Ch 3 Flashcards
A company is considering investing in a new state-of-the-art machine that initially costs $450,000 and will have a useful life of four years. The projected annual after-tax cash flows are $100,000 for the first two years and $200,000 for the subsequent two years. At the end of Year 4, the machinery can be salvaged for $75,000. The required rate of return is 12%.
Present value information is presented below:
Present value of $1 for Year 1 at 12% is 0.893
Present value of $1 for Year 2 at 12% is 0.797
Present value of $1 for Year 3 at 12% is 0.712
Present value of $1 for Year 4 at 12% is 0.636
What is the profitability index for this project?
A.
0.87
B.
0.97
C.
1.08
D.
1.50
C Profitability index (PI)=PV of cash flows / Initial Inc
The profitability index (PI) is the ratio of the present value (PV) of cash flows to the initial cost of a project. Businesses use this index to prioritize projects when investment funds are limited. A PI index greater than 1 indicates that the project generates more cash flow than its initial cost on a discounted basis. Therefore, accept a project if PI > 1 and reject it if PI < 1.
For calculating PI with uneven cash flow, each year is discounted separately. Note that the final year includes the cash flow of $200,000 and the salvage value of $75,000 for a total of $275,000.
Year 1 0.893 × 100,000 = $ 89,300 Year 2 0.797 × 100,000 = 79,700 Year 3 0.712 × 200,000 = 142,400 Year 4 0.636 × 275,000 = 174,900 Total PV . $ 486,300 Initial cost $ 450,000 PI ($486,300 ÷ $450,000) = 1.08
(Choice A) A PI of 0.87 results from incorrectly subtracting (instead of adding) the salvage value to Year 4’s cash flows.
(Choice B) A PI of 0.97 results from incorrectly excluding the salvage value in Year 4’s cash flows.
(Choice D) A PI of 1.50 results from not discounting the cash flows.
Things to remember:
The profitability index (PI) is used to evaluate investment projects and is the ratio of present value of cash flows to the initial cost of the project. If PI > 1, the project should be accepted.
A company is considering investing in a new state-of-the-art machine, which initially costs $450,000 and will have a useful life of four years. At the beginning of Year 5, the machinery can be salvaged for $50,000. The cost of capital is 12%. Pertinent information related to this project (excluding salvage value) is as follows:
Net cash flows Present value factor at 12% Year 1 $100,000 0.893 Year 2 100,000 0.797 Year 3 200,000 0.712 Year 4 250,000 0.636 What is the discounted payback period in years?
A.
3.20
B.
3.28
C.
3.73
D.
4.00
C
The discounted payback period is the first 3 years (totaling $311,400) plus $138,600 ($450,000 − $311,400) from Year 4. In other words, 87% ($138,600 / $159,000) from Year 4 cash flow is needed to recover the $450,000 initial investment. Therefore, the discounted payback period is 3.87 years, rounded. Note that salvage value is not relevant as the machinery is fully paid in Year 4.
(Choice A) A payback period of 3.20 years uses undiscounted cash flow.
(Choice B) A payback period of 3.73 years assumes the $50,000 salvage value was included in Year 4 cash flows [($250,000 + $50,000) × 0.636 = $190,800; $138,600 / $190,800 = .73 years + 3.0 years = 3.73 years]
(Choice D) A payback period of 4.00 years is based on taking a full year for Year 4 instead of prorating the final year.
Things to remember:
The discounted payback method calculates the present value of each year’s cash flows to determine how long it takes to recover the initial cost of the project.
Wexford Co. has a subunit that reported the following data for year 1:
Asset (investment) turnover 1.5 times
Sales $750,000
Return on sales 8%
The imputed interest rate is 12%. What is the division residual income for year 1?
A.
$60,000
B.
$30,000
C.
$20,000
D.
$0
Choice D (Correct) and Choices A, B, C (Incorrect): Residual income is profit reduced by the required return on assets. If return on sales is 8%, profit will be 8% of sales of $750,000 or $60,000. With an asset turnover of 1.5 times, sales represent 1.5 times assets, indicating assets are $500,000. There is an imputed interest rate of 12%, resulting in a required return on assets of 12% of $500,000 or $60,000, leaving no residual income.
A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company’s times-interest-earned ratio?
A.
5.4
B.
6.4
C.
7.4
D.
