty. y. (ssme that all cash flows are disconted at the cost of capital /1< percent0. 3ow mch of an impact will this second stage option have on the company’s decision to prse the first stage project today? a. ince ince the second second stage stage projec project t has an expect expected ed N&' that that is negative negative, , the existence of the second stage project makes it less likely that the company will go ahead with the first stage project today. b. ince ince the second second stage stage projec project t has an expect expected ed N&' that that is negative negative, , the company will never prse the second stage project, therefore it will have no impact on the company’s decision to ndertake the first stage project today. c. !ven !ven thogh thogh there there is a second second stage stage projec project, t, the company company will reject reject the first stage project as long as the N&' of the first stage project is less than Gero. d. $he existence existence of the the second stage stage project project means means that the company company will will proceed with the first stage project as the long as the N&' of the first stage project /calclated at t A <0 is greater than negative D1< million /i.e., N&' of first stage K D1< million.0 e. $he existence existence of the the second stage stage project project means means that the company company will will proceed with the first stage project as the long as the N&' of the first stage project /calclated at t A <0 is greater than negative D2.7) million /i.e., N&' of first stage K D2.7) million.0
Chapter 12 - Page 17
Multiple Part: (The following information applies to the next two problems.)
>iplomat.com is considering a project that has an pfront cost of D) million and prodces an expected cash flow of D+<<,<<< at the end of each of the next five years. years. $he project’s project’s cost of capital capital is 1< percent. percent. %ro#ect’s N%& )"
.
Answer: d
Diff: E
ase ased d on this this inf infor orma mati tion on wha what t is the the proj projec ect’ t’s s net net pres presen ent t val vale? e? a. D 76+, 76+,"< "<) ) b. D +<2, +<2,*; *;7 7 c. D +*,)<6 d. D1, D1,1< 1<*, *,2< 2<6 6 e. D 1<+,; <+,;;; ;;
'rowt options ))
.
Answer: a
Diff: M
%f >ipl >iplom omat at goes goes ahea ahead d with with this this proje project ct toda today, y, the the proje project ct will will crea create te additional additional opport opportniti nities es five five years from from now /t /t A +0. $he company company can can deci decide de at t A + whet whethe her r or not not it want wants s to prs prse e thes these e addi additi tion onal al opportnities. ased on the best information that that is available today, today, the company estimates that there is a )+ percent chance that its technology will be sccessfl, in which case the ftre investment opportnities will have a net net present present vale vale of D2 million million at at t A +. $here is a 2+ percent percent chance that its technology will not scceed, in which case the ftre investment opportnities will have a net present vale of D2 million at t A +. >iplomat.c >iplomat.com om does not not have to decide decide today today whether whether it wants wants to prse prse these addition additional al opportnit opportnities. ies. %nstead, %nstead, it can wait ntil ntil after it finds finds ot if its techno technolog logy y is scces sccessf sfl. l. 3oweve 3owever, r, >iploma >iplomat.c t.com om cannot prse these additional opportnities in the ftre nless it makes the initial investment today. today. What is the estimated net present vale of the project, after taking into accont the ftre opportnities? a. D 1;;,) ;;,)"7 "7 b. D +21,; 21,;*6 *6 c. D 7;7," ;7,"<+ <+ d. D1, D1,1< 1<*, *,2< 2<6 6 e. D", D","" """, ","2 "2+ + (The following information applies to the next two problems.)
5klahoma %nstrments /5%0 is considering a project that has an pfront cost of D"+<,<<<. $he project’s sbse9ent cash flows critically depend on whether its prodcts become the indstry standard. $here is a +< percent chance that the prodcts will become the indstry standard, in which case the project’s expected cash flows will be D11<,<<< at the end of each of the next five years. $here is a +< percent chance that the prodcts will not become the indstry standard, in which case the project’s expected cash flows will be D"+,<<< at the end of each of the next five years. (ssme that the cost of capital is 1" percent.
Chapter 12 - Page 18
%ro#ect’s N%& )*
.
as ased on this this inf informa ormati tio on, what what is the the vale?
Answer: a
proj projec ect’ t’s s
expe expect cted ed net net
Diff: E
pres prese ent
a. D 2, 2,267 b. D"<,<<* c. D"* D"*, ,6<1 6<1 d. D*+,;2+ e. D1+,)<) &alue &alue of abando abandonme nment nt option option )+
.
