Section 6 Applying Investment Analysis to Strategy-Driven Investments

Section 6 Applying Investment Analysis to Strategy-Driven Investments 1) One limitation of the net present value approach to investments is that investments with identical net present values may have very different cash flows. Answer: TRUE Diff: 2 Key Term: Net present value Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 2) The net present value of $10,000 to be received in exactly three years is considerably greater than $10,000. Answer: FALSE Diff: 1 Key Term: Net present value Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 3) Net present value: A) is gross domestic product less depreciation. B) is sales volume less sales and excise taxes. C) is profit after taxes. D) ignores the time value of money. E) is the discounted value of a series of future cash receipts. Answer: E Diff: 2 Key Term: Net present value Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 4) Net present value will be greater: A) as a fixed set of cash receipts occurs later rather than earlier. B) if the future value of a cash flow is smaller. C) for one end-of-year receipt of $1200 than for twelve monthly receipts of $100 each. D) for a 4% discount rate than for a 6% discount rate. E) All of the above are true. Answer: D Diff: 2 Key Term: Net present value AACSB: Analytic skills Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes S7-26 5) A capacity alternative has an initial cost of $50,000 and cash flow of $20,000 for each of the next four years. If the cost of capital is 5 percent, the net present value of this investment is: A) greater than $80,000 but less than $130,000. B) greater than $130,000. C) less than $30,000. D) impossible to calculate, because no interest rate is given. E) impossible to calculate, because variable costs are not known. Answer: C Diff: 2 Key Term: Net present value AACSB: Analytic skills Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 6) A capacity alternative has an initial cost of $50,000 and cash flow of $20,000 for each of the next four years. If the cost of capital is 5 percent, what is the approximate net present value of this investment? A) $20,920 B) $26,160 C) $49,840 D) $70,920 E) $106,990 Answer: A Diff: 3 Key Term: Net present value AACSB: Analytic skills Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 7) ________ is a means of determining the discounted value of a series of future cash receipts. Answer: Net present value or NPV Diff: 2 Key Term: Net present value Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes S7-27 8) What are the four limitations of the net present value technique? Answer: (1) Investments with the same net present value may have significantly different projected lives and different salvage values. (2) Investments with the same net present value may have different cash flows. Different cash flows may make substantial differences in the company's ability to pay its bills. (3) The assumption is that we know future interest rates, which we do not. (4) Payments are always made at the end of the period (week, month, or year), which is not always the case. Diff: 3 Key Term: Net present value Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 9) Health Care Systems of the South is about to buy an expensive piece of diagnostic equipment. The company estimates that it will generate uniform revenues of $500,000 for each of the next eight years. What is the present value of this stream of earnings, at an interest rate of 6%? What is the net present value if the machine lasts only six years, not eight? If the equipment cost $2,750,000, should the company purchase it? Answer: = × = 500,000 × 6.210 = $3,105,000; = × = 500,000 × 4.917 = $2,458,500 The company should purchase the equipment if it believes it will last eight years, but not if it fears that it will last only six. Diff: 2 Key Term: Net present value AACSB: Analytic skills Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes 10) A new machine tool is expected to generate receipts as follows: $5,000 in year one; $3,000 in year two, nothing in the next year, and $2,000 in the fourth year. At an interest rate of 6%, what is the net present value of these receipts? Is this a better net present value than $2,500 each year over four years? Explain. Answer: 5,000 × .943 + 3,000 × .890 + 2,000 × .792 = $8,969 using Table S7.1 ($8,971.16 using Excel). The steady stream generates an NPV of 2,500 × 3.465 = $8,662.5 ($8,662.76 using Excel). The irregular stream has a higher net present value because the larger receipts come early. Diff: 2 Key Term: Net present value AACSB: Analytic skills Objective: LO6 Learning Outcome: Explain options for managing bottlenecks and managing capacity in service and manufacturing processes S7-28 '11) Advantage Milling Devices is preparing to buy a new machine for precision milling of special metal alloys. This device can earn $300 per hour, and can run 3,000 hours per year. The machine is expected to be this productive for four years. If the interest rate is 6%, what is the net present value of the annual cash flows? What is the net present value if the interest rate is not 6%, but 9%? Why does present value fall when interest rates rise? Answer: = × = 300 × 3,000 × 3.465 = $3,118,500; = × = 300 × 3,000 × 3.240 = $2,916,000 NPV falls because higher interest rates create a greater discount on future receipts. Diff: 2 Key Term: Applying investment analysis to strategy-driven investments AACSB: Analytic skills S7-29