10.0
Choice D (Correct) and Choices A, B, C (Incorrect): Times interest earned is equal to earnings before interest and taxes (EBIT) divided by the amount of interest. If net income is $5.4 million with a tax rate of 40%, $5.4 million represents 60% of income before taxes, which would equal ($5.4million/60%) $9 million. With interest of $1 million, EBIT is $9 million + $1 million or $10 million and times interest earned is $10,000,000/$1,000,000 or 10 times.
ABC Co. had debt with a market value of $1 million and an after-tax cost of financing of 8%. ABC also had equity with a market value of $2 million and a cost of equity capital of 9%. ABC’s weighted-average cost of capital would be
A.
8.0%
B.
8.5%
C.
8.7%
D.
9.0%
Cost of capital is the financing cost that an entity pays to either issue long-term debt and/or stock to fund a capital project. When each component of the cost of capital is weighted in proportion to the total, the result is the weighted-average cost of capital (WACC).
WACC is calculated by weighting each financing rate by the amount of debt or equity that it applies to. ABC Co. had equity of $2 million and debt of $1 million, for a total of $3 million. The weighted-average rate will be:
(9%×$2M/$3M)+(8%×$1M/$3M) =
6.0% + 2.7% = 8.7%
Things to remember:
The weighted-average cost of capital is a calculation of a firm’s effective cost of capital that takes the portion that was obtained as debt, preferred stock, and common stock into account.
For the next 2 years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for 2 years is $1.74. What is the lease’s after-tax present value using a 10% discount factor?
A.
$ 2,610
B.
$ 4,350
C.
$ 9,570
D.
$11,310
Choice D (Correct) and Choices A, B, C (Incorrect): With an operating cash inflow of $7,500 before amortization and taxes, the increase in pre-tax income will be $2,500 after deducting $5,000 in amortization. At a tax rate of 40%, taxes will be $1,000. As a result, the after tax annual cash inflows will be $7,500 - $1,000 or $6,500. With a present value factor of 1.74 for a 2 year annuity at 10%, the present value of the lease is $6,500 x 1.74 = $11,310.
Galax, Inc. had operating income of $5,000,000 before interest and taxes. Galax’s net book value of plant assets at January 1 and December 31 were $22,000,000 and $18,000,000, respectively. Galax achieved a 25 percent return on investment for the year, with an investment turnover of 2.5. What were Galax’s sales for the year?
A.
$55,000,000
B.
$50,000,000
C.
$45,000,000
D.
$20,000,000
B
Companies use profitability ratios (ie, margins or return metrics) to evaluate performance. An example is return on investment (ROI), which measures how efficiently an asset or investment generates income. ROI is calculated as net income divided by average capital invested.
The components of ROI (eg, sales) are often analyzed using the Dupont approach. The Dupont approach breaks ROI into a product of two separate measures: return on assets and asset turnover. Return on assets reveals how easily profit is generated from sales, and asset turnover reveals how easily sales are generated from assets.
Using the Dupont ROI approach,
Return on Investment (ROI) =Return on sales ×Asset turnover
=Net Income/Sales×Asset turnover
Given that ROI is 25%, net income is $5,000,000, and asset turnover is 2.5, Galax, Inc.’s sales are calculated as:
25% =$5,000,000/Sales×2.5 Sales×25% =12,500,000 Sales =12,500,000/0.25 =$50,000,000 (Choice A) Sales of $55,000,000 erroneously add back the net income to sales.
(Choice C) Sales of $45,000,000 incorrectly adds the net income to both the beginning and ending assets.
(Choice D) Sales of $20,000,000 ignore the asset turnover part of the formula.
Things to remember:
The Dupont approach is used to evaluate the components of return on investment (ROI). This approach divides ROI into return on assets and asset turnover measures. Components of the Dupont equation can be arranged to determine potentially unknown variables (eg, sales).
A new venture will require an initial investment in fixed assets of $20,000 and in working capital of $10,000. The fixed assets will have no salvage value at the end of the project’s four-year life, and the working capital will be completely recovered at the end of the project. The organization’s cost of capital is 16%. At a time value of money of 16%, the present value of an ordinary annuity of $1/year for four years is 2.8 and the present value of $1 at the end of four years is 0.6. What is the annual net cash inflow required for the project to break even on a time-adjusted basis?
A.
$7,143
B.
$8,571
C.
