Choosing mandatory projects on the basis of least cost

Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 7.5%.

HCC	-$610,000	-$45,000	-$45,000	-$45,000	-$45,000	-$45,000
LCC	-$110,000	-$170,000	-$170,000	-$170,000	-$170,000	-$170,000

Which unit would you recommend?

Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since HCC's PV of costs is lower than LCC's, HCC would be chosen.

Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since LCC's PV of costs is lower than HCC's, LCC would be chosen.

Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.

Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.

Since all of the cash flows are negative, the IRR's will be negative and we do not accept any project that has a negative IRR.

If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?

The IRR of each project is negative and therefore not useful for decision-making.

The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.

The IRR cannot be calculated because the cash flows are in the form of an annuity.

The IRR of each project will be positive at a lower WACC.

There are multiple IRR's for each project.

If the WACC rose to 15% would this affect your recommendation?

When the WACC increases to 15%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.

Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.

When the WACC increases to 15%, the PV of costs are now lower for LCC than HCC.

When the WACC increases to 15%, the PV of costs are now lower for HCC than LCC.

When the WACC increases to 15%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.

Explain your answer and why this result occurred.

The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.

The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.

The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.

The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.

The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.

Choosing mandatory projects on the basis of least cost

Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 7%.

HCC	-$590,000	-$55,000	-$55,000	-$55,000	-$55,000	-$55,000
LCC	-$110,000	-$175,000	-$175,000	-$175,000	-$175,000	-$175,000

Which unit would you recommend?

Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since LCC's PV of costs is lower than HCC's, LCC would be chosen.

Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since HCC's PV of costs is lower than LCC's, HCC would be chosen.

Since all of the cash flows are negative, the IRR's will be negative and we do not accept any project that has a negative IRR.

Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.

Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.

-Select-IIIIIIIVVItem 1
If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?

The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.

The IRR cannot be calculated because the cash flows are in the form of an annuity.

The IRR of each project will be positive at a lower WACC.

There are multiple IRR's for each project.

The IRR of each project is negative and therefore not useful for decision-making.

-Select-IIIIIIIVVItem 2
If the WACC rose to 14% would this affect your recommendation?

When the WACC increases to 14%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.

When the WACC increases to 14%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.

Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.

When the WACC increases to 14%, the PV of costs are now lower for LCC than HCC.

When the WACC increases to 14%, the PV of costs are now lower for HCC than LCC.

-Select-IIIIIIIVVItem 3

Explain your answer and why this result occurred.

The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.

The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.

The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.

The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.

The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.

-Select-IIIIIIIVV

1. Which of the following is true?

The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.

Question 2.2. Which of the following is false?

For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.

Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false? (Points : 3.5)

The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.

Question 4.4. Which of the following is true? (

As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.

Question 5.5. Which of the following is false?

If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.

Question 6.6. Which of the following is not true? (Points : 3.5)

According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a companyâs expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.

Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call?

6.87%.
7.37%.
11.05%.
8.32%.

Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)

It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.

Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta?

1.56.
1.82.
2.00.
1.94

Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is

fairly priced.
undervalued.
overvalued.

Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000.

14.58%.
13.92%.
16.34%.
12.17%.

Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV? (Points : 3.5)

$259.57.
$221.86.
$195.23.
$257.35.

Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR?

12.58%.
10.82%.
11.76%.
9.64%.

Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)

5.40 years.
10 years.
4.58 years.
6.12 years.

Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR?

13.97%.
12.04%.
14.93%.
9.15%.

Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?

1.47 years.
1.24 years.
1.62 years.
1.15 years.

1. Which of the following is true?

The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.

Question 2.2. Which of the following is false?

For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.

Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false?

The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.

Question 4.4. Which of the following is true? (Points : 3.5)

As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.

Question 5.5. Which of the following is false? (Points : 3.5)

If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.

Question 6.6. Which of the following is not true? (Points : 3.5)

According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a companyâs expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.

Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call? (Points : 3.5)

6.87%.
7.37%.
11.05%.
8.32%.

Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)

It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.

Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta? (Points : 3.5)

1.56.
1.82.
2.00.
1.94

Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is (

fairly priced.
undervalued.
overvalued.

Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000. (Points : 3.5)

14.58%.
13.92%.
16.34%.
12.17%.

Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV?

$259.57.
$221.86.
$195.23.
$257.35.

Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR? (

12.58%.
10.82%.
11.76%.
9.64%.

Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)

5.40 years.
10 years.
4.58 years.
6.12 years.

Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR? (

13.97%.
12.04%.
14.93%.
9.15%.

Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?

1.47 years.
1.24 years.
1.62 years.
1.15 years.

FIN 3104 Lecture Notes - Lecture 19: Nancy Pelosi, Henry Paulson, Barney Frank

Document Summary

Get access

Related Documents

FIN 3104 Lecture Notes - Lecture 13: Net Present Value, Cash Flow, Weighted Arithmetic Mean

FIN 3104 Study Guide - Final Guide: Investment, Real Options Valuation, Net Present Value

FIN 3104 Chapter Notes - Chapter 11-12: Sunk Costs, Working Capital, Real Options Valuation

Related Questions