Exam 1 Practice Problems

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Rider University *

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Finance

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Apr 3, 2024

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Financial Strategy - Exam 1 Practice Problems Embedded Solutions to all of the problems. 1. List and explain the benefits and shortcomings of the NPV criterion in making capital budgeting decisions. 2. List and explain the benefits and shortcomings of the IRR criterion in making capital budgeting decisions. 3. List and explain the benefits and shortcomings of the payback criterion in making capital budgeting decisions. 4. List and describe the types of cash flows should be included when evaluating a new project. 5. List and describe the types of cash flows that should NOT be included when evaluating a new project. 6. In your own words, explain free cash flow. 7. Your company is considering two mutually exclusive projects. The projects have the following cash flows: 7 Year 10% 0 1 2 3 If the cost of capital for both projects is 10%, then what is the IRR for the project that has the highest NPV? 8. Assume that the appropriate cost of capital (risk-adjusted discount rate) for Project A is 10 percent. What is the NPV, MIRR, IRR, and Payback for Project A? Based on this information do you believe that Project A is good investment? 7 10% 9. You have two different investment options to choose from. Here are the net cash flows (in thousands of dollars) for each investment including all depreciation, salvage values, net working capital requirements, and tax effects:

10% 0 -500 1 180 239.58 -320 2 170 205.7 -150 3 160 176 0.9375 If the WACC for both investments is 5% and the options are mutually exclusive, which one would you choose? Why? Provide numbers to justify your explanation. 10. Your company is considering an expansion into a new product area. The company has collected the following information about the proposed product.  The project has an anticipated economic life of 5 years.  The company will have to purchase a new machine to produce the product. The machine has an up-front cost (T = 0) of $750,000. The machine will be fully depreciated using straight-line depreciation over 5 years to $0. After five years, it’s before-tax salvage value will equal $100,000.  If the company goes ahead with the project, it will have an effect on the company's net working capital. At the outset, T = 0, inventory will increase by $50,000 and accounts payable will increase by $30,000. At T = 5, the net working capital will be recovered after the project is completed.  The project is expected to produce EBIT of $200,000 the first year (T = 1), $300,000 the second and third years (T = 2 and 3), $200,000 the fourth year (T = 4), and $150,000 the final year (T = 5). These values already include operating costs that are expected to equal 50 percent of sales revenue and depreciation expense.  Because of synergies, the new project is expected to increase the after-tax cash flows of the company's existing products by $25,000 a year (T = 1, 2, 3, 4, and 5) and this is considered to be incremental to this particular project.  The company's overall WACC is 12 percent. However, the proposed project is less risky than the average project, leading the firm to use a WACC of 10 percent for this project.  The company's tax rate is 21 percent. What free cash flows does this project generate? What are the NPV and the IRR for this project? 11. Your company is considering an expansion into a new product area. The company has collected the following information about the proposed product. (Note: You may or may not need to use all of this information, use only the information that is relevant.)  The project has an anticipated economic life of 4 years.  The company will have to purchase a new machine to produce the product. The machine has an up-front cost (T = 0) of $500,000. The machine will be depreciated on a straight-line basis over 4 years (that is, the company's depreciation expense will be $125,000 in each of the first four years (T = 1, 2, 3, and 4). The company anticipates that the machine will last for at least four years, and that after four years its before-tax salvage value will equal $50,000.  Last year, the company invested $100,000 to ensure that the new machine would work seamlessly with the existing equipment.

 If the company goes ahead with the project, it will have an effect on the company's net working capital. At the outset, T = 0, inventory will increase by $40,000 and accounts payable will increase by $20,000. At T = 4, the net working capital will be recovered after the project is completed.  The project is expected to generate revenue from sales of $400,000 the first year (T = 1). After that, sales are expected to grow at a rate of 8% per year.  Operating costs that are expected to equal 30% of sales revenue each year.  The company's interest expense each year will be $40,000.  Because of externalities, the new project is expected to decrease the after-tax cash flows of the company's existing products by $20,000 a year (T = 1, 2, 3, and 4) and this is considered to be incremental to this particular project.  The company's overall WACC is 8 percent. However, the proposed project is more risky than the average project, leading the firm to use a WACC of 10 percent for this project.  The company's tax rate is 20 percent. What information is not necessary when determining free cash flows? Why? What free cash flows does this project generate? Determine the NPV and IRR for this project. Do you recommend for the company goes ahead with the expansion project? 12. Assume that your company is considering a new project and has collected the following information about the project. (Note: You may or may not need to use all of this information, use only the information that is relevant.)  The project has an anticipated economic life of 6 years.  The company will have to purchase a new machine. The machine will have an up-front cost of $1.8 million at Year 0. The machine will be depreciated on a straight-line basis over 6 years. The company anticipates that the machine will last for six years, and that after six years, its salvage value will equal zero.  If the company goes ahead with the proposed product, it will have to invest $1 million in NWC in Year 0.  At Year 6, the net operating working capital will be recovered after the project is completed.  You believe you will be able to sell 1 million units of your product at $7 per unit. It costs $2 per to produce each unit. And the project has fixed yearly expenses of $4 million.  The company’s interest expense each year will be $100,000.  The new project is expected to reduce the after-tax cash flows of the company’s existing products by $100,000 a year but only in Years 1-3.  The company’s overall WACC is 10 percent. However, the proposed project is riskier than the average project and the project’s WACC is estimated to be 12 percent.  The company’s tax rate is 20 percent. What information is not necessary when determining free cash flows? Why?

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What free cash flows does this project generate? Determine the NPV and IRR for this project. Conduct sensitivity analysis for a pessimistic view in which you decrease units sold or sales price by 5% or 10% or you increase variable costs or fixed costs by 5% or 10%.