Answer Answer: : e
Diff: Diff: M
Now Now ass assme me tha that t one one year year fro from m now now 5% will will kno know w if its its prod prodc cts ts wil will l have have become the indstry standard. (lso assme that after receiving the cash flows at t A 1, the company has the option to abandon the project. %f it abandons the project it will receive an additional D1<<,<<< at t A 1, bt will will no long longer er rece receiv ive e any any cash cash flow flows s afte after r t A 1. (ss (ssme me that that the the aban abando donm nmen ent t opti option on does does not not affe affect ct the the cost cost of capi capita tal. l. What What is the the estimated vale of the abandonment option? a. b. c. d. e.
D < D ", ",<6+ D *, *,<26 D 7, 7,;*+ D1<,6*+ (The following information applies to the next two problems.)
4air 4air 5il owns a tract tract of land that that may be rich rich with oil. oil. 4air 4air mst decid decide e whether whether or not to to drill on this this land. land. 4air estimat estimates es that the the project project wold wold cost D"+ million today /t A <0, and generate positive net cash flows of D1< million a year at the end of each of the next for years /t A 1, ", ), and *0. Whil While e the the comp compan any y is fair fairly ly conf confid iden ent t abo abot t its its cash cash flow flow fore foreca cast st, , it recogniGes that if it waits 1 year, it wold have more information abot the local geology geology and and the price of oil. oil. 4air estimate estimates s that if it waits one year, year, the project project will cost cost D"2 million million /at t A 10. %f 4air 5il 5il waits a year, year, there is an 7
.
Answer Answer: : e
Diff: Diff: E
N
%f the the com compa pany ny cho choos oses es to to dril drill l toda today, y, wha what t is the the pro proje ject ct’s ’s net net pre prese sent nt vale /N&'0? a. D*.2 D*.2" " mil milli lion on b. D+.1 D+.1+ + mil milli lion on c. D+.7 D+.7< < mil milli lion on
Chapter 12 - Page 19
d. D2." D2."" " mil milli lion on e. D2.6 D2.6< < mil milli lion on Investment timing option )6
.
Answer: c
Diff: M
N
4air 4air ms mst t deci decide de if if it mak makes se sense nse for for the the comp compan any y to wai wait a year ear to drill. %f it waits waits a year, what wold be the expected expected net present vale vale /N&'0 at t A
D6.2 D6.2"; "; D7." D7."2" 2" D7.6 D7.6++ ++ D;." D;."2* 2* D;.) D;.);1 ;1
Chapter 12 - Page 20
mil milli lion on mil milli lion on mil milli lion on mil milli lion on mil milli lion on
CHAPTE !" A&%-E% A&D %#'T$#&%
Chapter 12 - Page 21
1
Abandonment option
Answer: b
Diff: E
1(
Abandonment option
Answer: b
Diff: E
$he option to abandon will increase expected cash flow and decrease risk. %f a firm has the option to abandon a project, it will choose to do so only when things look bad /negative N&'0. $hs, abandoning a project eliminates the lowLnegative cash flows. $herefore, statement b is correct. "(
Investment timing option
Answer: e
Diff: E
y having the ability to wait and see yo redce the risk of the project. $herefore, statement a is false. $he greater the ncertainty, the more vale ther there e is in wait waitin ing g for for addi additi tion onal al info inform rmat atio ion n befo before re goin going g on with with a projec project. t. $heref $herefore ore, , statem statement ent b is false. false. tatem tatement ent c is not necess necessari arily ly tre tre. . y wait waitin ing g to do a proj projec ect t yo yo may may lose lose stra strate tegi gic c adva advant ntag ages es associated associated with being the first competitor competitor to enter a new line of bsiness, bsiness, which may alter the cash flows. ince statements a, b, and c are false, the correct choice is statement e. ).