$10,714
D.
$12,857
B
The net present value (NPV) is the difference between the present value of a project’s future cash flow and its initial investment. Present value calculations provide the present value of a future single amount or an equal series of amounts (ie, annuity) by discounting the future amounts with a discount factor. A project’s breakeven point is when NPV equals $0.
In this scenario, the annuity discount factor is applied to the future annual cash inflow because it is assumed that the project will generate an equal amount of cash inflow for four years. The present value discount factor is applied to the working capital recovered since it is a single cash inflow. Using a table format, set the unknown annual net cash inflow equal to “X” and solve as follows:
Cash Discount factor PV Amount
Future cash flow
Annual cash inflow X 2.8 $ 2.8X
Working capital recovery 10,000 0.6 6,000
Initial investment
Investment in fixed assets (20,000) (20,000)
Working capital outlay (10,000) (10,000)
Solve for X when NPV equals 0
PV of future cash flow−initial investment =NPV
2.8X+$6,000−20,000−10,000 =$0
2.8X−$24,000 =0
X =$8,571
Therefore, the annual net cash inflow required for the new venture to break even on a time-adjusted basis is $8,571.
Things to remember:
The net present value (NPV) is the difference between the present value of a project’s future cash flows and its initial investment. An annuity discount factor is applied when there is a series of equal future cash flows; the present value discount factor is applied when there is a single or a series of an unequal future cash flows. A project’s breakeven point is when NPV equals $0.
Select Co. had the following 20X4 financial statement relationships:
Asset turnover 5
Profit margin on sales 0.02
What was Select’s 20X4 percentage return on assets?
A.
0.1% (21%)
B.
0.4% (22%)
C.
2.5% (12%)
D.
10.0%
Choice D (Correct): With a profit margin of .02, profit is equal to 2% of sales. With an asset turnover of 5, average assets are equal to 1/5, or 20%, of sales. The return on assets is profit divided by average assets. As a result, return on assets is 2% of sales divided by 20% of sales or 10%.
Expanded Explanation:Asset turnover = Sales / Assets (or average assets)Return on assets = Net income / Average total assetsProfit margin on sales = Net income / Net salesWe are given profit margin on sales = 0.02 (or 2%). That means Net income / Net sales = 2%. Let’s say net sales are 100 and net income is 2. It doesn’t matter what numbers we use as long as the 2% relationship is preserved.We are also given asset turnover = 5. That means Sales / Assets = 5. With Sales of 100, that would mean 100 / x = 5. In other words, in the example we’re constructing that preserves all these ratios, Assets is 20.Now we must calculate return on assets.Return on assets = Net income / Average total assets = 2 / 20 (or 10%).
For the next two years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for two years is 1.74. What is the lease’s after-tax present value using a 10% discount factor?
A.
$2,610 (21%)
B.
$4,350 (20%)
C.
$9,570 (22%)
D.
$11,310
D
When determining cash inflows and outflows for a proposed lease, the tax effect of noncash items must be considered. Noncash expenses such as depreciation and amortization lower taxable income (ie, shield pretax income from taxes), so less income tax is paid; therefore, cash outflow decreases (ie, more cash is retained).
Noncash items like amortization are tax-adjusted by using the tax rate (cash items would use 1 − tax rate). The total present value (PV) of the cash inflow ($13,050) is reduced by the tax-adjusted savings ($1,740) to determine the after-tax PV of $11,310, as follows:
PV of cash inflow $7,500 × 1.74 = $13,050 Tax impact of amortization expense: Pretax income $7,500 Less amortization expense 5,000 Taxable income 2,500 Times the tax rate
0.40 1,000 × 1.74 = 1,740
After-tax PV $11,310
(Choice A) An after-tax PV of $2,610 incorrectly tax-adjusted and discounted $2,500 by 1 − tax rate [($2,500 × 60%) × 1.74 = $2,610].
(Choice B) After-tax PV $4,350 discounted annual amortization expense of $5,000 to $8,700 ($5,000 × 1.74) and then deducted from $13,050.
(Choice C) After-tax PV of $9,570 incorrectly tax-affected the annual $5,000 amortization expense to $2,000 ($5,000 × 40%), discounted it to $3,480 ($2,000 × 1.74), and then deducted it from total PV ($13,050 − $3,480).
