FN1 Module 6 Handout 2
Past Exam Questions
Question 1 (2 marks)
Identify two shortcomings of the payback period (PBP) method.
Solution:
.
Shortcomings of the payback period (PBP) method include:
• There is no standard against which to compare the calculated PBP figure.
• PBP ignores all cash flows beyond the PBP point.
• PBP typically ignores the time value of money (that is, discounting).
Question 2 (5 marks).
(3) i) Explain why firms might restrict their planning horizon to a relatively short period such as 4 years.
(2) ii)
Explain the potential consequences of this planning horizon for capital budgeting decisions.
Solution; i) The primary reason for a firm to restrict its planning horizon to a relatively short period of time is that it is easier for a firm to make near-term forecasts and also, forecasts made over the near term are likely to be relatively more accurate than those made further into the future. ii) By adopting a relatively short forecast horizon, the firm is ignoring all cash flows that occur after the cut-off point. Here, under an assumption that company would realize the same net cash flows for just one more year (year 5), the NPV of the project would be positive and the firm’s decision would be changed.
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FN1 Module 6 Handout 2
Past Exam Questions
Question 3 (6 marks)
(4) i) Briefly describe two complications with the IRR method.
(2) consistent. ii) Identify the best way to determine if the IRR and NPV methods are
Solution: i) Two complications are multiple IRRs and crossing NPV profiles. Multiple IRRs occur when a project’s cash flows have more than one switch in signs (that is, from outflow to inflow or vice-versa). The number of IRRs will equal the number of switches in sign. When there is more than one IRR, none is in fact correct.
Crossing NPV profiles potentially occur when two mutually exclusive projects with different patterns or timing of cash flows are examined. Selecting the best project on the basis of IRR may be misleading if the risk-adjusted discount rate is lower than either project’s IRR. The project with the highest NPV at the discount rate is the appropriate choice, not necessarily the project with the highest IRR. ii) The best way to make sure that the IRR and NPV methods are consistent is to draw the NPV profiles.
See page 513 of your text.
Question 4: (5 marks)
When is the firm’s weighted average cost of capital the appropriate discount rate to use in a capital budgeting analysis? Briefly explain why.
Solution:
The firm’s weighted average cost of capital is the appropriate rate to use when the project under consideration is in the same risk class as the firm. In general terms, the discount rate to be used for a project should reflect the opportunity cost to the firm of considering the project. By undertaking the project, the firm is foregoing the rate of return on an equivalent-risk alternative investment. Thus, once we know the risk of the project, we can estimate what return the firm could earn on an investment of that risk. The project under question must then offer a rate of return at least equal to the foregone rate of return.
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FN1 Module 6 Handout 2
Past Exam Questions
Question 5 :
Gremlin Inc. is planning to modernize its automobile assembly plant. The plan calls for an initial investment of $10 million in robots. The robots are expected to save $5 million per year in operating expenses over their 5-year life. Assuming a tax rate of 40%, an applicable CCA rate of 10%, and zero salvage, in what range is the payback period (PBP) for the robots?
1) Between 1 and 2 years
2) Between 2 and 3 years
3) Between 3 and 4 years
4) Between 4 and 5 years.
Solution
Step 1: Determine relevant cash flows for each year. Relevant cash flows include the after tax savings in operating expenses + CCA tax shield.
Net savings:
Year 1: (1-0.4)*5,000,000 + 0.4*0.10*1/2*10,000,000 = 3,200,000
Year 2: (1-0.4)*5,000,000 + 0.4*0.1*9,500,000 = 3,380,000
Year 3: (1-0.4)*5,000,000 + 0.4*0.1*8,550,000 = 3,342,000
Year 4: (1-0.4)*5,000,000 + 0.4*0.1*7,695,000 = 3,307,800
Re CCA tax shield:
½ year rule in effect the first year
This is a declining balance method – apply the given rate (d=10%) to the undepreciated capital cost balance.
Step 2:
Cash Flows
Initial Investment -10,000,000
Cumulative Cash Flows
Year 1
Year 2
Year 3
Year 4
+ 3,200,000
+ 3,380,000
+ 3,342,000
+ 3,307,800
-10,000,000
- 6,800,000
- 3,420,000
- 78,000
+ 3,229,800
Conclusion: The payback period is between year 3 and year 4
The correct payback period is:
3 years + 78,000/3,229,800 = 3.02 years
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FN1 Module 6 Handout 2
Past Exam Questions
Question 6: 12 marks
Pup Inc. is considering a 3-year project to manufacture guardrails from recycled plastic.
The project requires a $150,000 machine (amortized over 3 years on a straight-line basis), which can be sold for $25,000 at the end of the project. The project will also require an initial additional investment in inventory of $40,000, with the investment in inventory being increased to $50,000 for the second and third years. The project is expected to generate net (before-tax) operating cash flows of $80,000, $90,000, and $100,000 in years 1 through 3, respectively. Pup’s tax rate is 36%, its weighted average cost of capital is 21%, and the applicable CCA rate on the machine is 20%.
Required:
Using the net present value (NPV) method, determine if Pup should invest in the project.
Step 1:
Summarize the relevant given information:
Co = 150,000
Amortized over 3 years – irrelevant – amortization is a non cash expense, with no tax benefits
Sn = 25,000
WCo = 40,000
WC1 = 10,000 (the beginning of 2 nd year = end of year 1)
CF1 = 80,000(1-0.36)
CF2 = 90,000(1-.36)
CF3 = 100,000(1-.36) k = 21%
T = 36% d = 20%
Release of WC = 50,000 n = 3
Calculate PV Incremental after-tax operating cash flows:
= 80,000(1-.36) + 90,000(1-.36) + 100,000(1-.36) = 117,782
(1.21) (1.21) 2 (1.21) 3
Determine PVTS – PVTSL
= CodT 1+0.5k - Sndt 1
(d+k) (1+k) (d+k) (1+k) n
= 150,000*0.2*0.36 + 1.105 - 25,000*0.2*0.36 * 1
(0.21+0.20) (1.21) (0.21+0.20) (1.21) 3
= 24,055 – 2,478 = 21,577
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FN1 Module 6 Handout 2
Past Exam Questions
Step 2: Set up template, and enter information:
Initial Investment:
Machine
Inventory, time 0
$ (150,000)
(40,000)
Additional inventory
10,000/1.21 ( 8,264) $(198,264)
PV Incremental operating benefits
PVTS – PVTSL
ECF
Salvage 25,000/(1.21)3
NPV
Release WC 50,000/(1.21)3
117,782
21,577
14,112
28,224
$( 16,569)
Step 3: State your conclusion
Pup should NOT invest in the project because it has a negative NPV
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