Flexibility option
Answer: c
Diff: E
N
tat tatem emen ents ts a, b, c, and and d are are all all exam exampl ples es of diff differ eren ent t type types s of real real opti option ons. s. ( flex flexib ibil ilit ity y opti option on permit permits s the the firm firm to alte alter r oper operat atio ions ns depe depend ndin ing g on how how cond condit itio ions ns chan change ge dri dring ng the the life life of the the proj projec ect. t. $ypically, $ypically, either either inpts inpts or otpts, otpts, or both, both, can be be changed. changed. tatement tatement a is an exam exampl ple e of an inve invest stme ment nt timi timing ng opti option on, , whil while e stat statem emen ent t b is an exam exampl ple e of an aban abando donm nmen ent t opti option on. . tat tatem emen ent t c is an exam exampl ple e of a flexibility option, while statement d is an example of a growthLexpansion option. $herefore, statement c is the correct choice. *.
Real options
Answer: c
Diff: E
tat tatem emen ents ts a, b, c, and and d are are all all exam exampl ples es of diff differ eren ent t type types s of real real options. ( flexibility option permits the firm to alter operations depending on how conditions change dring the life of the project. $ypically, either inpts or otpts, or both, can be changed. tatement a is an example of an investment timing option, while statement b is an example of an abandonment option. tatement c is an example of a flexibility option, while statement d is an exampl example e of a growth growth option. option. $heref $herefore ore, , statem statement ent c is the correc correct t choice. +(
Real options
2(
$he $he corr correc ect t answ answer er is stat statem emen ent t b. tat tatem emen ent t a is incor incorre rect ctH H the the abandonment abandonment option option will will tend to to increase increase a project’s project’s N&'. N&'. tatement tatement b is corr correc ectH tH the the aban abando donm nmen ent t opti option on will will tend tend to red redce ce a proj projec ect’ t’s s risk risk. . tatem tatement ent c is incorr incorrect ectH H if there there are firstmov firstmover er advant advantage ages, s, it may be harmfl /lowers vale0 to wait a year to collect information. Real options Answer: b Diff: E N
Answer: b
Diff: E
N
$he correct correct answer answer is is statem statement ent b. tatemen tatement t a is clea clearly rly incorrec incorrect. t. %f there is no ncertainty, the option has no vale. $he option has vale de to the the ncer ncertai taint nty. y. $he $he vale vale of the optio option n incre increase ases s as the ncerta ncertain inty ty increas increases. es. tateme tatement nt b is corr correct. ect. $he firm will sht sht down down instead instead of realiGi realiGing ng negativ negative e cash flows. flows. $his will will tend to increa increase se the project project’s ’s expected cash flows. $he option will decrease the project’s riskH if not, the option will not even be consideredM o, statement c is also incorrect. 6(
Real options
Answer: a
Diff: E
N
7(
Real options
Answer: d
Diff: E
N
;(
Miscellaneous capital budgeting topics
Answer: d
Diff: E
N
$he correct answer is statement d. $he option to abandon the project project is a real real option option and this adds adds vale to the projec project. t. 5pport 5pportni nity ty costs costs are always always incld inclded ed when when evala evalatin ting g capita capital l bdget bdgeting ing projec projects, ts, while while snk snk costs are never inclded. inclded. $herefore, the correct choice is statement d. 1<(
Real options
Answer: b
Diff: M
11(
Real options
Answer: d
Diff: M
Answer Answer: : a
Diff: Diff: M
1".
Abando Abandonme nment nt and growt growt option options s
y failin failing g to consid consider er both both abando abandonme nment nt and growth growth option options, s, the firm’s firm’s capita capital l bdget bdget wold wold be too small. small. %n both cases cases, , the firm might might reject reject what what migh might t othe otherw rwis ise e be prof profit itab able le proj projec ects ts if thes these e opti option ons s had had been been considered. $herefore, the correct choice is statement a.