Things to remember:
Noncash expenses such as amortization expense act as a tax shield by lowering pretax income and decreasing cash paid for taxes. Accordingly, the present value (PV) of the tax expense is used when determining the after-tax PV.
In determining cash flows from a proposed investment, the amount of the investment’s depreciation tax savings (shield) in a given year is equal to
A.
The depreciation. (3%)
B.
The depreciation times (one minus the tax rate). (50%)
C.
The depreciation times the tax rate. (43%)
D.
The depreciation times (one plus the tax rate).
C
When determining cash inflows and outflows for a proposed investment, the tax effect of noncash items must be considered. Noncash expenses lower taxable income (ie, shield pretax income from taxes), so less income tax is paid; therefore, cash outflow decreases. The most common tax shield is provided by depreciation expense.
Assume pretax income before depreciation expense is $130,000, depreciation expense is $30,000, and the tax rate is 20%. Below shows the tax impact of using depreciation expense to shield taxable income and lower taxes.
Including the depreciation expense deduction on the income statement, estimated taxes are $20,000. Without the depreciation expense deduction, taxes are $26,000. The $6,000 difference is called the depreciation tax shield. In other words, the noncash depreciation expense shields what would otherwise be taxable income, resulting in a reduced cash outflow for taxes.
A shortcut method can be used to calculate the depreciation tax shield by multiplying the noncash depreciation expense by the tax rate ($30,000 × 0.20 = $6,000). The depreciation tax shield is not depreciation alone or depreciation multiplied by one plus the tax rate (Choices A and D).
For cash expenses such as insurance, the net effect on tax savings is the amount of the cash expense multiplied by one minus the tax rate (Choice B). The difference in formulas is a result of the real cash outflow from paying cash expense versus the lack of a cash outflow for noncash items.
Things to remember:
Noncash expenses act as a tax shield by lowering pretax income and decreasing cash paid for taxes. The most common tax shield is depreciation expense. The difference in taxes between income with and without the noncash expense is the tax shield.
A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8%. The company is required to maintain a 20% compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?
A.
8%. (7%)
B.
10%. (75%)
C.
20%. (5%)
D.
28%.
Choice B (Correct) and Choices A, C, D (Incorrect): Since the company is required to maintain a 20% compensating balance, or $100,000, the funds available for use are limited to $400,000 of the $500,000 borrowed. Interest, at 8% of $500,000, is $40,000 per year, which would be the equivalent of a 10% rate of interest on $400,000.
A company is trying to determine the cost of capital for a major expansion project. A survey of commercial lenders indicates that cost of debt is currently 8% based on the company’s debt ratio of 40%. The company complies with this requirement and has determined that a stock issuance would require a 10% return in order to attract investors. Which of the following is the company’s cost of capital?
A.
8.8% (7%)
B.
9.2% (65%)
C.
10.6% (12%)
D.
18.0%
B
For this scenario, only the aggregate cost of debt and cost of equity are provided. Since the total must equal 100%, and the cost of debt is given as 40%, the cost of equity must be 60%. These percentages are weighted to determine the WACC, as follows: (40% × 8%) + (60% × 10%) = 9.2%.
Things to remember:
To maximize shareholder return, businesses should accept only projects with an internal rate of return greater than the cost of capital.
A company uses its fixed assets of $1,000,000 at 95% capacity to generate sales of $2,000,000. The company wishes to generate sales of $3,000,000. What amount of additional fixed assets must be acquired, assuming that all fixed assets will operate at maximum capacity?
A.
$425,000 (36%)
B.
$475,000 (32%)
C.
$500,000 (23%)
D.
$578,000
Choice A (Correct) and Choices B, C, D (Incorrect): The assumed relationship between fixed assets and sales is that sales are 2.105 times total fixed assets, based on dividing 2,000,000 by 950,000 (not 1,000,000, because capacity was only 95%). Once this ratio is known, the total fixed assets operating at 100% capacity necessary to generate sales of $3,000,000 can be determined algebraically: 3,000,000 / 2.105 = 1,425,000. Since the company already has 1,000,000 in fixed assets, additional fixed assets of $425,000 must be acquired in order to arrive at the $1,425,000 in fixed assets necessary for achieving $3,000,000 in sales
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322. What is the accounting rate of return?
A.
30% (5%)
B.
20% (32%)
C.
12% (19%)
D.
