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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?
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?
A. Since the most likely return for both projects is the same and the initial
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
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
___%.
```