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1、 Copyright 2014 Pearson Education,Inc.CHAPTER 12 CAPITAL BUDGETING AND RISK QUESTIONS 1.The objective of capital budgeting is to assess the worth of projects which usually entail large expenditures of cash at the beginning of the undertaking with inflows of cash following over an extended period,usu
2、ally several years.2.The term“time value of money”simply says that a dollar today is worth more than a dollar tomorrow,since the dollar you receive today can earn a return(interest)over time,and therefore increase in value.3.The net present value is calculated by summing the present value of all cas
3、h inflows and subtracting the present value of all the cash outflows.If the result is positive(i.e.the PV of inflows is larger than the present value of outflows),the project should be accepted on financial grounds.If the result is negative,the project should be rejected.If net present value equals
4、0,then this proposal is just earning the cost of capital,and we could be indifferent as to whether or not to accept it.However,since the proposal is just earning what is required by those who supply the funds,it could be accepted;it is a borderline decision.The internal rate of return is that intere
5、st rate which equates the present value of cash inflows and outflows.If the IRR exceeds the relevant cost of capital,the project should be accepted;if the IRR is less than the cost capital,it should be rejected.If IRR equals the cost of capital,then the project is earning its required rate of return
6、 and is acceptable even though the decision here is a borderline situation.4.The two calculations can lead to conflicting results in the case where,for instances,two mutually exclusive projects are evaluated.While both projects could be acceptable under the NPV and IRR criteria(that is,NPV0 and IRRk
7、),only one of the two projects can be accepted.In such a case the two techniques are capable of giving opposite resultsone project has the higher IRR,while the other has the higher NPV.Such conflicting results can occur when the sizes of the two projects differ or the shapes of the cash inflow strea
8、ms differ.The major reason for the existence of this discrepancy is that the two techniques assume different interest rates on cash inflows being returned to the project.The IRR method assumes that all cash inflows are reinvested at the IRR of the project,while the NPV method assumes reinvestment at
9、 the cost of capital.Financial economists consider the NPV method to be the better one,because the reinvestment assumption for NPV appears to be the more logical one,and also because the NPV method is more consistent with the corporate objective of value maximization.5.a.Initial cash outflows:this i
10、s the original investment in the project,such as the purchase of the machine,the cost of erecting a new factory,and so on.b.Operating cash flows:these are the periodic(annual)inflows and outflows from additional revenues,costs,cost savings,adjusted for tax effects,including those from depreciation a
11、nd amortization.Capital Budgeting and Risk 111 Copyright 2014 Pearson Education,Inc.c.Changes in working capital:certain projects require,for instance,additional inventory or a higher level of accounts receivable.This represents a cash investment(just as the purchase of new equipment),and must be sh
12、own as a cash outflow at the time of the cash flow.These amounts may be returned to the projects later or at the end of the projects,and will then appear as a cash inflow.d.Salvage(terminal values):at the end of a project,the equipment(and/or the land and building)originally acquired may have some c
13、ash value.This must be shown(adjusted for possible tax effects)as an inflow at the end of the project.e.Non-cash investments:these are actually opportunity costs of using certain resources elsewhere in the business or of obtaining a cash value in the absence of their employment in the project under
14、consideration.6.Depreciation is not a cash expense.It is an accounting entry which is meant to consider the decrease in the value of an asset,and thus would not be considered to be a cash flow.However,as it is considered to be an expense for income statement purposes,it will affect the tax liability
15、 of a company.Being an expense,it decreases the companys taxes,and the decrease in taxes is a decrease in the companys cash outflowor an increase in a companys cash inflow.7.Last years marketing research project is considered a sunk cost,and is not relevant to the analysis.The amount has already bee
16、n spent,and it will have no bearing on the current computation.8.A company should invest in capital projects up to the point where the project with the lowest internal rate of return just equals the cost of capital of the last dollar spent.Or,it can be said that a companys optimal budget will occur
17、at the point where the investment opportunity schedule(or curve)intersects the marginal cost of capital curve.This determination is very similar to the procedure for determining price and output of a product;a company should produce at the point where marginal cost equals marginal revenue.9.Each com
