I’m very busy today thus I cannot participate. What topic should I post?
Corp Fin - Have at it! Question 5 - 87077 Jackson Huang is an analyst for Oswald Technologies. Huang is considering a $150 million capital project that is expected to produce operating earnings before interest and taxes of $80 million per year for all three years of the project’s life. The project is being depreciated on a straight-line basis and at the end of 3 years the project will have zero salvage value. Huang believes the project is an average risk project for the firm and is planning to apply Oswald’s weighted average cost of capital (WACC) of 8% and tax rate of 30% to the project. Huang’s supervisor has asked him to use both the economic income and economic profit approaches to analyze the project. After completing his analysis, Huang makes the following statements to his supervisor. Statement 1: In the first year of the project’s life, the economic income exceeds the economic profit generated from the project. Statement 2: The discount rate applied to the economic profit to calculate the project’s net present value (NPV) will be identical to the economic rate of return earned by the project each year. How should Huang’s supervisor respond to his statements? A) Agree with one only. B) Agree with both. C) Agree with neither. -------------------------------------------------------------------------------- Question 6 - 87149 Norine Benson is studying for the Level I CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is most accurate? A) An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC). B) Replacement decisions involve mutually exclusive projects. C) For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV). -------------------------------------------------------------------------------- Question 7 - 87124 Rachel Moore, an analyst with Dawson Corporation, is discussing a potential capital project with her colleague, Phillip Cora. The project involves producing a new product that will be sold in discount retail stores. If sales for the new product are favorable, Dawson has the ability to purchase new equipment for the existing production facility that will expand production to double its current rate. However, Moore is concerned that other companies may easily replicate the product and that low barriers to entry will reduce Dawson’s profitability. If sales for the new product are disappointing after the first two years, Dawson has a potential buyer that will pay $2 million for the production facility. Moore explains these facts to Cora and asks him for help in computing an accurate net present value (NPV) for the project. Cora replies with the following statements: Statement 1: You cannot compute a dollar value for the project that includes both the expansion option and the abandonment option, since only one of them can actually be exercised. Statement 2: Since you do not have any control over what is going on at other companies, you should not factor in the creation of competing products from other companies into your analysis, and focus totally on the incremental cash flows generated from our production of the product. How should Moore respond to Cora’s statements? A) Agree with one only. B) Agree with neither. C) Agree with both -------------------------------------------------------------------------------- Question 8 - 87160 Which of the following statements is most accurate? A) A company that does not adjust the discount rate for differences in project risk is likely to accept an excessive number of low risk projects. B) The financial manager of a large corporation should view stand alone risk as most important because of its impact on debt capacity, credit worthiness, and job stability. C) In a graphical depiction of sensitivity analysis, the project with the steeper line would be considered most risky, because a small error in estimating a variable, such as unit sales, will produce a large error in the net present value’s prediction.
A economic profit = nopat - $WACC 80(1-.3) - 0.08(150) = 44 mil i can’t remember how to get economic income… so A is a guess here but i’ll play the odds. i need to look up economic income, blanking. help. B B C
Corp Fin was the 1st subject I started in Feb. So I might be way off in my thinking. 5.A [S1: FALSE; S2: TRUE] 6.C [NPV better than IRR method (if equal lives and no budgeting constraints)] 7.B [NPV = NPV w/o options + expansion option val - expansion option cost + abandonment option value - abandonment option cost] 8.C (steep slope means more impact in NPV for changes in 1 unit of sensitive-input-factor)
ok i’m on schwser now- let’s learn. A project’s economic income is equal to the after-tax cash flow plus the change in the investment’s market value. Interest is ignored for cash flow calculations and is instead included as a component of the discount rate. so my after tax cash flow here is 80(1-.3) + depreciation of 50 = 106, yes? how do i get the change in the investment’s mkt value? SG HELLLLLLP
first year: 106, for 3 years, 8% ==> 273.17 2nd year: 106, 2 years: 8% -> 189.02 so change in market value = 84.14 Economic income = 106-84.14 = 21.85
Your answer: C was incorrect. The correct answer was A) Agree with one only. To answer the first question, we need to calculate the economic income and economic profit for the first year of the project. Economic income is the after-tax cash flow plus the change in market value for an investment. Cash flow = operating income (1 − T) + depreciation = $80(1 − 0.30) + $50 = $106 million. Next determine the current market value of the project as: (106 / 1.08) + (106 / 1.082) + (106 / 1.083) = $273.17 million. The value after Year 1 = (106 / 1.08) + (106 / 1.082) = $189.03 million. The change in market value = (273.17 − 189.03) = $84.4 million. The economic income is $106 − $84.4 = $21.86 million. Economic profit = NOPAT − $WACC = EBIT(1 − T) − $WACC Economic profit (Year 1) = $80(1 − 0.30) − 0.08($150) = $44 million Huang’s supervisor should disagree with the first statement as the economic profit of $44 million exceeds the economic income of $22 million. Huang’s supervisor should agree with the second statement. The discount rate applied to the economic profit to determine the project’s NPV is the WACC. The economic rate of return using the economic income approach will be equal to the WACC, so the rates are identical. We can take the first year’s economic income divided by the market value of the project and see that the economic rate of return is the same as the WACC. ($22 / $273) = 0.08, or 8%. Your answer: C was incorrect. The correct answer was B) Replacement decisions involve mutually exclusive projects. Because replacement decisions involve either keeping the old asset or replacing the old asset, the projects are mutually exclusive. The decision rule for NPV is to pick the project with the highest positive NPV. Only projects with positive NPV add to the company’s value. If neither project has a positive NPV, neither project should be chosen. Because the WACC is adjusted for inflation, the analyst must adjust project cash flows upward to reflect inflation. If the cash flows are not adjusted for inflation, the NPV will be biased downward. (Reverse the preceding logic for deflation.) Your answer: A was incorrect. The correct answer was B) Agree with neither. Moore should disagree with both of Cora’s statements. Even though both the option to double production and the option to sell the production facility cannot be exercised simultaneously, they both add value to the project and should be both be considered in any analysis. Even if it is difficult to compute an exact dollar value for each option’s contribution to the project, Moore can compute the value for the project without the options, and if the project does not already have a positive NPV, she can estimate whether the option values are enough to make the NPV positive. Cora’s second statement is also incorrect. The reaction from competitors has a definite impact on the potential profitability of the project and must be considered in the analysis. Your answer: C was correct! The steeper the sensitivity analysis profile, the more important it is to accurately forecast that variable’s true level. Financial managers are typically most sensitive to corporate, or within firm risk. Those companies not reducing required returns for projects with lower risk will end up accepting a higher number of high risk projects.
Thx CPK- so that’s not terrible then. just calc out the cash flow and just a little discounting and subtraction gets you to the promised land. i can handle that i think.
Q6 was a complete googly that stumped my center wicket. The cruel act of not having the ‘positive’ word in there made the difference between right and wrong.
swaptiongamma Wrote: ------------------------------------------------------- > Q6 was a complete googly that stumped my center > wicket. The cruel act of not having the ‘positive’ > word in there made the difference between right > and wrong. I actually chose C because there can be two projects that differ in size and timing. If a project that has a shorter life has a lower NPV, that project might actually be preferrable if it is renewable. Best, TheChad