Name_________________________________________
AREC 450
Spring 2003
Quiz #5
(60 Points)
Show all your work in order to receive full credit. Manage your time wisely. All
problems/questions are worth 6 points.
1. The cost of capital is a valuable number to decision makers as they prepare their
investment opportunity schedule (IOS) and determine their optimal capital
budget. Combine a firm’s weighted average cost of capital (define WACC with
an equation) with an IOS to graphically illustrate the optimal capital budget for
the firm. Why is the level of investment optimal?
2. Assume you want to buy a home located along a new golf course near Benson,
Arizona. The home plus the one-acre lot are valued together for $300,000. Suppose you
have $50,000 as a downpayment and you have negotiated with the developer to make you
payments annually. If the negotiated interest rate is 6% and the mortgage is for 30 years,
what is the annual payment?
3. Two employees of Data Systems International are arguing about the correct
purchase decision for two data servers for Data Systems’ network. They have the
following information:
Original Cost (Year 0)
Project Life
Expected annual maintenance costs
System A
$12,000
3 years
$3,000
System B
$15,000
4 years
$2,500
If both employees’ opportunity cost of capital is 15%, which system is the least
cost alternative? Use the equivalent annual annuity method to solve this problem.
4. Briefly discuss the fundamental differences between IRR and MIRR. Use the
appropriate equations to support your answer.
5. Allied Foods is considering two investment projects in one of their food
manufacturing plants. The plant manager has asked you to analyze this decision
using capital budgeting tools. Both projects have different initial costs and expect
benefits (actually cost savings) for the plant. The cost of capital for both projects
is 8%. The expected stream of costs and benefits for the two projects are:
Year
0
1
2
3
4
Project A
($135,000)
50,000
50,000
50,000
50,000
Project B
($165,000)
60,000
60,000
60,000
60,000
Calculate each projects payback period and net present value. Which project
should be accepted?
6. Haley’s Graphic Designs Inc. is considering two alternative, mutually exclusive
projects. Both projects require an initial investment of $10,000 and are typical,
average-risk projects for the firm. Project Y has an expected life of 2 years with
after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2,
respectively. Project Z has an expected life of 4 years with after-tax cash inflows
of $4,000 at the end of each of the next four years. The firm’s cost of capital is 10
percent. If the projects can be repeated and there are no anticipated changes in the
cash flows, which project will be selected, and what is its net present value?
7. You are faced with a difficult decision. Your current car is averaging approximately
$1,200 per year in maintenance costs. You think you could sell the car today for $500. If
you keep the car for three more years you realize that it will have a zero resale value.
Your cousin has offered to sell you his old car for $3,000 today (remember, you can sell
your car for $500). Your cousin estimates that your repair bills will average $200 per
year for three years and this “new” car will have a resale value of $750. If your discount
rate is 10% what should you do: keep your current car or buy your cousin’s car?
8. Sensitivity analysis and scenario analysis are two tools used to incorporate risk
into capital budgeting decisions. Please construct two generic tables that contrast
each of these tools.
a. Sensitivity Analysis Table
b. Scenario Analysis Table
9. Suppose you are a financial analyst for the U.S. Agency for International
Development, the primary U.S. agency responsible for rebuilding Iraq. You have
been asked to calculate the benefit/cost ratio of the following small education
project assuming the social cost of capital is 5%. Should this education project be
funded?
Year
0
1
2
3
Benefits
$ 0
30,000
60,000
90,000
Costs
$100,000
10,000
10,000
10,000
How would your answer change if the social cost of capital was 15% (do not
recalculate your answer)? Why?
10. Briefly discuss under what conditions NPV and IRR can produce conflicting
results when comparing two investment projects.