10%
D
The accounting rate of return (ARR) is a capital budgeting technique generally used to compare multiple projects by calculating a given project’s anticipated rate of return. ARR equals the average annual profit of the proposed capital investment divided by the average investment for the project. The numerator is calculated as the project’s average annual income less the project’s depreciation expense (if given) and any other related expenses.
In this scenario, the annual depreciation expense is $10,000 (ie, $100,000 / 10 years), reducing the average annual profit (ie, the numerator) from $20,000 to $10,000. Because there is no information indicating that the denominator should be the average investment, the average annual profit of $10,000 is divided by the initial cost of $100,000 for an ARR of 10%.
One of the disadvantages of ARR is that it ignores the time value of money; therefore, the discount factors provided in the question are irrelevant.
Things to remember:
The accounting rate of return, a capital budgeting technique, equals the average annual profit of the proposed capital investment divided by the average investment for the project. The numerator is calculated as the net of the project’s depreciation expense.
A company provides the following financial information:
Cost of equity 20% Cost of debt 8% Tax rate 40% Debt-to-equity ratio 0.8 What is the company's weighted average cost of capital?
A.
9.8% (23%)
B.
11.5% (24%)
C.
13.3% (42%)
D.
14.7%
C
In this scenario, the only capital sources are debt and equity; therefore, the proportional weight of each component can be ascertained using the debt-to-equity ratio. Debt-to-equity ratio of 0.8 or 8/10 implies that for every $8 of debt, equity is $10. Therefore, the percentage of debt is 44% ( 8/8+10) and equity is 56% ( 10//8+10). Since interest expense is tax deductible, the applicable cost of long-term debt in WACC calculation is net of tax. At a tax rate of 40%, the after-tax cost of the 8% debt is 4.8% [ie, 8% × (1 − 40%)].
Source of capital Cost of capital Weight
Debt 4.8% × .44 = 2.1%
Equity 20% × .56 = 11.2%
WACC 13.3%
(Choice A) A WACC of 9.8% results from incorrectly interchanging the cost of debt and equity.
(Choice B) A WACC of 11.5% erroneously suggests that the debt weight is 56% and equity weight is 44%.
(Choice D) A WACC of 14.7% is the result of incorrectly using the pretax cost of debt.
Things to remember:
When each component of the cost of capital is weighted in proportion to the total, the result is the weighted average cost of capital (WACC). The cost of long-term debt included in the WACC calculation is net of tax since interest expenses are tax deductible.
A company is considering investing in a new state-of-the-art machine, which initially costs $450,000 and will have a useful life of four years. The projected annual after-tax cash flows are $100,000 for the first two years and $200,000 for the subsequent two years. Straight-line depreciation is used. At the end of Year 4, the machinery can be salvaged for $75,000. The required rate of return is 12%.
Present value information is shown below:
Present value of $1 at 12% at the end of one period 0.893
Present value of $1 at 12% at the end of two periods 0.797
Present value of $1 at 12% at the end of three periods 0.712
Present value of $1 at 12% at the end of four periods 0.636
What is the accounting rate of return for this project?
A.
33.3% (26%)
B.
16.7% (27%)
C.
12.5% (25%)
D.
8.3%
B
The accounting rate of return (ARR) is generally used to compare multiple projects. ARR (ie, the project’s average annual profit divided by its average investment) calculates a given project’s anticipated rate of return. The ARR should exceed the required rate of return (eg, 12% in this scenario); for competing projects, the CPA should select the project with the greatest ARR.
The numerator is calculated as the project’s average annual income less its depreciation expense (if given). In this scenario, the annual depreciation expense is $93,750 [($450,000 − $75,000) / 4 years]. Because there is no information provided to calculate the average investment for the denominator, the numerator is divided by the initial cost of $450,000 for an ARR of 16.7%, calculated as follows:
One of the disadvantages of ARR is that it ignores the time value of money; therefore, the discount factors provided in this scenario are irrelevant.
(Choice A) The initial investment (ie, denominator) was incorrectly averaged [ie, ($0 + $450,000) / 2 = $225,000], causing the denominator to be understated and the ARR to be overstated (ie, $75,000 / $225,000 = 33.3%). The initial investment can be correctly averaged only if the appropriate information is provided.
(Choice C) The salvage value of $75,000 was not included in Year 4 cash inflow.
