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Principles of Managerial Finance by Lawrence Gitman 13th Edi. Chapter 8 1. Solar designs is considering an investment in an expanded product line. Two possible types of expansions are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table. Expansion A $ 14,000 A. B. C. D. Expansion B $ 14,000 Initial investment Annual Rate of Return Pessimistic 16% 12% Most likelu 21% 21% Optimistic 29% 27% Determine the range of the rates of return for each of the two projects. Which project is less risky? Why? If you are making the investment decision, which one would you choose? Why? What does this imply about your feelings towards risk? Assume that expansion B’s most likely outcome is 22% per year and that all other facts remain the same. Does this change your answer to part C? Why? a. What is the range of rate of return for expansion A? (Round the nearest whole number) What is the range of rate of return for expansion B? b. Which project is less risky? ____ is less risky because it has___range for the rate of return. c. If you are making the investment decision, which one would you choose? What does this imply about your feelings towards risk? A. Since the most likely return for both projects is the same and the initial investment are equal, the answer depends on your risk preference. B. Choose expansion A because it is less risky and thus a better investment. C. Choose expansion A because it has a higher optimistic rate of return regardless of its risk. D. Since the most likely return for both projects is the same, you can choose either project regardless of your preference. d. Assume that expansion B’s most likely outcome is 22% per year and that All other facts remain the same. Does this change your answer to part c? ___Yes ___No ___Not enough information to answer 2. Metal Manufacturing has isolated four alternatives for meeting its need for increased production capacity. The following table summarizes data gathered relative to each of these alternatives. Alternative Expected return Standard Deviation of Return A 20% 8.1 B 23% 8.7 C 16% 6.5 D 13% 5.1 a) Calculate the coefficient of variations for each alternative b) If the firm wishes to minimize risk, which alternative do you recommend? Why? a) What is the coefficient of variation for alternative A? (round to three decimal) What is the coefficient of variation for alternative B? (round to three decimal) What is the coefficient of variation for alternative C? (round to three decimal) What is the coefficient of variation for alternative D? (round to three decimal) b) If the firm wishes to minimize risk, which alternative do you recommend? Why? To minimize the risk, the firm needs to choose the alternative____ because it has (lowest coefficient of variation/highest coefficient of variation/low standard of deviation/highest standard of deviation). 3. Use the basic equation for the capital asset pricing model (CAPM) to work each of the following problems: (Round to two decimals) a. Find the required return for an asset with a beta of 0.90 when the risk-free rate and market return are 8% and 12%, respectively. b. Find the risk-free rate for a firm with a required return of 15% and a beta of 1.25 when the market return is 14%. c. Find the market return for an asset with a required return of 16% and a beta of 1.10 when the risk-free rate is 9%. d. Find the beta for an asset with a required return of 15% when the risk-free rate and market return are 10% and 12.5%, respectively. 4. Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of return for two similar-risk investments, X and Y. Douglas’s research indicates that the immediate past return will serve a reasonable estimates of future returns. A year earlier, investment X had a market value of $ 12,000; investment Y had a market value of $ 68,000. During the year, investment X generated cash flow of $ 900 and Y $ 7,830. The current market value of investments X and Y are $ 12,719 and $ 68,000, respectively. a. What is the expected rate of return on investment X. (Round to two decimal places) b. What is the expected rate of return on investment Y. c. Assuming that the two investments are equally risky, which one should Douglas recommend? Why? a. Douglas should recommend investment X because it has a higher rate of return and lower risk. b. Douglas should recommend investment Y because it has a lower rate of return and equal risk. c. Douglas should recommend investment X because it has a higher rate of return and equal risk. d. Douglas should recommend investment Y because it has a higher rate of return and equal risk. Chap 11 1. Given the following list of outlays, indicate whether each is normally considered a capital expenditure or an operating expenditure. a. An initial lease payment of $ 4900 for electronic point-of-sale cash register systems. b. An outlay of $ 19800 to purchase patent rights from an inventor. c. An outlay of $ 76300 for a major research and development program. d. An $ 78700 investment in a portfolio of marketable securities program. e. A $ 300 outlay for an office machine. f. An outlay of $ 1700 fr a new machine tool. g. An outlay of $ 241000 for a new building. h. An outlay of $ 1800 for a marketing research report. 