1)(
!ptimal capital budget and divisional ris"
Answer: c
Diff: E
4ind the W(##s sing both :ohn’s and ecky’s methods. /W(## A k s becase there is no debt0. :ohn’s W(## for >ivision based on overall company’s beta= k A k-4 -&/b0 k A +E +E/1."0 k A +E 2E k A 11E. $herefore, $herefore, :ohn wold only choose &roject &roject 1, becase becase it is the only project whose whose %-- exceed exceeds s its cost cost of capita capital. l. #onse9 #onse9en ently tly, , the firm’s firm’s capita capital l bdget /based on :ohn’s W(##0 is only D*<< million. ecky’s W(## for >ivision = k A k-4 -&/b0 k A +E +E/<.;0 k A +E *.+E k A ;.+E. ecky wold choose projects 1, ", ), and * becase all of these projects have an %-- that exceeds the >ivision’s ;.+ percent cost of capital. ased on ecky’s W(##, the firm’s capital bdget wold be D1,"6< million /D*<< D)<< D"+<
D)"<0. D)"<0. $heref $herefore ore, , the firm’s firm’s capita capital l bdget bdget based based on ecky’ ecky’s s million /D1,"6< D*<<0 larger than the one based on :ohn’s W(##. 1*(
Replacement cain
tep tep 1=
Answer: b
&roject ( #ash 4lows /D1"<,<<<0 7<,<<< 7<,<<< O 1"+,<<< A /*+,<<<0 7<,<<< 7<,<<<
$her $heref efor ore, e, vale.
&roject #ash 4lows /D1<<,<<<0 *1,<<< *1,<<< *1,<<< *1,<<<
D)<,"7). ≈ D";,;2*. ≈
:ayh :ayhaw awk k
sho shold ld
sele select ct
&roj &rojec ect t
(
Replacement cain =
< k A P 7,<<<
1
< k A P 11,+<<
1
sinc since e
it
Answer: d
1 P +,<<<
%-- A 12."2E. N&' A D1,")6.62. @=
Diff: E
>ete >eterm rmin ine e each each proje project ct’s ’s N&' by ente enteri ring ng the cash flow flows s into into the cash flow register and sing 1< percent for the cost of capital. N&'( A D)<,"7).*+ N&' A D";,;2*.*7
1+(
is D76< D76<
>eterm >etermine ine each each proj project ect’s ’s cash cash flows flows dri dring ng the the *year *year peri period. od. Jear < 1 " ) *
tep tep "=
W(## W(##
" P +,<<< 7,<<< ),<<<
) P +,<<<
* P +,<<<
) P *,<<<
* P *,<<<
adds adds
more more
Diff: E
/extended N&'0
1 P *,<<<
" P *,<<<
%--@ A 1*.22E. N&'@ A D1,16;.*2. 12(
Investment timing option
Answer: d
Di Diff: E
N
!xpe !xpect cted ed N&' N&' one one year year from from now now A <."+ <."+/D /D1< 1< mill millio ion0 n0 <.+< <.+
Replacement cain
tep tep 1=
>raw >raw the the time time line lines s /in /in mill million ions s of dollar dollars0= s0=
Answer: c
Diff: M
tep tep "= "=
17(
ystem =
< 1 " ) * + 2 6 7 ; 1< Jears 1"E P P P P P P P P P P P ) ".+ ".+ ".+ ".+ ".+ ".+ ".+ ".+ ".+ ".+ ).< ).< ).< ).< <.+ <.+ <.+ <.+
ystem @=
< 1 1"E P P + "
" P "
) P "
* P "
+ P " * "
2 6 7 ; 1< Jears P P P P P 1.+ 1.+ 1.+ 1.+ 1.+
#alc #alcl lat ate e the the N&' N&' for for each each sys syste tem= m= N&' A D) D".+L1.1" D<.+L/1.1"0 " D".+L/1.1"0 ) D<.+L/1.1"0 * D".+L/1.1"0 + D<.+L/1.1"0 2 D".+L/1.1"0 6 D<.+L/1.1"0 D<.+L/1.1"0 7 D".+L/1.1"0 ; D".+L/1.1"0 1< N&' A D) D".") D".")" " D<.);; D<.);; D1.66; D1.66; D<.)1 D<.)17 7 D1.*1; D1.*1; D<."+) D<."+) D1.1)1 D<."<" D<.;<" D<.7<+ N&' A D*.<;2 ≈ D*.1 million.
