Corporate Finance Session 8 - Reading 28

CFA Level 2 - Corporate Finance Session 8 - Reading 28 (Practice Questions, Sample Questions) 1. Jayco, Inc. is considering the purchase of a new machine for $60,000 that will reduce manufacturing costs by $5,000 annually. -Jayco will use the MACRS accelerated method (5 year asset) to depreciate the machine, and expects to sell the machine at the end of its 6-year operating life for $10,000. (The percentages for the 5-year MACRS class are, beginning with year 1 and ending with year 6, 20%, 32%, 19%, 12%, 11%, and 6%.) -The firm expects to be able to reduce net working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 6 years. -Jayco's marginal tax rate is 40%, and it uses a 12% cost of capital to evaluate projects of this nature. Use this data for the next 4 questions. What is the first year's modified accelerated cost recovery system (MACRS) depreciation? A) $12,000. B) $15,000. C) $10,000. Explanation: The first year MACRS depreciation equals 60,000 × 20%, or 60,000 × 0.2 = 12,000. What is the initial cash outlay? A) $45,000. B) $75,000. C) $15,000. Explanation: Initial cash outlay = up-front costs (including cost) and changes in working capital. Here, the price of the machine is 60,000 and the working capital initally decreases 15,000 (which is a source of funds). Thus, the initial cash outlay = 60,000 cost − 15,000 working capital = 45,000. What is the first year's operating cash flow? A) $4,800. B) $7,800. C) $3,000. Explanation: The first year's cash flow equals the after-tax impact of the 5,000 operating savings and the depreciation tax shield, or (5,000)(0.6) + (60,000)(0.2)(0.4) = 3,000 + 4,800 = 7,800. What is the terminal year's cash flow (not counting the last year's operating cash flow)? A) $21,000. B) ($9,000). C) ($4,000). Explanation: The terminal cash flow = [sales (salvage) price] − (tax rate) × [sales (salvage) price − book value] ± change in working capital. Here, = 10,000 − (0.40) × (10,000 − 0) − 15,000 (increased working capital is a use of funds) = 10,000 – 4,000 − 15,000 = −9,000. 2. Karen Feasey, the Plant Manager of Industrial Coatings, is trying to decide whether to replace the old coatings machine with a new computerized machine. Her executive assistant gathers the following information: Company Assumptions: Tax rate: 40% Weighted average cost of capital (WACC): 13% New Machine Assumptions: Cost of (includes shipping and installation): $150,000 Salvage value at end of year 5: $35,000 Depreciation Schedule: MACRS 7-year, with depreciation rates in years 1-5 of 14%,25%, 17%, 13%, and 9%, respectively Purchase will initially increase current assets by $15,000 and will increase current liabilities by $10,000 Impact on Operating Cash Flows Years 1- 5 (includes depreciation and taxes): $28,000 (assume equal amount each year for simplicity) Old Machine Assumptions: Sell old machine for current market value: $25,000 Book value: $15,000 During the process of making the decision whether or not to replace the old machine, Feasey calculates the initial cash outlay as approximately: A) $134,000. B) $155,000. C) $130,000. Explanation: The initial investment outlay is calculated as follows: cost of new machine + proceeds/loss from old machine + change in net working capital (NWC) = -$150,000 + $25,000 - $4,000 $5,000 = -$134,000 (cash outflow) Details of calculation: Cost of new machine = $150,000 outflow Sale of Old Machine: Sales price = $25,000 inflow Tax/tax credit: $4,000 outflow = (Sales price – book value)*(tax rate) = (25,000 – 15,000)*0.4 Change in NWC = $5,000 outflow Δ NWC = Δ current assets - Δ current liabilities = 15,000 – 10,000 = 5,000 3. Financial leverage would NOT be increased if a firm financed its next project with: A) common stock. B) preferred stock. C) bonds with embedded call options. Explanation: Financial leverage is the result of financing assets with fixed income securities such as bonds or preferred stock. Each of these alternatives has a required payment component that increases the risk of the firm beyond that arising solely from business risk. 4. Norine Benson is studying for the Level I CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is most accurate? A) An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC). B) For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV). C) Replacement decisions involve mutually exclusive projects. Explanation: Because replacement decisions involve either keeping the old asset or replacing the old asset, the projects are mutually exclusive. The decision rule for NPV is to pick the project with the highest positive NPV. Only projects with positive NPV add to the company’s value. If neither project has a positive NPV, neither project should be chosen. Because the WACC is adjusted for inflation, the analyst must adjust project cash flows upward to reflect inflation. If the cash flows are not adjusted for inflation, the NPV will be biased downward. (Reverse the preceding logic for deflation.) 5. An increase in expected inflation will generally: A) leave weighted average cost of capital (WACC) unchanged. B) increase the weighted average cost of capital (WACC). C) decrease the weighted average cost of capital (WACC). Explanation: Required rates of return on investments generally exceed inflation. An increase in expected inflation will generally increase the required return on equity and debt; therefore, the WACC will rise as inflation rises. 