AGEC 424 Exam 3 Fall 2014 (100 points)
Name___________________________
To receive credit you must show all work including calculator inputs and outputs and distinguish the
output.
1.
a.
b.
c.
d.
(2 points) The cost of capital is the appropriate discount rate in capital budgeting when:
all the projects are equally risky.
all the projects have the same risk as the current firm.
the projects can be ranked from riskiest to least risky.
all the projects have less risk than the risk of the current firm.
2. (2 points) The technique for incorporating risk into capital budgeting that involves the use of numbers drawn
randomly from probability distributions is called a:
a. probability simulation.
b. scenario analysis.
c. sensitivity analysis.
d. Monte Carlo simulation.
3.
(5 points) Sanville Quarries is considering acquiring a new drilling machine which is expected to be more efficient
than their current machine. The project is to be evaluated over four years. The initial outlay required to get the new
machine operating is $675,000. Incremental cash flows associated with the machine are uncertain, so management
developed the following probabilistic forecast of cash flows by year ($000). Sanville’s cost of capital is 10%.
Year1 Prob
$150
.30
$175
.40
$300
.30
Year2
$200
$210
$250
Prob
.35
.45
.20
Year3
$350
$370
$400
Prob
.30
.25
.45
Year4
$300
$360
$375
Prob
.25
.35
.40
a. What is the NPV of the expected (mean) cash flows? Show Work.
b. Calculate the project’s best and worst NPVs. Show Work.
4. (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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5. Projected cash flows for two projects are as follows (again, show work, clearly identify all calculator inputs and
outputs):
Year
0
1
2
3
4
5
Project A
($150,000)
80,000
60,000
50,000
Project B
a. (4 points) Compute the payback of each investment
($200,000)
50,000
50,000
50,000
60,000
60,000
b. (7 points) If the firm’s cost of capital is 10% compute the NPV and IRR. If the projects are independent, which would
be chosen?
c. (4 points) If the projects are mutually exclusive and the equivalent annual annuity method is used to eliminate the
disparity between the projects’ lives, which project should be undertaken? Why?
Questions 6 and 7 are on the back page and that page may be removed from the exam.
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Question 6
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
3
Question 7
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
4
The previous sheets are for these two problems. You may detach this page.
New Investment
6. (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 $70,000, 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 $40,000 (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 $100,000 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:
7. (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 $500,000 (but would be worth only $200,000 if
kept 3 more years). More efficient equipment can be purchased today for $3 million and is expected to last 3 years
(economic life), at which time its anticipated salvage value would be $300,000. The new machine will be depreciated
using 3-year MACRS (percentages: 33%, 45%, 15% and 7%). Our company would realize a $2,000,000 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 (3 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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