(Choice D) The salvage value of $75,000 was incorrectly deducted from Year 4 cash inflow.
Things to remember:
The accounting rate of return is the project’s average annual profit divided by the average (or initial) investment. The numerator is the net of the project’s depreciation expense. The information is not discounted.
Sen Corp., a publicly-traded, mid-cap company, wanted to obtain $30 million in new capital to expand its Iowa plant. Cost of capital was a factor in making the decision. Sen Corp. could either issue new preferred stock or new debentures. Sen Corp.’s underwriter estimated that preferred stock should have an annual dividend payout of $6 and an issue price of $103 per share. The debentures should have a coupon interest rate of 9% and an issue price of $101. Sen Corp.’s marginal income tax rate was 40%. Which of the following approaches describes Sen Corp.’s best strategy?
A.
Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would be less than the cost of equity (5.825%).
B.
Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would be less than the cost of equity (6%).
C.
Sen Corp. should issue the preferred stock because the cost of equity (6%) is less than the cost of debt (9%).
D.
Sen Corp. should issue the preferred stock because the cost of equity (5.825%) is less than the cost of debt (9%)
Choice A (Correct): The after-tax cost of the debt is ($9 / $101) x (1 - .40 tax rate) = 5.347%. The after-tax cost of the equity is $6 / $103 = 5.825% (rounded). Thus, issuing the debt is less expensive of an option for Sen Corp.Note that 9% of the debt will be $9 of every $100 borrowed and not $9.09 (9% of $101) since the debt is issued at a premium.Alternative calculation for cost of debt: Annual interest would be 9% of $30,000,000 = $2,700,000. This total annual cost of debt is then multiplied by (1-.40 tax rate) to get the after-tax cost of debt (i.e., $2,700,000 x .6 = $1,620,000). The after-tax cost of debt is then divided by the total proceeds of $30,300,000 (i.e., $101 x 300,000). Thus, $1,620,000/$30,300,000 = 5.347%
A company is considering investing in a new state-of-the-art machine, which initially costs $450,000 and will have a useful life of four years. The projected annual after-tax cash flows are $100,000 for the first two years and $200,000 for the subsequent two years. At the end of the fourth year, the machinery can be salvaged for $75,000. The required rate of return is 12%.
Present value information is presented below:
Present value of $1 at 12% at the end of one period 0.893
Present value of $1 at 12% at the end of two periods 0.797
Present value of $1 at 12% at the end of three periods 0.712
Present value of $1 at 12% at the end of four periods 0.636
What is the net present value for this project?
A.
($59,100) (5%)
B.
($11,400) (18%)
C.
$36,300 (67%)
D.
$63,600
Net present value = present value of cash flows − initial cost
Net Present Value (NPV) is the difference between the present values of cash inflows and outflows (typically the initial cost). The discount rate used is known as the hurdle rate of return or cost of capital and represents the minimum rate of return the company is willing to accept on an investment.
A project that earns exactly the hurdle rate has an NPV = $0, which is essentially the break-even point. Therefore, projects generally must have an NPV > $0 to be considered acceptable. NPV can be used to rank competing projects.
To calculate NPV with uneven cash flow, each year is discounted separately, as follows (note that the salvage value is added to Year 4 cash flow to calculate total Year 4 cash inflow):
Year 1 0.893 × $100,000 = $ 89,300
Year 2 0.797 × 100,000 = 79,700
Year 3 0.712 × 200,000 = 142,400
Year 4 0.636 × 200,000 + 75,000 = 174,900
Total present value of cash inflow $486,300
Less initial cost 450,000
NPV $36,300
(Choice A) ($59,100) results from the salvage value being incorrectly deducted from (instead of added to) Year 4 cash flow.
(Choice B) ($11,400) results from the salvage value being incorrectly excluded in Year 4 cash flow.
(Choice D) $63,600 results from the salvage value being included in Year 4 but not discounted.
Things to remember:
Net Present Value is the difference between the present values of cash inflows and outflows. For scenarios with uneven cash flow, each year must be discounted as a single sum. The salvage value, if any, is added to the final year cash flow.
A company’s target gross margin is 40% of the selling price of a product that costs $178 per unit. The product’s selling price should be
A.
$445.00 (19%)
B.
$296.67 (56%)
C.
$284.80 (4%)
D.
