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# Initial investment in the product

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Chapter 7(Brealey et al) Practice Problems

1. NPV rule states that you should accept projects with a positive net present value.
a. True
b. False

2. If you're comparing two mutually exclusive projects which both have positive NPV, you should be more attracted to the project with the lower NPV.
a. True
b. False

3. A project with a NPV of \$1 million is preferred over a project with a NPV of \$100,000.
a. True
b. False

4. A project that costs \$3,000 to install will provide annual cash flows of \$800 for each of the next 6 years. Assuming a 10% discount rate, what is the NPV?
a. 384.21
b. 484.21
c. 584.21
d. 684.21

5. A project that costs \$3,000 to install will provide annual cash flows of \$800 for each of the next 6 years. Assuming a 10% discount rate, what is the IRR?
a. 13.3%
b. 14.3
c. 15.3
d. 16.3

6. The payback rule states that a project is acceptable if you get your money back in equal installments.
a. True
b. False

7. NPV and IRR calculations take into consideration the time value of money.
a. True
b. False

8. A project with IRR of 20% is preferred over a project with IRR of 15%.
a. True
b. False

9. If the discount rate is less than the IRR for a project, then NPV will be negative.
a. True
b. False

10. The profitability index = NPV/Initial Investment
a. True
b. False

11. Capital rationing is necessary because of the trade imbalance.
a. True
b. False

Chapter 8 (Brealey et al)

12. When calculating NPV, recognize investment expenditures later when they show up as depreciation, not when they occur.
a. True
b. False

13. Sunk costs will affect a project's NPV.
a. True
b. False

14. Opportunity cost is the same thing as sunk costs.
a. True
b. False

15. An increase in working capital is an investment, and therefore implies a negative cash flow; a decrease in working capital implies a positive cash flow.
a. True
b. False

16. A corporation donates a valuable painting from its private collection to an art museum. Which of the following is positive incremental cash flow associated with the donation for the corporation?
a. The price the firm paid for the painting
b. The deduction from income that it declares for its charitable gift.
c. Reduction in taxes due to its declared tax deduction.
d. The bonus that the CFO gets for his generous idea.

17-20

Revenues generated by a new fad product are forecast as follows:
Year Revenues
1 \$40,000
2 30,000
3 20,000
4 10,000
Thereafter zero

Expenses are expected to be 40% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of \$45,000 in plant and equipment.

17. What is the initial investment in the product? Remember working capital.
a. \$45,000
b. 50,000
c. 53,000
d. 62,000
e. 85000

18. The projects cash flow increases over the life of the project.
a. True
b. False

19. If the plant and equipment were depreciated on a 4 year straight line basis and the firm's tax rate is zero, then cash flow will be impacted by the depreciation.
a. True
b. False

20. If we know what the cash flows are for this project, then IRR can be calculated.
a. True
b. False

21. You can buy a car for \$25,000 and sell it in 5 years for \$5,000. Or you can lease the car for 5 years for \$5,000 per year. The discount rate is 12% per year. Which option is least expensive?
b. Lease
c. Indifferent

Chapter 10

22. Expected return on investment provides compensation to investors both for waiting (the time value of money) and for worrying (the risk of the particular asset).
a. True
b. False

23. In finance, we measure risk of a portfolio of assets by looking at
a. Treasury bills
b. Discount rates
c. Volatility of returns
d. Common stock returns

Chapter 11

24. Under CAPM, what is typically considered the risk free rate?
a. Treasury bill rates
b. Treasury Notes
c. Treasury Bonds
d. Corporate Bonds

25. Using CAPM, if risk free return is 4%, beta is 1.5, and expected market risk premium is 8%, then the expected return is
a. 10%
b. 12
c. 16
d. 18

#### Solution Preview

Chapter 7(Brealey et al) Practice Problems

1. NPV rule states that you should accept projects with a positive net present value.
a. True
b. False

2. If you're comparing two mutually exclusive projects which both have positive NPV, you should be more attracted to the project with the lower NPV.
a. True
b. False

3. A project with a NPV of \$1 million is preferred over a project with a NPV of \$100,000.
a. True
b. False

4. A project that costs \$3,000 to install will provide annual cash flows of \$800 for each of the next 6 years. Assuming a 10% discount rate, what is the NPV?
a. 384.21
b. 484.21
c. 584.21
d. 684.21

5. A project that costs \$3,000 to install will provide annual cash flows of \$800 for each of the next 6 years. Assuming a 10% discount rate, what is the IRR?
a. 13.3%
b. 14.3
c. 15.3
d. 16.3

6. The payback rule states that a project is acceptable if you get your money back in equal installments.
a. True
b. False

7. NPV and ...

#### Solution Summary

This provides the steps to compute the initial investment in the product

\$2.19
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## Investment Decisions

Problems:

1). You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost \$ 5000 and will be posted for one year. You expect that it will generate additional revenue of \$ 500 per month. What is the payback period?

2). Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are \$5 million. The product is expected to generate profits of \$ 1 million per year for ten years. The company will have to provide product support expected to cost \$ 100,000 per year in perpetuity for 10 years. Assume all profits and expenses occur at the end of the year. What is the NPV of this investment if the cost of capital is 6 %? Should the firm under-take the project? Repeat the analysis for discount rates of 2 % and 11 %.

3). You own a coal mining company and are considering opening a new mine. The mine itself will cost \$ 120 million to open. If this money is spent immediately, the mine will generate \$ 20 million for the next ten years. After that, the coal will run out and the site must be cleaned and maintained at environmental standards. The cleaning and maintenance are expected to cost \$ 2 million per year in perpetuity for 10 years. What does the IRR rule say about whether you should accept this opportunity? If the cost of capital is 8 %, what does the NPV rule say?

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