6. Spencer Charlson, Executive Vice President for PWK Design, is considering purchasing a new computer system for the firm. Charlson believes that PWK would benefit from purchasing the system now, but also is aware that Macroware, a software developer is coming out with a new operating system that will available in three months. Charlson is unsure whether or not the new operating system would help PWK and decides to wait until the new operating system comes out before making a purchase. The computer system project Charlson is evaluating would be best described as having a(n): A) flexibility option. B) fundamental option. C) timing option. Explanation: Timing options allow a company to delay an investment with the hope of having better information in the future. Delaying an investment and basing the decision on the better information gained by waiting may improve the NPV of the overall project. 7. Takamura Motors is evaluating a new piece of equipment that will automatically install power windows in cars coming off the production line. The equipment cost is $3.5 million, and the firm estimates that the present value of the annual cost savings from installing the equipment is $2.8 million. The production manager is also considering purchasing a module that will allow the equipment to be used for Takamura’s SUV production. The additional module represents a real option with a cost of $1.1 million dollars. The production manager estimates that adding the module would give Takamura cost savings of an additional $2.0 million. What is the profitability of the project before and after considering the real option? Before After A) $1,300,000 $200,000 B) -$700,000 $1,800,000 C) -$700,000 $200,000 Explanation: The profitability of the project before considering the real option is the difference between the cost savings and the cost of the equipment, or 2.8 – 3.5 = -$700,000. The profitability of the project after considering the real option = NPV (based on project alone) – cost of option + value of option. The cost of the option is $1.1 million, while the value of the option is $2.0 million. Profitability after option = -0.7 -1.1 + 2.0 = $200,000. 8. Michael Fullen is discussing the evaluation of capital budgeting projects with his coworker, Katina Katzenmoyer. During conversation, Katzenmoyer makes the following statements regarding the determination of real option values:Statement 1: For independent projects, an analyst must determine a value for the real option that is separate from the project regardless of the profitability of the project. Statement 2: Abandonment options can be valuable, but should only be exercised when the abandonment value is greater than the discounted present value of the remaining cash flows of the project. Are the statements made by Katzenmoyer correct? A) Only one is correct. B) Both are correct. C) Both are incorrect. Explanation: Fullen should disagree with Katzenmoyer’s first statement. The value of a real option is always positive. For an independent project, if the project is already profitable, a manager can accept the project simply knowing that the real option will simply add to the profitability without determining a separate value for the option. Fullen should agree with Katzenmoyer’s second statement. An abandonment option should be exercised when the abandonment value for a project is greater than the discounted present value of the remaining cash flows from the project. 9. Rachel Moore, an analyst with Dawson Corporation, is discussing a potential capital project with her colleague, Phillip Cora. The project involves producing a new product that will be sold in discount retail stores. If sales for the new product are favorable, Dawson has the ability to purchase new equipment for the existing production facility that will expand production to double its current rate. However, Moore is concerned that other companies may easily replicate the product and that low barriers to entry will reduce Dawson’s profitability. If sales for the new product are disappointing after the first two years, Dawson has a potential buyer that will pay $2 million for the production facility. Moore explains these facts to Cora and asks him for help in computing an accurate net present value (NPV) for the project. Cora replies with the following statements:Statement 1: You cannot compute a dollar value for the project that includes both the expansion option and the abandonment option, since only one of them can actually be exercised. Statement 2: Since you do not have any control over what is going on at other companies, you should not factor in the creation of competing products from other companies into your analysis, and focus totally on the incremental cash flows generated from our production of the product. How should Moore respond to Cora’s statements? A) Agree with one only. B) Agree with neither. C) Agree with both Explanation: Moore should disagree with both of Cora’s statements. Even though both the option to double production and the option to sell the production facility cannot be exercised simultaneously, they both add value to the project and should be both be considered in any analysis. Even if it is difficult to compute an exact dollar value for each option’s contribution to the project, Moore can compute the value for the project without the options, and if the project does not already have a positive NPV, she can estimate whether the option values are enough to make the NPV positive. Cora’s second statement is also incorrect. The reaction from competitors has a definite impact on the potential profitability of the project and must be considered in the analysis. 