Business Finance
BUSI 3360 Finance for Business Quiz Questions

BUSI 3360

BUSI

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Please complete Quiz2 using the method in the courseware. I posted the related documents below, please contact me if you have any questions

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FINANCE 1 – BUSI 3360 Quiz #2 Due March 23rd by 6pm. 1) Best Darn Glasses (BDR) is thinking of investing in a sandblasting machine for its glassware. It provides you with the following information: The initial investment for this project would be $235,000 in specialized machinery. According to CRA, this machine falls into a CCA class of 8%. There is the possibility of salvage of $6,000, although it’s not for sure. The risk-adjusted cost of capital is 12% and the company’s tax rate is 25%. Calculate the CCA tax shield under both scenarios – with and without salvage. 2) Using the information from above, calculate the project’s NPV if the following information were also provided to you: Cost of maintenance of the sandblasting machine is $35,000 per year, and the machine will only last 10 years. The salvage value, at that point, will be zero. The company’s revenues will be $170,000 per year with direct production costs of $27,000. Please show all calculations and workings. If you are going to use Excel, please put both questions on the same sheet. You may also use Word. Please also name your file with your name before you submit it. Chapter 8 Net Present Value and Other Investment Criteria Prepared by Tanya Willis Saint Mary’s University © 2016 McGraw-Hill Education Limited Chapter 8 - 1 After studying this chapter, you should be able to:      LO1 Calculate the net present value of an investment. LO2 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. LO3 Explain why the payback and discounted payback rules don’t always make shareholders better off. LO4 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. LO5 Calculate the profitability index and use it to choose between projects when funds are limited. © 2016 McGraw-Hill Education Limited Chapter 8 - 2  Capital budgeting is the process that companies use for decision making on capital projects — those projects with a life of a year or more. ◦ Replacement projects  The easier capital budgeting decision. ◦ Expansion projects  May involve more uncertainties than expansion projects. ◦ New products and services  Involve even more uncertainties than any other projects ◦ Regulatory, safety and environmental projects  May generate no revenues but may incur significant costs ◦ Other  Pet projects of someone Source: Clayman, Fridson and Troughton (2012) 8-17  Some important capital budgeting concepts: ◦ Sunk costs  Costs that have already been incurred ◦ Opportunity costs  What a resource is worth in its next-best use ◦ Incremental cash flow  Cash flow with a decision minus the cash flow without the decision; the additional operating cash flow that a company receives from taking on a new project. ◦ Externality  Cannibalization ◦ Conventional vs Nonconventional cash flows Source: Clayman, Fridson and Troughton (2012) 8-19  Several types of project interactions make the incremental cash flow analysis challenging: ◦ Independent vs. mutually exclusive projects  Independent projects are projects whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. ◦ Project sequencing  Many projects are sequenced through time, so that investing in a project creates the option to invest in future project. ◦ Unlimited funds vs capital rationing  Capital rationing exist when the company has a fixed amount of funds to invest. Source: Clayman, Fridson and Troughton (2012) 8-20 • CF = Cash flow • NPV = Net present value • IRR = Internal rate of return 8-22  Capital Budgeting is the process of determining what investments will maximize the value of the firm. ◦ Suppose, you are given the opportunity to buy a building today for $350,000 and a guarantee of being able to sell it next year for $400,000. Should you take it? 0 1 r% -$350,000 $400,00 0 ? LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 3 What discount rate do we use to value this stream of cash flows? What else could we have done with the $350,000? What other opportunity are we giving up by investing in the building?    What if the interest rate on the risk-free T-bill is 7%? 