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					                            CAPITAL INVESTMENT ANALYSIS

                                           Practice Exam 3
                                                                                Section Time:

Multiple Choice

1.     In calculating a project’s annual operating cash flows, which of the following is NOT relevant?

       a.   Revenues generated from the new project.
       b.   The savings generated by replacing a manually operated machine with a fully automated one.
       c.   The incremental short-term capital required to get the process up and running.
       d.   To permit flexibility to changing market conditions, a firm takes on a more manual intensive
            project and its additional expenses.
       e.   Additional depreciation benefits or detriments.

2.     A firm‘s total risk increases over time. Which is a likely result of the increased risk?

       a.   The firm’s operating costs would likely increase.
       b.   The company would have more opportunity to take advantage of tax credits due to the greater
            variability of operating income and taxable income associated with the increased risk.
       c.   The firm’s sales would see a corresponding increase.
       d.   Investment funding would be more available.

3.     Which of the following is false when considering drawbacks of using the internal rate of return as
       a decision-making method in project analysis?

       a.   It can lead to conflicting results when considering mutually exclusive projects.
       b.   It can create multiple internal rates of return when cash flows change from negative to
            positive once in the project’s life.
       c.   The modified internal rate of return allows for re-investment at the project’s cost of capital,
            whereas the IRR does not.
       d.   The timing of cash flows affects internal rate of return analysis.

4.     In spreadsheet valuation models, cash flows occur at the end of each period instead of evenly
       throughout the year. This

       a.   has no impact on the value of the operations.
       b.   overstates the true value of the operations.
       c.   can be adjusted by increasing the i, or discount rate, by .5% to reflect the half-year affect.
       d.   can be adjusted by altering the compounding time periods by one-half year increments.

5.       Your valuation model reflects a value much higher than the current stock price. Which of the
         following is most accurate?

         a.   Reverse engineering should be done starting with the inputs you’re most certain of.
         b.   Excessive changes of some inputs into the model were required to drive the model’s value
              down to the stock’s market price. Given confidence in the unchanged inputs, you’d conclude
              that, in fact, that stock was under priced and a good investment bet.
         c.   Small changes of some inputs into the model were required to drive the stock’s price up to
              equal you’re model’s value. Given confidence in the unchanged inputs, you’d conclude that,
              in fact, that stock was over priced and an unsound investment.
         d.   None of the above are accurate.

6.       A company is growing at a constant rate at the horizon, which is greater than its WACC. Barriers
         to entry exist that enables the company’s ROIC to exceed its WACC indefinitely. Calculating the
         Horizon Value would be similar to using a
         a. constant growth dividend approach
         b. perpetuity valuation approach
         c. supernormal growth approach
         d. book value approach
         e. none of the above

7.       When considering the optimal replacement policy on two capital budgeting scenarios with
         different time frames and cost schedules, which is most correct?
         a. NPV analysis says accept the one with higher value.
         b. The replacement chain validates the payback time frame.
         c. The option with the lower equivalent annual annuity should be accepted.
         d. Select the one which maximizes the equivalent annual benefit.

8.   Which of the following is NOT a major cause of capital rationing constraints?

         a.   Management’s desire to maintain target ratios.
         b.   Restrictive covenants.
         c.   Restrictions placed on retained earnings as part of the firm’s dividend policy.
         d.   Debt limits placed by outside management during the normal operations of your business.

9.    When considering a project’s incremental cash flow, cannibalization must be considered. Which
      of the following is NOT true regarding cannibalization?

      a.   Coca-Cola’s introduction of Diet Coke affected the cash flows generated by Tab.
      b.   IBM saw the development of its Reduced Instruction Set Computing (RISC) platform as
           cannibalizing its core mainframe business, and shelved RISC.
      c.   GE’s analysis showed cannibalization so great on its CAT scanners by introducing MRI
           technology to the market place, a negative NPV was produced on the MRI project. Yet, GE
           proceeded in bringing the MRI to market.
      d.   All of the above are true.

10.   In determining a project’s cash flows, one must consider the value attached to allocating fixed
      assets over a period of time. This can best be described as

      a.   straight-line depreciation
      b.   Modified Accelerated Cost Recovery System (MACRS)
      c.   depreciation tax shield
      d.   incremental depreciation
      e.   depreciation add-back

11.   The value of a real option is

      a.   lower the more exclusive the option is.
      b.   lower the shorter the time period until execution.
      c.   greater when the risk factors are lower
      d.   none of the above are true.

12.   Company A is a highly-automated, capital-intensive firm. Company B is less-automated, more
      labor intensive. Which of the following is true?

      a.   Company A has low fixed costs and high variable costs.
      b.   Company B has higher operating leverage.
      c.   Company A has greater project risk.
      d.   Company B has a greater break-even quantity.
      e.   None of the above are true.