N&'@ A D+ D+ D"L D"L/1 /1.1 .1"0 "01 D"L/1.1"0 " D"L/1.1"0 ) D"L /1.1"0 * D"L /1.1"0+ D1.+L/1.1"0 2 D1.+L/1.1"0 6 D1.+L/1.1"0 7 D1.+L /1.1"0; D1.+L/1.1"0 1< N&'@ A D+ D+ D1.6 D1.672 72 D1.+; D1.+;* * 1.*" 1.*"* * D1." D1."61 61 D1.1) D1.1)+ + D<.6 D<.62< 2< D<.26; D<.2<2 D<.+*1 D<.*7) N&'@ A D).<<; ≈ D).<1 million. Replacement cain Answer: c Diff: M $o find the N&' of the system we mst se the replacement chain approach. $ime < 1 " ) * + 2
ystem (
ystem
1<<,<<< 2<,<<< 2<,<<< 1<<,<<< A *<,<<< 2<,<<< 2<,<<< 1<<,<<< A *<,<<< 2<,<<< 2<,<<<
1<<,<<< *7,<<< *7,<<< *7,<<< 11<,<<< A 2",<<< +",7<< +",7<< +",7<<
Qse the #4 key to enter the cash flows for each period and enter %LJ- A 11. $his shold give the following N&'s= N&'( A D2,6;2.;). N&' A D)1,"11.+". #ompter system creates the most vale for the firm, so the correct answer is c. 1; (
Replacement cain
Answer: e
Diff: M
$he #4s and N&'s /calclated with % A 1<.+E0 are as follows= t &roject ( < 1<<,<<< 1 *<,<<< " *<,<<< ) *<,<<< * *<,<<< + *<,<<< 2 *<,<<< N&' D61,276.17 ≈ D61,276 "<(
Replacement cain
achine ( /time line in thosands0=
&roject +<,<<< )<,<<< )<,<<< )<,<<< ++,<<< A "+,<<< )",<<< )",<<< )",<<< D*1,2++.+7 ≈ D*1,2+2 Answer: d
Diff: M
< k P 1,<<<
A 1"E
1 P )+<
•
•
•
+ P )+< 1,"<< 7+<
2 P )6+
•
•
1< P )6+
•
With a financial calclator inpt the following= #4< A 1<<<<<
"1(
•
; P *<<
•
1< P *<< 1<< +<<
#4< A 1+<<<<
1 P "+,<<<
1+E
" P "+,<<<
) P "+,<<< +<,<<< "+,<<<
* P "+,<<<
+ P "+,<<<
2 P "+,<<<
* P "),<<<
+ P "),<<<
2 P "),<<<
%-- A ").)7E. N&' A D11,6)2."2 /extended N&'0. ?s @= < k A P 6+,<<<
1 P "),<<<
1+E
" P "),<<<
) P "),<<<
%--@ A "<.7
Replacement cain
Answer: e
Diff: M
N
$he cash flows /sing the replacement chain0 for both projects are= &roject I= I=
#4 < A +<<<<
&roject J= J=
#4 < A +<<<<
3ence, &roject J adds more more vale and and shold be be accepted. provide an N&' of D"2;,211.)7.
%t is expected expected to
")(
Replacement cain
Answer: a
Diff: M
N
$he N&' for &roject ( is calclated as follows= #4< A )<
is correct correct. . (s long as both both projects projects are indep independ endent ent, , both be accepted accepted as long long as both N&'s N&'s are positive. positive. tatement tatement b is %f the two proj projec ects ts are mtal mtally ly excls exclsiv ive, e, then only only one one be chos chosen en. . $he $he projec project t chosen chosen shol shold d be the one with with the therefore, &roject ( wold be selected over &roject .