0 1 7% -$350,000 $400,000 $400,000/(1+0.07) = $373,832 NPV = $23,832 LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 4   NPV = PV of cash flows minus initial investment. Expected rate of return given up by investing in a project is the opportunity cost of capital. Ct C1 C2 NPV = C0 + + + ... + 1 2 (1 + r ) (1 + r ) (1 + r )t Where: Ct = Cash flow at time t r = Opportunity cost of capital LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 5  Risk and Present Value ◦ The discount rate used to discount a set of cash flows must match the risk of the cash flows. ◦ Instead of being risk-free, if the building investment in the previous example was estimated to be as risky as the stock market yielding 12%, the NPV would be: NPV =PV – C0 = [$400,000/(1+.12)] - $350,000 = $357,143 - $350,000 = $7,143 LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 6  Valuing long lived projects: ◦ The NPV rule works for projects of any duration. ◦ The critical problems in any NPV problem are to determine:  The amount and timing of the cash flows  The appropriate discount rate  Net Present Value Rule: ◦ Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. ◦ Therefore, they should accept all projects with a positive net present value. LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 7  Example: A company is considering the purchase of a piece of production equipment to increase volume. The equipment has a cost of $500,000 and will produce annual cash flows over the next 3 years of $150,000 in year 1, $200,000 in year 2, and $250,000 in year 3. If the required return on investment is 10%, should the company purchase the equipment? NPV = C0 + Ct C1 C2 + + ... + (1 + r )1 (1 + r ) 2 (1 + r ) t 150,000 200,000 250,000 NPV = −500,000 + + + 1 2 (1.10) (1.10) (1.10) 3 NPV = −500,000 + 136,364 + 165,289 + 187,829 NPV = −500,000 + 489481 = −10,519 LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 8  Using the NPV Rule to Choose Among Projects ◦ Most companies must choose between multiple projects. If doing one project precludes you from doing the other the projects are said to be mutually exclusive. ◦ If projects are mutually exclusive, determine NPV and choose the project with the higher positive NPV. LO1 © 2016 McGraw-Hill Education Limited Chapter 8 - 9  Other criteria are sometimes used by firms when evaluating investment opportunities.  Most commonly used alternatives are: Payback, Discounted Payback and Internal Rate of Return (IRR)  Payback and Discounted payback are rough guides to an investment’s worth and often give an incorrect decision.  Internal rate of return will usually lead to the same decision as NPV however there are exceptions. LO2, LO3 © 2016 McGraw-Hill Education Limited Chapter 8 - 10  Payback ◦ Payback is the time period it takes for the cash flows generated by the project to cover the initial investment in the project. If the payback period is less than a specified cutoff point, the project should be accepted. LO3 © 2016 McGraw-Hill Education Limited Chapter 8 - 11  Example: A company has the following three investment opportunities. The company accepts all projects with a 2 year or less payback period and uses a 10% discount rate. Project C0 C1 C2 C3 A -2,000 +1,000 +1,000 +10,000 B -2,000 +1,000 +1,000 - C -2,000 - +2,000 - LO3 © 2016 McGraw-Hill Education Limited Chapter 8 - 12 Project C0 C1 C2 C3 Payback NPV @ 10% A -2,000 +1,000 +1,000 +10,000 2 $7,249 B -2,000 +1,000 +1,000 - 2 -$264 C -2,000 - +2,000 - 2 -$347 Although all the projects have a payback period of 2 years and are therefore acceptable, the use of NPV shows us that only the first project will create value for the shareholders. Therefore, only Project A should be chosen. LO3 © 2016 McGraw-Hill Education Limited Chapter 8 - 13  Discounted Payback Period ◦ Discounted payback is the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project. The acceptance rule is still the same – the discounted payback should be less than a pre-set cutoff point. ◦ Although better than payback, it still ignores all cash flows after an arbitrary cutoff date. ◦ Therefore it will reject some positive NPV projects. LO3 © 2016 McGraw-Hill Education Limited Chapter 8 - 14  Example: A company has the following cash flows. If the cut-off is 2 years, should the project be accepted? Year CF Discounted CF Cumulative Discounted @ 10%, $ CF @ 10%, $ 0 -2,000 -2,000 -2,000 1 +1,000 909 1,091 2 +1,000 827 264 3 +10,000 7513 +7,249 NPV=7,249 LO3 © 2016 McGraw-Hill Education Limited Chapter 8 - 15  Internal Rate of Return (IRR) ◦ IRR is the discount rate at which the NPV of the project equals zero. ◦ A project is acceptable if the IRR is more than the cost of capital of the project. ◦ Recall the NPV example we used earlier, where the NPV was $23,832 at a discount rate of 7% and $7,143 at a rate of 12%. ◦ At what discount rate will the NPV be equal to 0? LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 16  IRR Calculation: If we solve for the “r” in the equation below, we will find the IRR. NPV = C0 + C1 (1 + r )1 400,000 (1 + r )1 r = .142857  14.3% 0 = −350,000 + Another way of finding IRR is using the NPV profile. By finding out where the profile crosses the X axis, we can find out the IRR. LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 