$249.20
Gross profit margin is a profitability ratio that is calculated as gross profit divided by net sales. Gross profit (also referred to as gross margin) is sales less COGS. Remember that the COGS percent of sales and the gross profit percent of sales must equal 100%.
If gross profit is 40% of the selling price, then the cost is equal to 60% (ie, total must equal 100%). The product’s selling price can be determined as follows:
Selling price=Cost of productCost percentage of sales=$17860%=$296.67
Things to remember:
Gross profit margin is a profitability ratio which is calculated as gross profit divided by net sales. Gross profit (ie, gross margin) is sales less COGS. The COGS percent of sales and the gross profit percent of sales must equal 100%.
A company has the following financial information:
Net operating profit after taxes $18,000 Capital expenditures 10,000 Depreciation expense 8,000 Change in working capital 4,000 What amount is the company's free cash flow?
A.
$4,000 (19%)
B.
$8,000 (25%)
C.
$12,000 (39%)
D.
$16,000
C
Free cash flow is the after-tax cash available after accounting for operating expenses, investments in fixed assets, and working capital. Because it is based on cash, not accrual income, any noncash items such as depreciation and amortization expenses are added back to net operating profit after taxes (NOPAT).
FCF highlights the cash an entity produces through operations. It essentially indicates how much cash is left over to pay investors a return on their investment once all business expenses have been paid. It is commonly used for valuation of securities, capital projects, and firms as it is much more difficult to manipulate cash than it is net income, which is based in part on estimates and accruals.
The company’s free cash flow is $12,000, calculated as follows:
Net operating profit after taxes $18,000 \+ Depreciation expense 8,000 − Capital expenditures 10,000 − Change in working capital 4,000 Free cash flow $12,000 Things to remember: Free cash flow (FCF) is the after-tax cash available after accounting for operating expenses, investments in fixed assets, and working capital. FCF highlights the cash that an entity produces through operations. It is commonly used for valuation of securities, capital projects, and firms. FCF equals net operating profit after taxes plus depreciation/amortization expense less capital expenditures less net change in working capital.
Spear Corp. had sales of $2,000,000, a profit margin of 11%, and assets of $2,500,000. Spear decided to reduce its debt ratio to 0.40 from 0.50 by selling new common stock and using the proceeds to repay principal on some outstanding long-term debt. After the refinancing, what is Spear’s return on equity?
A.
3.5% (6%)
B.
5.3% (24%)
C.
14.7% (61%)
D.
22.9%
Choice C (Correct): With a profit margin of 11% on sales of $2,000,000, profit is $220,000. Total assets are $2,500,000. If the debt ratio is reduced to 40%, debt will be $1,000,000 and equity will be $1,500,000. The return on equity would then be $220,000/$1,500,000 or 14.7%.
Which of the following is not a strategy through which a financial institution (or any business) could manage the risk that it cannot obtain funding in the short run (or roll over its obligations)?
A.
Purchase credit default swaps. (55%)
B.
Reduce the mismatch between the maturities of their assets and liabilities. (17%)
C.
Maintain a large cushion of cash and short-term securities. (7%)
D.
Maintain a variety of long, secure lines of credit
Choice A (Correct): Credit default swaps protect lenders against default by its borrowers but does not assure the availability of debt in the future.
Choice B (Incorrect): By reducing the mismatch of maturities of assets and liabilities, receivables will become collectible closer to when liabilities become payable, providing funding to replace the liabilities.
Choice C (Incorrect): By maintaining a large cushion of cash and short-term securities, an entity will assure the available of funds when liabilities come due.
Choice D (Incorrect): Maintaining a variety of long, secure lines of credit will assure that debt financing will be available to the entity when its obligations come due.
References
A company recently issued 9% preferred stock. The preferred stock sold for $40 a share with a par of $20. The cost of issuing the stock was $5 a share. What is the company’s cost of preferred stock?
A.
4.5% (13%)
B.
5.1% (49%)
C.
9.0% (19%)
D.
10.3%
Choice B (Correct) and Choices A, C, D (Incorrect): Preferred dividends pay an annual dividend based on the dividend rate applied to the par value. In this case, dividends will be 9% of the $20 par or $1.80 per share. The proceeds from the sale of the shares would be $40 less the cost of issuance of $5 for a net amount of $35. As a result, the cost of the preferred stock to the company is $1.80/$35 or 5.1% per year.