(ssme that both projects can be repeated= Jear < 1 " ) * + 2
&roject ( D)<< 1+< 1+< 1+< O )<< A 1+< 1+< 1+< 1+<
&roject D)<< "<< "<< O )<< A 1<< "<< "<< O )<< A 1<< "<< "<<
$he extended N&' for &roject ( is calclated as follows= #4< A )<
Investment timing option
Answer: b
Diff: M
tep tep 1= 1=
#alcl #alclate ate the the expecte expected d N&' of the the project project today today. . $he expec expected ted cash cash flow is /<.6+0/D+<<, /<.6+0/D+<<,<<<0 <<<0 /<."+0/D+<,< /<."+0/D+<,<<<0 <<0 A D)76,+<<. D)76,+<<. $o find the N&' N&' of the the proj projec ect, t, ente enter r the the foll follow owin ing g data data inp inpts ts in the the financial calclator= #4< A 1+<<<<
tep tep "=
#alc #alclat late e the N&' N&' of the proj project ect if if it waits waits. . %f the firm firm wait waits, s, it will know with certainty whether the prodct has become the indstry standard. %t will do the project only if the cash flows are D+<<,<<<. $o find find the the N&' N&' at t A < of the proj projec ect t if it wait waits, s, enter enter the following data inpts in the financial calclator= #4< A
tep tep )=
"+(
#alcl #alclate ate the increa increase se in in the the N&' N&' from from wait waiting ing= = D212,<"7 D)72,+1" A D"";,+12. Investment timing option Answer: a
Di Diff: M
N
!xpected N&' if the firm proceeds today= D1< million. !xpected N&' if the firm waits a year /in today’s dollars0= R<.+
Abando Abandonme nment nt option option
Answer Answer: : e
Diff: Diff: M
%n order to solve this problem, yo calclate the trck’s N&' at each point in time and then choose the trck life that maximiGes its N&'. (ban (bando don n afte after r Jear Jear 1= N&' A D*++.
#4 < A "+<<
(ban (bando don n afte after r Jear Jear "= #4 < A "+<<
#4 < A "+<<
$hs, the firm /in order to maximiGe its N&'0 wold never choose to sell the trck. "6(
!ptimal pro#ect selection
Answer: a
Diff: $
#alclate the aftertax component cost of debt as 110 as D+<,<<
"7(
!ptimal capital budget
Answer: b
Diff: $
$he siGe of Fibson’s capital bdget will be determined by the nmber of projects it can profitably ndertake, that is, those projects for which %-K applicable applicable W(##. W(##. 4irst, 4irst, find the costs costs of each type type of financing financing= = cost of retained earnings A k s A D*LD*" <.<2 A 1+.+"E and cost of debt A k d A 11E. $o calcla calclate te the the cost of new new e9ity, e9ity, k e we solve for k e A D*L/D*" D"0 <.<2 <.<2 A <.12 A 12E. Fiven the firm’s target capital strctre strctre and its retained earnings balance of D2<<,<<<, the firm can raise D1,<<<,<<< with debt and retained earnings earnings before before it mst se otside e9ity. e9ity. $herefore,
the W(## for < throg throgh h D1,<<< D1,<<<,<< ,<<< < of financ financing ing A <.*/<. <.*/<.110 110/1 /1 <.*0 <.*0 <.2/<. <.2/<.1++ 1++"0 "0 A 11.;+E 11.;+E. . (bove (bove D1,<<<, D1,<<<,<<< <<<, , the firm mst mst isse some some new e9ity, so the W(## A <.*/<.110/1 <.*0 <.2/<.120 A 1"."*E. 5bviosly, &rojec &rojects ts ( and will will be ndertak ndertaken. en. Jo mst mst then determ determine ine wheth whether er &roj &rojec ect t # will will be profi profita tabl ble. e. inc ince e in taki taking ng ( and and we will will need need financ financing ing of D7<<,< D7<<,<<<, <<, the D*<<,< D*<<,<<< << needed needed for &rojec &roject t # wold wold involv involve e financing D"<<,<<< with debt and retained earnings and D"<<,<<< with debt and new new e9ity. e9ity. $hs, $hs, the W(## W(## for &roje &roject ct # is /D"<<,< /D"<<,<<
!ptimal capital budget
Answer: b
Diff: $
#alc #alcl lat ate e the the reta retain ined ed earn earnin ings gs brea break k poin point t /& /& -!0 as D)<< D)<<,< ,<<< <1L&< g A D"/1.<20LD)< 2E A 1).<6E. #alclate k e as >1L/&< 40 g A D"/1.<20L/D)< D+0 2E A 1*.*7E. 4ind W(## below & -! as= W(## A <.2/1).<6E0 <.*/;E0/1 <.)+0 A 1<.17E. $hs, p to D+<<,<<< can be financed at 1<.17E. 4ind W(## above & -! as= W(## A <.2/1*.*7E0 <.*/;E0 /1 <.)+0 A 11.<)E. $hs, financing in excess of D+<<,<<< costs 11.<)E. &roj &rojec ects ts ", ), and and * all all have have %--s %--s exce exceed edin ing g eith either er W(## W(## and and sho shold ld be accept accepted. ed. $hese $hese projec projects ts re9ir re9ire e D*+<,< D*+<,<<< << in financ financing ing. . &rojec &roject t 1 is the next most profitable project. Fiven its cost of D1<<,<<<, half or D+<,<<< can be financed at 1<.17E and the other half mst be financed at 11.<)E. $he relevant cost of capital for &roject 1 is then <.+/1<.17E0 <.+/11.<)E0 A 1<.21E. ince &roject 1’s %-- is less than the cost of capital, it shold not be accepted. $he firm’s optimal capital bdget is D*+<,<<<.