17 LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 18 For a multi-period case, we can solve the IRR either by trial and error or by a financial calculator. ◦ Example: You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? ◦ We can picture the project in the following way:  0 -$350,000 1 $16,000 3 2 $16,000 $466,000 LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 19  In this case, what we are trying to do is to solve the following equation: 16,000 16,000 466,000 0 = − 350,000 + + + 1 2 (1 + IRR ) (1 + IRR ) (1 + IRR ) 3 • By trial and error or by financial calculator, we find: IRR = 12.96% LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 20  Borrowing vs. Lending: ◦ Let’s say project J involves lending $100 at 50% interest. Project K involves borrowing $100 at 50% interest. Which one will you choose?  According to the IRR rule, both projects have a 50% rate of return and are thus equally desirable.  However, you lend in Project J, and earn 50%; you borrow in Project K, and pay 50%.  Pick the project where you earn more than the opportunity cost of capital. LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 21  Mutually Exclusive Projects – Timing of Cash Flows: ◦ Calculate the IRR and NPV for the following projects: ◦ Cash flows in $000’s Project C0 H I C1 C2 C3 IRR NPV @ 7% -350 400 - - 14.29% $24,000 -350 16 16 466 12.96% $59,000 Project H has a higher IRR but is not the best choice at a discount rate of 7% as NPV is higher for Project I. LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 22  The decision depends on the discount rate used. If we plot the NPV of each project as a function of the discount rate, the two profiles cross at an interest rate of 12.26%.  At discount rates above 12.26%, project H with its rapid cash inflow would provide a higher NPV. At discount rates below 12.26%, project I, with more total cash flow but received later, would provide a higher NPV.  LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 23  Mutually Exclusive projects – Size of Project ◦ A small project may have a high IRR but a low NPV. ◦ A large project may have a low IRR but a high NPV.  Example: Would you rather earn 50% on a $1 investment or 10% on a $100 investment? LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 24  Multiple Rates of Return: ◦ Projects with cash flows that change direction more than once, will have more than one discount rate at which the NPV will be zero. That means, there are multiple IRRs for projects with nonconventional cash flows. ◦ The IRR rule would not work in this case; NPV works! LO2 © 2016 McGraw-Hill Education Limited Chapter 8 - 25  Choosing between competing projects can be tricky. We will look at three important but challenging problems: ◦ The Investment timing project ◦ The choice between long- and short-lived equipment ◦ The replacement problem LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 26    Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. The decision rule is to choose the investment date that results in the highest NPV today. Example: ◦ You can buy a computer system today for $50,000 which will last 4 years from date of installment. Based on the PV of savings it provides to you ($70,000), the NPV of this investment is $20,000. ◦ However, you know that these systems are dropping in price every year. ◦ When should you purchase the computer? LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 27 The decision rule for investment timing is to choose the investment date that results in the highest NPV today. LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 28  Suppose you must choose between buying two machines with different lives.  Machines D and E are designed differently, but have identical capacity and do the same job.  Machine D costs $15,000 and lasts 3 years. It costs $4,000 per year to operate.  Machine E costs $10,000 and lasts 2 years. It costs $6,000 per year to operate. ◦ Which machine should the firm acquire? LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 29 Costs, $000s Machine C0 C1 C2 C3 PV of costs @ 6% Machine D 15 4 4 4 25.69 Machine E 10 6 6 - 21.00 We cannot compare the PV of costs of assets with different lives. LO4 © 2016 McGraw-Hill Education Limited Chapter 8 – 30  For comparing assets with different lives, we need to compare their Equivalent Annual Costs (EAC).  