10. Which of the following is least likely to cause a problem when analyzing a capital budgeting project? A) Incorporating actions taken by competitors in the capital budgeting analysis. B) Using the firm’s weighted average cost of capital for the discount rate on all projects. C) Basing investment decisions on the impact on earnings per share. Explanation: One of the common pitfalls when analyzing capital projects is not incorporating economic responses from competitors. Economic responses to an investment often affect profitability. Note that managers who make decisions based on short-term EPS considerations may fail to consider projects that do not boost accounting numbers in the short-run, but are in the best long term interests of the business. The discount rate for a project should be adjusted for the project’s risk. 11. Sharon Kelley and Joyce Wening are discussing potential capital projects for the Flagstaff Corporation. Kelley is concerned about making errors in the capital budgeting decision making process and wants to take necessary steps to avoid such errors. In response to Kelley’s concerns, Wening makes the following statements:Statement 1: We should avoid including factors such as management time and information technology support since these are sunk costs that should not be attributed to the project. Statement 2: Once we have determined a set of profitable project options, we should stop considering other alternatives in order to focus our resources on making sure that we are not omitting relevant cash flows or double counting cash flows for our existing set of projects. A) Both are correct. B) Only one is correct. C) Both are incorrect. Explanation: Wening’s first statement is incorrect. Overhead costs are difficult quantify, but project costs should include any overhead costs that are attributable to a project. Wening’s second statement is also incorrect. Failure to consider investment alternatives is a major capital budgeting pitfall. Generating good investment ideas is the most important step in the capital budgeting process. Managers need to make sure they are not avoiding the consideration of “better” projects simply because the existing project under consideration is “good.” 12. Which of the following is most likely to cause a problem when evaluating a capital budgeting project? A) Including overhead costs in the total cost of a capital project. B) Taking on the pet projects of management without going through the complete capital budgeting process. C) Avoiding the use of IRR when evaluating mutually exclusive projects. Explanation: Pet projects that influential managers want the company to invest in will ideally receive the same scrutiny received by other investments. Another potential concern with management’s pet projects is that overly optimistic projections will make the project appear more profitable than it really is. Note that using IRR for mutually exclusive projects will tend to steer management toward smaller, short term projects with high IRRs and may not lead management to the same decision as the more appropriate NPV method. Overhead costs are often difficult to estimate, but should be included in the cost of a capital project. 13. The most appropriate definition of economic income is: A) cash flow minus economic depreciation. B) accounting income minus economic depreciation. C) cash flow. Explanation: economic income = cash flow − economic depreciation where: economic depreciation = (beginning market value − ending market value) Economic income is not the same as economic profit. 14. Firehouse Company is investing in a €300 million project that is being depreciated on a straight-line basis over a two-year life with no salvage value. The project will generate operating earnings of €130 million each year for the two years. The required rate of return for the project is 10% and Firehouse’s tax rate is 30%. What is Firehouse’s economic income for years 1 and 2? Year 1 Year 2 A) €61 €76 B) €42 €22 C) -€20 -€20 Explanation: Note that this question is asking about economic income, not economic profit. First, determine the after-tax cash flow for Years 1 and 2 as: Cash flow = operating income (1-T) + depreciation = €130 (1 - 0.30) + 150 = €241 Next, determine the current market value of the project as: Market value = (241 / 1.102) + (241 / 1.101) = €418; market value after year 1 = (241 / 1.101) = €219 Constructing a table, we see that the economic income for years 1 and 2 are €42 and €22 respectively. Note also that the economic rate of return is equal to the required return on the project. Year 1 Year 2 Beginning market value €418 €219 Ending market value 219 0 Change in market value -199 -219 After-tax cash flow 241 241 Economic income €42 €22 Economic rate of return 10% 10% 15. Jackson Huang is an analyst for Oswald Technologies. Huang is considering a $150 million capital project that is expected to produce operating earnings before interest and taxes of $80 million per year for all three years of the project’s life. The project is being depreciated on a straight-line basis and at the end of 3 years the project will have zero salvage value. Huang believes the project is an average risk project for the firm and is planning to apply Oswald’s weighted average cost of capital (WACC) of 8% and tax rate of 30% to the project. Huang’s supervisor has asked him to use both the economic income and economic profit approaches to analyze the project. After completing his analysis, Huang makes the following statements to