18、ponent of capital(e.g.bonds,preferred stock,common stock)should be assigned a weight based on the market value of all the components combined.The cost of each component must then be determined.The weight of each component is multiplied by its respective cost;the results of these computations are add
19、ed to obtain the weighted cost of capital.10.Beta calculates the volatility of the returns on a particular stock relative to the return on a total stock market portfolio.The greater the volatility,the greater is the riskiness of the stock.The higher risk will result in a higher required rate of retu
20、rn.Dominion Resources stock fluctuates less than half as much as Hewlett-Packards stock.The higher risk of Hewlett-Packard will result in a higher required rate of return.For example,assume that todays riskless interest rate is 5%,and the average return on a market portfolio is 12%.Then the respecti
21、ve rates of return,based on the Capital Asset Pricing Model,will be:Dominion Resources:.05+(.12-.05)0.5=.085=08.5%Hewlett-Packard.05+(.12-.05)1.2=.134=13.4%11.Under the rule of capital rationing,some projects with positive net present value will not be implemented.This is because the company has lim
22、ited capital expenditure to a certain sum,which 112 Capital Budgeting and Risk Copyright 2014 Pearson Education,Inc.may not be sufficient to implement all projects,which would add to the value of the company.Thus,the company is not maximizing its value.12.Causes of business risk:a.Changes in conditi
23、ons of the economy as a whole b.Changes in economic conditions of a specific industry c.Possible actions by competitors d.Technological changes e.Cost and expense changes 13.No.In a risky project,both expected value and level of risk must be considered.Risk is measured by the standard deviation.Thus
24、,project A,which has the higher expected NPV,may have a considerably higher standard deviation.The extra NPV may not be worth the higher risk.A coefficient of variation could be calculated to ascertain the relative risk.14.Yes.If the normal curve has a high peak and steep declines around the peak,th
25、is indicates a relatively small standard deviationthe possible outcomes will not fall far from their mean(expected value).A relatively small standard deviation signifies lower risk.15.The coefficient of variationthe standard deviation divided by the expected valuemeasures the relative risk of a set
26、of potential outcomes,and is necessary to evaluate the extent of risk in projects with unequal expected values.16.Yes.Different projects may have different degrees of risk,and,therefore,different interest rates(risk adjusted discount rates)should be applied to them.The cash flows from a riskier proj
27、ect should be discounted at a higher discount rate.17.The RADR method appears to be the simpler of the two techniques to apply.The certainty equivalent method requires the specification of certainty equivalent factors for each cash flow.Of course,to be precise,the risk premium to be included in the
28、risk adjusted discount rate should also be an exact measure.However,since all of these calculations are estimates,the risk adjusted discount rate method lends itself much more to a relatively rough calculation.18.Sensitivity analysis involves the changing of one variable in a capital project evaluat
29、ion to calculate the impact of the change on the final results,i.e.,the net present value or the internal rate of return.The item that is to be changed could be sales quantity,sales price,production cost,the cost of capital,or just the net cash flow.Scenario analysis differs from sensitivity analysi
30、s in that it considers the changes in the final results when more than one variable is changed.Thus,sales quantity,sales price and production costs could be changed simultaneously.Simulation analysis identifies the key variables and assigns probabilities to each.The results are“simulated”by the used
31、 of random numbers representing each of the probabilities.Such calculations are repeated a large number of times(each time selecting random numbers to represent probabilities)to obtain a distribution of expected values(e.g.,profit,rate of return,profit margin),and the standard deviation of the distr
32、ibution.19.If a company which is analyzing a capital project has the ability to make changes while the project is in process,such“option”may improve the results.The use of real option analysis is indicated when a company can expand or contract operations,vary its inputs,abandon or postpone a project
33、.Capital Budgeting and Risk 113 Copyright 2014 Pearson Education,Inc.Having such flexibility may increase the NPV compared to a project where all aspects are cast in concrete.The difference in the NPV is the value of the“real option.”PROBLEMS 1.This offer is too good to be true.The calculations do n