)<(
!ptimal capital budget
Answer: b
Diff: $
tep tep 1= 1=
#alcl #alclate ate the retain retained ed earnin earnings gs breakp breakpoin oint= t= &-! A -etained earningsLw c A /D+<<,<<< × <.20L<.2 A D+<<,<<<.
tep tep "=
#alcl #alclate ate the the W(##s= W(##s= /$here /$here will will be two= two= one with with retain retained ed earnin earnings gs and one with new e9ity.0 W(##1 A R<.* × 7E × /1 <.*0S R<.2 × 1"ES A ;.1"E. W(##" A R<.* × 7E × /1 <.*0S R<.2 × 1)ES A ;.6"E.
tep tep )= )=
>ete >eterm rmin ine e the the opti optima mal l capi capita tal l bdg bdget et= = Now, work throgh throgh the projects, starting with the highestret highestretrn rn projec project t first, first, to determ determine ine the firm’s firm’s optima optimal l capita capital l bdget bdget. . %nit %nitia iall lly, y, the the W(## W(## is ;.1" ;.1" perc percen ent t for for the the firs first t D+<< D+<<,< ,<<< << of projec projects, ts, provid providing ing they retrn retrn more than than ;.1" ;.1" percen percent. t. 5n the basi basis s of this this, , we will will take take &roj &rojec ects ts (, , and and #, for a tota total l bdget of D*<<,<<<. &roject > will be fnded half by W(## 1 and half by W(## "H however, since &roject > retrns ;.7+ percent, we shold stil still l acce accept pt it beca becas se e this this is grea greate ter r than than W(## W(## ". &roj &rojec ect t ! retrns ;."+ percent, bt it will be fnded entirely ot of W(## " fnds at ;.6" percent, so we wold not accept &roject !. $herefore,
&rojects (, , #, and > shold be accepted and the total capital bdget is D2<<,<<<.
)1(
Real options
Answer: e
Diff: $
N
$he corre correct ct answer answer is state statemen ment t e. $o see this, this, yo yo mst eval evalate ate the the followon project after the initial project has been evalated. $he project cash flows are shown below /in millions of dollars0= Jear Qpfront costs %ncrease in N5W# ales 5perating costs >epreciation !%$ $axes !%$/1 $0 >epreciation 5perating #4 ($/'0 N5W# recovery Net #4
< )<< +<
)+<
1
"
)
*
"<< 1<< 6+ "+ 1< 1+ 6+ ;<
"<< 1<< 6+ "+ 1< 1+ 6+ ;<
"<< 1<< 6+ "+ 1< 1+ 6+ ;<
;<
;<
;<
"<< 1<< 6+ "+ 1< 1+ 6+ ;< )< +< 16<
Qsing yor financial calclator, enter the following data inpts= #4< A )+
N&'
A
$he N&' at Jear * of the second stage project is /<."+0/D*<0 /<.6+0/<0 A D1< millio million. n. Qsing Qsing yor financi financial al calcla calclator tor, , compare compare the second second stage stage project with the first stage project by entering the following inpt data /in millions of dollars0= #4< A 1<. 1<.<6 <6H H #41)
tatement tatement a is incorrec incorrect. t. oth are are negative negative N&' projects projectsH H so, the second second stage project project has has no impact impact on the the first stage project. project. Jo wold wold not do the first stage project. tatement b is incorrect. $his assmes the first project project has a negative negative N&'. N&'. $he company company may consider consider taking taking a first first stage project with a positive N&' and a second stage project with a negative N&', as long long as the combi combine ned d proj projec ect t has has a posi positi tive ve N&'. N&'. tat tatem emen ent t c is incorr incorrect ect. . %f a positive positive N&' N&' second second stage proje project ct is greater greater than than the nega negati tive ve N&' N&' firs first t stag stage e proj projec ect, t, the the comp compan any y may may cons consid ider er taki taking ng the the projec project. t. tatem tatement ent d is incorr incorrect ect. . ince ince the the N&' N&' of of the the whole whole projec project t needs to be positive, changing #4 < to ;.;; million does not do the trick. %t is still a negati negative ve N&' project. project. tatement tatement e is is correct. correct. #hanging #hanging #4 < to 2.7" million makes the project a positive N&' project. )".