2. Covol Industries is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a new, technologically advanced one. Given the following costs related to the proposed project, explain whether each would be treated as a sunk cost or an opportunity cost in developing the relevant cash flows associated with the proposed replacement decision. a. Covol would be able to use the same tooling, which had a book value of $ 33000, on the new machine tool as it had used on the old one. b. Covol would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the firm’s computer has excess capacity available, the capacity could be leased to another firm for an annual fee of $ 16,000. c. Covol would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Covol 3 years earlier at a cost of $ 120,000. Because of its unique configuration and location, it is currently of no use to either Covol or any other firm. d. Covol would retain an existing overhead crane, which it had planned to sell for its $ 153,000 market value. Although the crane was not needed with the old machine tool, it would be used to position raw materials on the new machine tool. a. Opportunity cost ____ Sunk cost ____ b. Sunk cost ____ Opportunity cost ____ c. Sunk cost Opportunity cost ____ ____ d. Sun cost Opportunity cost ____ ____ e. Opportunity cost Sunk cost ____ ____ 3. Troy Industries purchased a new machine 3 years ago for $ 76,000. It is being depreciated under MACRS with a 5-year recovery period using the percentages given in the table. Assume a 40% tax rate. Recovery yr 1 2 3 4 5 6 7 8 9 10 11 Totals 3 yrs 33% 45% 15% 7% 5yrs 20% 32 19 12 12 5 7 yrs 14% 25 18 12 9 9 9 4 100% 100% 100% 10 yrs 10% 18 14 12 9 8 7 6 6 6 4 100% a. What is the book value of the machine? b. Calculate the firm’s liability if it sold the machine for each of the following amounts: $ 91,200; $ 53,200; $ 36,480; and $ 25,500. Sale Price $91200 captital gain ____ tax on capital gain _____ depreciation recovery _____ Tax on recovery _____ Total tax _____ $ 53200 ____ _____ ____ ____ ____ $36480 ____ _____ ____ ____ ____ $25500 ____ _____ ____ ____ ____ 4. Miller Corporation is considering replacing a machine. The replacement will reduce operating expenses (that is, increase earnings before depreciation, interest, and taxes) by $ 15,000 per year for each of the 5 years the new machines is expected to last. Although the old machine has zero book value, it can be used for 5 more years. The depreciable value of the new machine is $ 46,000. The firm will depreciate the machine under MACRS using a 5-year recovering period and is subject to a 40% tax rate. Estimate the incremental operating cash inflows generated by the replacement. (Note: Be sure to consider the depreciation in year 6) Recovery yr 1 2 3 4 5 6 7 8 9 10 11 Totals 3 yrs 33% 45% 15% 7% 5yrs 20% 32 19 12 12 5 7 yrs 14% 25 18 12 9 9 9 4 100% 100% 100% 10 yrs 10% 18 14 12 9 8 7 6 6 6 4 100% Year____________________________________________1______ Incremental expenses savings $ 15,000 Incremental profits before depreciation and taxes ______ Less: Depreciation ______ Net profit before taxes ______ Taxes ______ Net profits after taxes ______ Operating cash flows ______ Calculate year 2, 3, 4, 5, 6 Chap 10 1. Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs 1.11 million and requires installation costs of $ 140,000. The existing machine can be sold currently for $ 191,000 before taxes. It is a 2 year old, cost $ 803,000 new and has $ 385,440 book value and a remaining useful life of 5 years. It was being depreciated under MACRS using a 5-year recovery period and therefore has the final 4 years of depreciation remaining. If it is held for 5 more years, the machine’s market value at the end of year 5 will be $ 0. Over its 5 year life, the new machine should reduce operating costs by $ 341,000 per year. The new machine will be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $ 190,000 net of removal and cleanup costs at the end of 5 years. An increased investment in net working capital of $ 23,000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate operating income against which to deduct any loss experienced on the sale of the existing machine. The firm has a 8.6% cost of capital and is subject to a 40% tax rate. Develop the relevant cash flows needed to analyze the proposed replacement. Calculate the initial investment. Cost of the new machine $______ Installation cost $______ Installed cost of new asset $______ Proceeds from sale of existing machine $______ Tax on sales of existing machine $______ Total after tax proceeds from sale $______ Increase in net working capital $______ Initial investment $______ Calculate the operating cash flows from existing machine. Cash flows existing machine Year 1 Depreciation $_____ Net profit before taxes $_____ Taxes $_____ Net profit after taxes $_____ Operating cash inflows $_____ Calculate years 2, 3, 4, 5, 6 Cash inflows new machine Year Reduction in operating costs 1 $____ Depreciation $____ Net profit before taxes $____ Taxes $____ Net profits after taxes $____ Operating cash inflows $____ Incremental cash flow $____ Calculate years 2, 3, 4, 5, 6 Calculate terminal cash flow. Proceeds from sale of new asset $____ Tax on sales of new asset $____ Total proceeds – sale of new asst $____ Change in new working capital $____ Terminal cash flow $____ Determine the new present value (NPV) of the proposal. The net present value is $_____ The internal rate of return is ____% Since the NPV (< or >) 0 and the IRR (< or >) cost of capital, the new machine (should not/should) be purchased. The highest cost of capital that the firm could have and still accept the proposal is ___%.