34、ot consider the fact that if the buyer borrows,he/she will have to make monthly payments of$266.93.Where do these come from?If they come from his/her money market account,then the original amount,$12,000,will have to be drawn down,and thus will not earn the interest which the dealer claims will be e
35、arned.Or else,the monthly payments will have to be made from the buyers earnings and will not be available for savings.2.a.PV(at 12%)Cash flow year 0$-50,000.00 year 1 8,928.57 year 2 15,943.88 year 3 21,353.41 year 4 12,710.36 year 5 2,837.13 NPV$11,773.35 b.21.1%(or 21%,rounded off to nearest perc
36、ent)PV(at 21.1%)Cash flow year 0$-50,000.00 year 1 8,257.64 year 2 13,637.72 year 3 16,892.30 year 4 9,299.37 year 5 1,919.77 NPV$6.80 c.Yes,this project should be accepted.The net present value is positive and,correspondingly,the internal rate of return is higher than the cost of capital.3.The resu
37、lts can be calculated in two ways:a.Calculate NPV of each years value:Today 1 2 3 4 5 6 70.0 80.0 86.0 89.4 90.2 88.2 84.7 The NPV in year 5 is lower than in year 4.This indicates that the collection should be sold at the end of year 4.b.Calculate the growth rate each year.The growth rate is actuall
38、y the internal rate of return.When that becomes smaller than the cost of capital,the collection should be sold.1 2 3 4 5 6 25.7%18.2%14.4%10.9%7.6%5.6%114 Capital Budgeting and Risk Copyright 2014 Pearson Education,Inc.IRR k in year 5.4.Cost of new crane$-500,000 Cash value of old crane 70,000 Tax b
39、enefit from loss on sale of old crane(30,000 x 0.4)12,000 Cash investment$-418,000 5.Year 1 Year 2 Year 3 Year 4 Year 5 Revenue$50,000$80,000$80,000$80,000$40,000 -Cost&Exp 25,000 40,000 40,000 40,000 20,000 -Deprec.30,000 30,000 30,000 30,000 30,000 Profit b.t$-5,000$10,000$10,000$10,000$-10,000 Ta
40、xes+2,000-4,000-4,000-4,000+4,000 Profit a.t$-3,000$6,000$6,000$6,000$-6,000 +Deprec.30,000 30,000 30,000 30,000 30,000 Cash Flow$27,000$36,000$36,000$36,000$24,000 PV(at 12%)24,107 28,699 25,624 22,879 13,618 Total present value of operating cash flows:$114,927 Present value of salvage:Since book v
41、alue is 0,a 40%tax must be paid on the$10,000.The remaining$6,000 must be discounted at 12%for 5 years(PV factor is.5674).Thus,present value is$3,404.Present value of returned working capital:$15,000 x.5674=$8,511.Summary:Original investment$-150,000 PV of operating cash flows 114,927 PV of salvage
42、3,404 Additional working capital-15,000 Return of working capital 8,511 Net present value$-38,158 Since the net present value is negative,the purchase is not indicated.6.Choice A Original cost of first truck-$6,000 Depreciation tax-shield of first truck$1,200/yr times tax rate(34%):$408 PV of tax sh
43、ield for 4 years 1,239 PV of market value of first truck 508 Loss on sale of first truck:$400 PV of tax reduction on loss of sale 86 PV of cost of second truck-7,626 Depreciation tax-shield on second truck$2,400/yr times tax rate:$816 PV of tax shield for 5 years(back to year 0)1,869 Present value c
44、ost-$9,924 Capital Budgeting and Risk 115 Copyright 2014 Pearson Education,Inc.Choice B Cost of truck-$16,000 Depreciation tax-shield$3,200/yr times tax rate:1088 PV of tax shield for 5 years 3,922 PV of market value 322 PV of tax on profit from sale -109 Present value cost-$11,865 Choice A is prefe
45、rred.7.If company furnishes the car,its cash flows will be as follows:Year 0 Year 1 Year 2 Year 3 Year 4 Original cost$-15,000 Current cash flow:Depreciation$-3,750$-3,750$-3,750$-3,750 Gasoline -900-900-900-900 Licenses&Ins.-600-600-600-600 Garaging -300-300-300-300 Maintenance -250-350-450-600 Tot
46、al Expense$-5,800$-5,900$-6,000$-6150 Tax 2,320 2,360 2,400 2,460 Net Expense(a.t.)$-3,480$-3,540$-3,600$-3690 Add:Depreciation 3,750 3,750 3,750 3,750 Cash flow$270$210$150$60 Salvage(after tax)_ _ _ _ 1,500 Total cash flows$-15,000$270$210$150$1,560 Present value$-15,000$245$174$113$1,066 Net pres
47、ent value$-13,402 If company pays mileage:18000 miles at$.35 per mile$6,300 Annual cost After taxes(60%)$3,780 Present value cost(4-year annuity at 10%)$11,982 Present value cost of paying mileage is less than present value of furnishing car.Therefore,company should pay mileage.8.The dividend of$1.6
48、0 will grow by 10%to$1.76 in year 1.k=1.76/40+.1=.144 Thus,the cost of retained earnings is 14.4%.k=1.76/38+.1=.146 116 Capital Budgeting and Risk Copyright 2014 Pearson Education,Inc.Thus,the cost of new equity is 14.6%.9.Market value weights:Bonds(20,000 x$980)$19,600,000 28%Common stock(1,000,000
49、 x$50)50,000,000 72 Total$69,600,000 100%k of bonds:11%x(1-tax rate)11%x.6=6.6%k of equity:3/50+.08=.14=14%Weighted cost of capital:Bonds 28%x.066.0185 Equity 72%x.14.1008 Weighted cost of capital.1193=11.9%10.a.kj=Rf+(km-Rf)x beta =.08+(.14-.08)x 1.3=.08+.078=.158=15.8%b.If Rm remains at 14%,then r
50、isk premium is only 5%:kj=.09+(05)x 1.3=.09+.065=.155=15.5%If Rm rises to 15%,the risk premium remains at 6%:kj=.09+(.06)x 1.3=.09+.078=.168=16.8%c.kj=.08+(.06)x.8=.08+.048=.128=12.8%11.a.Calculation of net present values Project C Cash Flows PV of Cash Flows Year 0$-40,000$-40,000 Year 1 10,000 8,9