Download 1 - Purdue Agricultural Economics

AGEC 424 Third Hour Exam Fall 2011 (103 points)
Name___________________________
To receive credit you must show all work (calculator inputs/output when appropriate).
1. (2 points) The appropriate interest rate to use in capital budgeting is:
a. always the company’s cost of capital.
b. the company’s cost of capital if the project’s risk is about the same as the
company’s.
c. the cost of capital plus any additional risk premium required to compensate for the
project’s higher risk.
d. both b & c
2.
a.
b.
c.
d.
(2 points) The __________ method consists of regressing historical values of a division’s
return on equity against the return on a major stock market index.
accounting beta model
CAPM
overlay
pure play
3. (2 points) A company is evaluating a capital project on a new line of business for the firm.
The firm’s current cost of equity capital is 12%. However, another firm, whose principal focus is
in the same field, is publicly traded and has a beta of 1.6. The market is currently yielding 12%
and the yield on short-term treasury bills is 6%. The appropriate cost of equity for this project is:
a. 12%
b. 18%
c. 25.2%
d. 15.6%
4. (2 points) Scenario/Sensitivity analysis is a procedure that can be used in the capital
budgeting process to indicate how sensitive the _____ is to changes in a particular variable.
a. probability
b. return distribution
c. net present value
d. standard deviation
5. (6 points) Provide the missing information for the following projects. Show calculator inputs and
output in the space provided.
a.
Project
Initial
Investment
Length
(in years)
Annual
Cash Flow
Cost of
Capital
NPV
A
B
C
$100,000
$200,000
$300,000
5
4
7
$35,000
“b”
$50,000
8%
13%
“c”
“a”
$35,000
$15,000
b.
c.
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Show calculator inputs and outputs and indicate output if you want any credit.
6. (9 points) Olsen Engineering is considering including two pieces of equipment, a truck and an
overhead pulley system, in this year’s capital budget. The projects are independent. The cash
outlay for the truck is $22,430, and for the pulley system it is $17,100. Each piece of equipment
has an estimated life of five years. The annual after-tax cash flow expected to be provided by
the truck is $7,500, and for the pulley it is $5,100. The firm’s required rate of return is 14
percent.
a. Compute the projects payback.
b. What are the net present value (NPV) and internal rate of return (IRR) of the projects
and which would you choose if they are independent?
c. Which would you choose if they were mutually exclusive?
7. (8 points) Projected cash flows for two mutually exclusive projects are as follows (again, identify all
calculator inputs and outputs):
Year
0
1
2
3
4
5
6
Project A
($150,000)
80,000
60,000
50,000
Project B
($200,000)
40,000
50,000
50,000
60,000
50,000
53,000
If the firm’s cost of capital is 10% and the equivalent annual annuity method is used to eliminate the
disparity between the projects’ lives, which project should be undertaken? Why?
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The attached sheets are for these two problems.
New Investment
8. (30 points) You have been asked by the president of your company to evaluate the proposed
acquisition of a spectrometer for the firm’s R&D department. The equipment’s base price is $140,000,
and it would cost another $30,000 to modify it for special use by your firm. The spectrometer, which falls
into the MACRS three-year class, would be sold after three years for $60,000 (percentages: 33%, 45%,
15% and 7%). Use of the equipment would require an increase in net working capital (spare parts
inventory) of $10,000. The spectrometer would have no effect on revenues, but it is expected to save the
firm $150,000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax rate is 40
percent and cost of capital is 12 percent. Determine the cash flows, payback, NPV, and IRR on the
attached sheet. Recommend either acceptance or rejection and say why.
Replacement Problem:
9. (40 points) Two years ago our company bought equipment for $2 million that has been
depreciated straight line over a five-year life. The existing equipment has a current market value
of $400,000 (but would be worth only $100,000 if kept 4 more years). More efficient equipment
can be purchased today for $3 million and is expected to last 4 years (economic life), at which
time its anticipated salvage value would be $500,000. The new machine will be depreciated
using 3-year MACRS (percentages: 33%, 45%, 15% and 7%). Our company would realize a
$1,200,000 per year operating cost savings by replacing the old equipment with the new
equipment. Also, our Net Working Capital requirement would decrease by $50,000 as soon as
we bought the equipment, but would increase again when it is sold at the end of its economic life
(4 years). Our marginal tax rate is 40% and the firm’s WACC is 10%. Identify the relevant cash
flows for this project, NPV, IRR, and should the company make this replacement investment
(state why)?
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Question 8
Initial Outlay
Depreciation [initial basis =
]
Operating Cash flow
minus
deprec.
EBT
less taxes
EAT
Dep. addback
OCF
Terminal CF
Calculator inputs/outputs and investment decision
TCF workspace
4
Question 9
Initial Outlay
Depreciation [initial basis =
]
Work space
Operating Cash flow
minus
deprec.
EBT
less taxes
EAT
Dep. addback
OCF
Terminal CF
Calculator inputs/outputs and investment decision
TCF workspace
5