The Equivalent Annual Cost is the cost per period with the same PV as the cost of buying and operating the machine. LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 31 Calculating equivalent annual cost for Machine D  Machine Co C1 C2 C3 Machine D 15 4 4 4 $25.69 ? ? ? $25.69 Equivalent Annual Cost PV @ 6% The equivalent annual cost is calculated as follows: Equivalent Annual Cost = PV of Costs / Annuity Factor = $25.69 / 3 Year Annuity Factor = $25.69 / 2.673 = $9.61 per year LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 32   If mutually exclusive projects have unequal lives, then you should calculate the equivalent annual cost of the projects. Picking the lowest EAC allows you to select the project which will maximize the value of the firm. Machine PV @ 6% Equivalent Annual Cost D $25.69 $9.61 E $21.00 $11.45 LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 33  Example: ◦ You are operating an old machine that will last two more years before it will be worthless. ◦ It costs $12,000 per year to operate. ◦ You can replace it now with a new machine, which costs $25,000 but is much more efficient ($8,000 per year in operating costs) and will last for five years. ◦ Should you replace it now or wait a year? ◦ The opportunity cost of capital is 6%. LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 34 Year 0 New Machine -25 Equivalent 5-year annuity     1 2 3 4 5 PV @ 6% 8 8 8 8 8 58.70 13.93 13.93 13.93 13.93 13.93 58.70 Cash flow will be $13,930 for new machine Cash flow will be $12,000 for old machine Why replace an old machine with a new one that will cost $1,930 more to run? Decision: Do not replace - wait the two years. LO4 © 2016 McGraw-Hill Education Limited Chapter 8 - 35  We refer to the limit set on the amount of funds available for investment as capital rationing. A limit may be set for 2 reasons:  Soft Rationing: Imposed by the senior management.  Hard Rationing: Imposed by the unavailability of capital in the market. For example, the limit set during the 2008 credit crunch crisis. LO5 © 2016 McGraw-Hill Education Limited Chapter 8 - 36  Example: A company has an opportunity cost of capital of 10% and total resources of $20 million. Which projects should the firm select? Cash Flows, $ Millions Project C0 C1 C2 PV @ 10% NPV L -3 +2.2 +2.42 $4 $1 M -5 +2.2 +4.84 6 1 N -7 +6.6 +4.84 10 3 O -6 +3.3 +6.05 8 2 P -4 +1.1 +4.84 5 1 LO5 © 2016 McGraw-Hill Education Limited Chapter 8 - 37    The solution is to pick the projects that give the highest NPV per dollar of investment. We do this by calculating the Profitability Index: The ratio of NPV to initial investment. The company will select the projects with the highest possible NPV within the budget. LO5 © 2016 McGraw-Hill Education Limited Chapter 8 - 38 Project PV Investment NPV PI Decision L $3 $3 $1 1/3=.33 accept M 5 5 1 1/5=.20 reject N 7 7 3 3/7=.43 accept O 6 6 2 2/6=.33 accept P 4 4 1 1/4=.25 accept All projects would be acceptable if sufficient funds were available. • Project N with highest PI is picked first. • Projects L and O are picked next, both with PI of .33. • Project P is last with a PI of .25 • These 4 projects add up to $20 million (the budget) and will provide the highest increases in value to shareholders. LO5 © 2016 McGraw-Hill Education Limited Chapter 8 - 39  Profitability Index will not always be reliable when choosing between mutually exclusive projects (just like with IRR). • • A small project may have a high PI but a low NPV. A large project may have a low PI but a high NPV.  A higher NPV is always preferable to a higher PI. LO5 © 2016 McGraw-Hill Education Limited Chapter 8 - 40  NPV is the best decision criteria.  It tells you whether an investment will increase the value of the firm and by how much.  The only exception is when the firm is facing capital rationing.  Despite the advantages of discounted cash flow methods, many corporations use payback. © 2016 McGraw-Hill Education Limited Chapter 8 - 41 © 2016 McGraw-Hill Education Limited Chapter 8 - 42  NPV measures the difference between a projects cost and its benefits (all in today’s dollars).  It is the only measure which always gives the correct decision when evaluating projects.  IRR is the discount rate that results in an NPV of zero. The project should be accepted if the IRR exceeds the opportunity cost of capital. © 2016 McGraw-Hill Education Limited Chapter 8 - 43  Be careful using IRR when: (1) early cash flows are positive, (2) more than one change in the sign of the cash flows occurs, or (3) projects are mutually exclusive.  Payback and discounted payback methods ignore cash flows that occur beyond ...
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Running head: CCA TAX AND NVP ASSIGNMENT

CCA Tax and NVP Assignment
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CCA TAX AND NVP ASSIGNMENT

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CCA Tax and NVP Assignment
Question 1
Salvage value is given by = 𝑃 (1 − 𝑖)𝑦 ; where p is the original cost of the asset, I is the
depreciation rate, and y is the number of years.
Part a)
Assuming the salvage value = 0 then the tax shield will be calculated as follows:
Value of tax shield given

C...

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