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Working Capital Management and Capital Budgeting

Working Capital Management and Capital Budgeting
Objective: Evaluate alternative capital projects.
10. Consider a project with the following cash flows:
After-Tax After-Tax
Accounting Cash Flow
Year Profits from Operations
1 $799 $ 750
2 $150 $1,000
3 $200 $1,200
Initial outlay = $1,500
Terminal cash flow = 0
Compute the profitability index if the company's discount rate is 10%.
a. 15.8
b. 1.61
c. 1.81
d. 0.62
Objective: Analyze risks associated with capital projects.
11. Aroma Candles, Inc. is evaluating a project with the following cash flows. Calculate the IRR of the project. (Round to the nearest whole percentage.)

Year Cash Flows
0 ($120,000)
1 $ 30,000
2 $ 70,000
3 $ 90,000
a. 18%
b. 23%
c. 28%
d. 33%
Objective: Identify the decision-making factors in lease versus buy.
12. A machine costs $1,000, has a three-year life, and has an estimated salvage value of $100. It will generate after-tax annual cash flows (ACF) of $600 a year, starting next year. If your required rate of return for the project is 10%, what is the NPV of this investment? (Round your answerer to the nearest $10.)
a. $490
b. $570
c. $900
d. -$150
Long-Term Financing
Objective: Identify the impact of financing strategies on cost of capital.
13. When calculating the average cost of capital, which of the following has to be adjusted for taxes?
a. Common stock
b. Retained earnings
c. Debt
d. Preferred stock
Objective: Calculate the weighted average cost of capital (WACC) of a firm.
14. Armadillo Mfg. Co. has a target capital structure of 50% debt and 50% equity. They are planning to invest in a project which will necessitate raising new capital. New debt will be issued at a before-tax yield of 12%, with a coupon rate of 10%. The equity will be provided by internally generated funds. No new outside equity will be issued. If the required rate of return on the firm's stock is 15% and its marginal tax rate is 40%, compute the firm's cost of capital.
a. 13.5%
b. 12.5%
c. 7.2%
d. 11.1%

Solution Preview

Working Capital Management and Capital Budgeting
Objective: Evaluate alternative capital projects.
10. Consider a project with the following cash flows:
After-Tax After-Tax
Accounting Cash Flow
Year Profits from Operations
1 $799 $ 750
2 $150 $1,000
3 $200 $1,200
Initial outlay = $1,500
Terminal cash flow = 0
Compute the profitability index if the company's discount rate is 10%.
a. 15.8
b. 1.61
c. 1.81
d. 0.62
Profitability Index = PV of cash flows / Initial investment
We consider the after tax cash flows in capital budgeting since investors have to be repaid in cash.
PV of after tax cash flows = 750/1.1 + 1,000/1.1^2 + 1,200/1.1^3 = 2,410
Initial Investment = 1,500
Profitability Index = 2,410/1,500 = 1.61
Objective: Analyze risks associated with capital ...

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