his supervisor. Statement 1: In the first year of the project’s life, the economic income exceeds the economic profit generated from the project. Statement 2: The discount rate applied to the economic profit to calculate the project’s net present value (NPV) will be identical to the economic rate of return earned by the project each year. How should Huang’s supervisor respond to his statements? A) Agree with both. B) Agree with neither. C) Agree with one only. Explanation: To answer the first question, we need to calculate the economic income and economic profit for the first year of the project. Economic income is the after-tax cash flow plus the change in market value for an investment. Cash flow = operating income (1 − T) + depreciation = $80(1 − 0.30) + $50 = $106 million. Next determine the current market value of the project as: (106 / 1.08) + (106 / 1.082) + (106 / 1.083) = $273.17 million. The value after Year 1 = (106 / 1.08) + (106 / 1.082) = $189.03 million. The change in market value = (273.17 − 189.03) = $84.4 million. The economic income is $106 − $84.4 = $21.86 million. Economic profit = NOPAT − $WACC = EBIT(1 − T) − $WACC Economic profit (Year 1) = $80(1 − 0.30) − 0.08($150) = $44 million Huang’s supervisor should disagree with the first statement as the economic profit of $44 million exceeds the economic income of $22 million. Huang’s supervisor should agree with the second statement. The discount rate applied to the economic profit to determine the project’s NPV is the WACC. The economic rate of return using the economic income approach will be equal to the WACC, so the rates are identical. We can take the first year’s economic income divided by the market value of the project and see that the economic rate of return is the same as the WACC. ($22 / $273) = 0.08, or 8%. 16. James Case and Erica Gallardo are considering differences between accounting income and economic income when evaluating capital projects. Case makes the following statements to Gallardo: Statement 1: One of the main reasons why accounting income and economic income will differ is that interest expense is subtracted when calculating accounting income, but is not considered when computing economic income. Statement 2: Another reason why accounting income and economic income may differ is that accounting depreciation is based on original costs while economic depreciation is based on market values. Gallardo considers both of Case’s statements. Gallardo would find which statements CORRECT? A) Neither are correct. B) Only one is correct. C) Both are correct. Explanation: Case has accurately described the two major differences between accounting income and economic income. Accounting depreciation is based on the original cost of an investment, while economic depreciation is based on the market value of the asset. Also, the interest expense that is subtracted from accounting income is not considered when computing economic income because interest expenses are implicit in the required rate of return used to calculate the asset’s market value. 17. Paul Ulring, Chief Executive Officer of Arlington Machinery, has asked Sara Trafer about the benefits of using a variety of valuation models for evaluating capital projects. In response to Ulring’s questions, Trafer makes the following statements:Statement 1: The economic profit, residual income, and claims valuation methods of valuation should all result in the same valuation for an asset or project, despite the use of different discounts rates in the calculations. Statement 2: The claims valuation and economic profit valuation models both include cash flows that will flow to debt holders, and the cost of debt is a factor in both calculations. Which is CORRECT regarding Trafer's statements? A) Both are incorrect. B) Both are correct. C) Only one is correct. Explanation: Trafer’s first statement is correct. In theory, all three of the different valuation approaches should lead to the same result, despite the economic profit method using the WACC, the residual income method using the cost of equity, and the claims valuation approach separately using the cost of debt and cost of equity as discount rates. Trafer’s second statement is also correct. The claims valuation approach looks at cash flows to equity holders and debt holders separately, while the economic profit method looks at cash flows from the perspective of all suppliers of capital, so debt holders’ concerns are included in both methods. Also, the discount rate used with the economic profit method is the WACC, while the claims valuation approach considers the cost of equity and the cost of debt separately, so the cost of debt is a factor in both calculations. 18. Firehouse Company is investing in a €300 million project that is being depreciated on a straight-line basis to zero over a two-year life with no salvage value. The project will generate operating earnings of €130 million each year for the two years. The Firehouse’s weighted average cost of capital and required rate of return for the project is 10%. Firehouse’s tax rate is 30%. What is Firehouse’s economic profit for years 1 and 2? Year 1 Year 2 A) €61 €76 B) -€20 -€20 C) €42 €22 Explanation: Note that this question is asking about economic profit, not economic income. Economic profit is calculated as NOPAT - $WACC = EBIT(1-T) $WACC NOPAT = EBIT (1-Tax Rate) = €130 (1 - 0.3) = €91 $WACC Year 1 = 0.10 × €300 = €30 $WACC Year 2 = 0.10 × €150 = €15 Economic profit (Year 1) = €91 - €30 = €61 Economic profit (Year 2) = €91 - €15 = €76