13.   Given the attached Marginal Cost of Capital and Investment Opportunity Schedule information for
      RMM Inc. At what dollar level of total project capital will RMM’s returns last exceed costs?

      a.   $ 165,973
      b.   $ 407,769
      c.   $ 445,529
      d.   $ 829,866
      e.   $1,960,191

14.   Given the attached Marginal Cost of Capital and Investment Opportunity Schedule information for
      RMM Inc. At what hurdle rate is it no longer beneficial to undertake projects?

      a.   10.51%.
      b.   11.48%
      c.   12.31%
      d.   13.82%
      e.   13.85%

15    Your company is considering two mutually exclusive projects, X and Y, whose costs and cash
      flows are shown below:

               Project X   Project Y
           Year Cash Flow Cash Flow
            0    -$2,000  -$2,000
            1      200      2,000
            2      600       200
            3      800       100
            4     1,400       75

      The projects are equally risky, and the firm's cost of capital is 12 percent. You must make a
      recommendation, and you must base it on the modified IRR (MIRR). What is the MIRR of the
      better project?

      a.   12.00%
      b.   11.46%
      c.   13.59%
      d.   12.89%
      e.   15.73%

16.   Machine A costs $100 to buy, and $10 per year to operate. It wears out and must be replaced
      every two years. Machine B costs $140 to buy and $8 per year to operate. It lasts three years
      then must be replaced. Given a 10% discount rate, and using Equivalent Annual Annuities, which
      project do we accept, and what is its EAA?

      a.   Machine A; $-117.36
      b.   Machine B: $ 159.89
      c.   Machine A: $ 67.62
      d.   Machine B: $- 64.29
      e.   None of the above.

17.     Your company is considering two different production facilities. The Alcatraz facility is highly
        automated, has fixed costs of $2,000,000, and variable costs of $1 per unit. The SuperMax
        production facility is less capital-intensive and more labor intensive. Its fixed costs are $1,000,000
        and variable costs of $2 per unit. Your product will sell for $5 per unit no matter which facility is
        used. At what quantity will you be indifferent between choosing SuperMax and Alcatraz? If your
        sales level in units are expected to be above the indifference point, which facility would you

        a.   1,000,000; SuperMax
        b.     500,000; Alcatraz
        c.     333,334: SuperMax
        d.     500,000: SuperMax
        e.   1,000,000; Alcatraz

The following information relates to the next three problems:

Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3
years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be
recovered when the operation is closed at the end of Year 3. The facility will produce sales revenues of
$50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No
fixed costs will be incurred. Operating cash inflows will begin 1 year from today. By an act of Congress,
the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3
respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it
to get a tax refund on this project if the project's income is negative, and a 15 percent cost of capital.
Inflation is zero.

18.     What is the depreciation tax shield dollar amount for the second operating year?

        a.   $ 5,000
        b.   $ 2,000
        c.   $ 3,000
        d.   $13,333
        e.   $ 5,333

19.     What’s the company’s operating cash flow for year one?

        a.   $ 50,000
        B.   $ 34,000
        c.   $-10,000
        d.   $ - 6,000
        e.   None of the above

20.     What’s the firm’s total net cash flow for the project’s final year that would be used in determining
        the project’s NPV?
        a. $ 7,673.71
        b. $15,000
        c. $18,000
        d. $20,000
        e. $38,000

                         FNCE 4050Cap Investment analysis
                                    Practice Exam 3

15.   MIRR and NPV
      Time line:
      Project X
                r = 12%
            0               1               2               3                4    Years
                MIRR = ?

         -2,000             200             600             800             1,400.00
                                                                  r = 12%
                                                  r = 12%
                                  r = 12%

                                                  Terminal Value (TV) = 3,329.63
                                     MIRRX = ? = 13.59%
      PV of TV = 2,000
             NPV = 0

      Time line:
      Project Y
                r = 12%
            0               1               2               3                4    Years
                MIRR = ?

         -2,000           2,000             200             100                  75.00
                                                                  r = 12%
                                                  r = 12%
                                  r = 12%

                                                  Terminal Value (TV) = 3,247.74
                                     MIRRX = ? = 12.89%
      PV of TV = 2,000
             NPV = 0

      Financial calculator solution:
      Project X Inputs: CF0 = 0; CF1 = 200; CF2 = 600; CF3 = 800; CF4 =
                          I = 12.
                  Output: NFVX = $3,329.63; NPVX = $2,116.04.
                  Inputs: N = 4; PV = -2,000; FV = 3,329.63.
                  Output: IRRX = 13.59% = MIRRX.
      Project Y Inputs: CF0 = 0; CF1 = 2,000; CF2 = 200; CF3 = 100; CF4
      = 75;
                          I = 12.
                  Output: NFVY = $3,247.74; NPVY = $2,063.99.
                  Inputs: N = 4; PV = -2,000; FV = 3,247.74.
                  Output: IRRY = 12.885%  12.89% = MIRRY.
      Note that the better project is X because it has a higher NPV.
      Its corresponding MIRR = 13.59%.
      NPVX = $2,116.04 - $2,000 = 116.04.
      NPVY = $2,063.99 - $2,000 = 63.99.
      NPVX > NPVY. MIRR of the better project is 13.59%.

18. New project NPV

                            0                 1        2         3
                                    r = 15%

      Purchase           -50,000
      Sales                               50,000    50,000    50,000
      - VC                               -20,000   -20,000   -20,000
      - Deprec.                          -40,000    -5,000    -5,000
      EBT                                -10,000    25,000    25,000
      - Taxes                             +4,000   -10,000   -10,000
      Net income                          -6,000    15,000    15,000
      + Depreciation                     +40,000    +5,000    +5,000
                                          34,000    20,000    20,000
      NWC                 -12,000                            +12,000
      RV(AT)              _______       _______    _______    +6,000
      NCF                 -62,000        34,000     20,000    38,000
      NPV15% = $7,673.71.


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