%ro#ect ’s N%&
Answer: d
Diff: E
4ind 4ind the the proj projec ect’ t’s s N&' N&' sin sing g a fina financ ncia ial l calc calcl lat ator or and and ente enteri ring ng the the following data inpts= #4< A )<<<<<
)).
'rowt options
Answer: a
Diff: M
< k A 1
tep tep 1= 1=
4ind 4ind the the N&' N&' at at t A < of of the the firs first t proj projec ect= t= !nter the following data inpts in the financial calclator= #4< A )<<<<<
tep tep "= "=
4ind 4ind the the N&' N&' at at t A < of the the new new proj projec ects ts= = %f at t A + the firm’s technology is not sccessfl, sccessfl, the firm will choose choose to not do the addition additional al projec projects ts /since /since their N&' is D2,< D2,<<< <<,< ,<<< <<0. 0. $her $heref efor ore e, the N&' N&' at t A + is calc calcl lat ated ed as <.)+/D2,<<<,<<<0 <.2+/D<0 A D",1<<,<<<. 3owever, 3owever, this is the N&' at t A +, so we need to discont discont this N&' to find find the the N&' N&' of the the addi additi tion onal al proj projec ects ts toda today. y. !nte !nter r the the following data inpts in the financial calclator= N A +H % A 1
tep )=
)*.
4ind the N&' of the entire project opportnities= D1,1<*,2<6 D1,)<),;)+ A D1;;,)"7.
%ro#ect ’s N%&
considering
its
Answer: a
ftre
Diff: E
tep tep 1= 1=
4ind 4ind the proje project’ ct’s s expecte expected d cash flow flows s in Jears Jears 1 throg throgh h += /<.+0 /<.+0 /D11<,<<<0 /<.+0/D"+,<<<0 A D26,+<<.
tep tep "=
4ind 4ind the proje project’ ct’s s N&' by enter entering ing the the follow following ing data data inpts inpts in in the financial calclator= #4< A "+<<<
)+.
&alue &alue of abando abandonme nment nt option option
Answer Answer: : e
Diff: Diff: M
No abandonment= Jr. <
&rob N&'
<.+
×
1 " ) * + &rob N&' P P P P P 11<,<<< 11<,<<< 11<,<<< 11<,<<< 11<,<<< <.+ D1*2,+"+ D6),"2)
"+<,<<< <.+
"+,<<<
"+,<<<
"+,<<<
"+,<<<
"+,<<< <.+
1+;,771 O6;,;*1 !/N&'0 A D2,267
(bandonment= Jr. <
&rob N&'
<.+
×
1 " ) * + &rob N&' P P P P P 11<,<<< 11<,<<< 11<,<<< 11<,<<< 11<,<<< <.+ D1*2,+"+ D6),"2)
"+<,<<< <.+
1"+,<<<
<.+ 1)7,);) O2;,1;2 !/N&'0 A D *,<26 'ale of (bandonment A D*,<26 O /D2,2670 A D1<,6*+
)2(
New pro#ect N%&
Answer: e
Diff: E
N
We can solve for N&' by entering the following data into the cash flow register. #4< A "+<<< "+<<<<<< <<
Investment timing option
A 1<<<<< 1<<<<<<
A
≈
Answer: c
Di Diff: M
N
4air will only invest if market conditions are favorable, hence the "
Now, we mst find the N&' of the project as of Jear <, which is fond by taking the present vale of D;,2)<,6<7 received in Jear 1. N&' of project A D;,2)<,6<7L1.1 N&' of project A D7,6++,17;.
