Concept explainers
a)
Case summary:
Company S considering adding a new line to its product mix and the production line would be set up in unused space in the main plant. It has installed machinery which generates the incremental sales of $1,250 units per year.
Due to this the sale price and cost prices are increased by 3% and firm’s net working capital would have to increase by an amount equal to 12% of sales revenues.
To discuss: Whether Company S new line would be classified as high risk or low risk or average risk when its coefficient of variation ranges in between 0.2 to 0.4 and discuss the type of risk is being measured in this case.
b)
To discuss: Whether the new line will be accepted or not, if Company S adds or subtracts 3% points to overall cost of capital to adjust for risk.
c)
To discuss: Whether any subjective risk factors should be considered before making final decision.
Want to see the full answer?
Check out a sample textbook solutionChapter 13 Solutions
Intermediate Financial Management (MindTap Course List)
- Porbandar plc is considering the investment in a project that has an initial cash outlay followed by a series of net cash inflows. The business applied the NPV and IRR methods to evaluate the proposal but, after the evaluation had been undertaken, it was found that the correct cost of capital figure was lower than that used in the evaluation. What will be the effect of correcting for this error on the NPV and IRR figures? Effect on NPV Effect on IRR A Decrease Decrease B Decrease No Change C Increase No Change D Increase Increasearrow_forwardLaramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Project Risk Expected Return A High 15% B Average 12% C High 11% D Low 9% E Low 6% Which set of projects would maximize shareholder wealth? Group of answer choices A and B. A, B, C, D, and E. A, B, and D. A, B, C, and D. A, B, and C.arrow_forwarda. If NPV is negative, company usually rejects the project. While, if ARR is greater than cost of capital, company accept the project. Last, if Profitability index is greater than 1, accept the project.b. If IRR on investment is zero, its annual cash flows is equal to its required investment. A• FF B• TT C• TF D• FTarrow_forward
- For a typical project evaluation with initial investment at time=0 and positive cash flows afterwards, each statement in the following shows possible answers in parenthesis. Choose the answer that shows correct answers for all statements. Statement 1: When NPV = 0, investors earn (negative/zero/positive) return. Statement 2: Accept the project when valuation is (higher/the same/lower) than the cost. Statement 3: When IRR> cost of capital, NPV is (negative/zero/positive). Statement 4: Cost of capital is determined by the (company/investors) considering the (business risk/systematic) risk) a. negative, higher, positive, investors and systematic b. positive, lower, positive, investors and business c. positive, higher, zero, company and systematic d. positive, higher, positive, investors and systematicarrow_forwardIf two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking of mutually exclusive projects?Note: DONOT GIVE BREIF ANSWER USE SHORT CONCEPTUAL ANSWERarrow_forwardAs a financial analyst, you are tasked with evaluating a capital-budgeting project. You were instructed to use the IRR method, and you need to determine an appropriate hurdle rate. The risk-free rate is 4%, and the expected market rate of return is 11%. Your company has a beta of 0.75, and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be A. 15%. B. 9.25%. C. 4%. D. 11%. E. 0.75%arrow_forward
- Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average-, high-, and low-risk projects?arrow_forwardSuppose a firm uses a constant WACC in determining the value of capital budgeting projects rather than using a project beta. The firm will tend to A. accept profitable, low risk projects and reject unprofitable, high risk projects B. accept profitable, low risk projects and accept unprofitable, high risk projects C. reject profitable, low risk projects and accept unprofitable, high risk projects D. reject profitable , low risk projects and reject unprofitable, high risk projectsarrow_forwardWhich of the following statements is true about the internal rate of return? a. It is the interest rate that sets a project's net present value at zero. b. It is the minimal acceptable interest rate on an investment. c. It is the difference between the present value of the cash inflows and outflows associated with a project. d. It is the difference between the present value of a cash outflow and the depreciation associated with an asset.arrow_forward
- Consider the relationship between a project’s net present value (NPV), its internal rate of return (IRR), and a company’s cost of capital. For each scenario that follows, indicate the relative value of the unknown. If cost of capital is unknown, indicate whether it would be higher or lower than the stated IRR. If NPV is unknown, indicate whether it would be higher or lower than zero. Project 1 is shown as an example.arrow_forwardIf a net present value analysis for a normal project gives an NPV greater than zero, an internal rate of return calculation on the same project would yield an internal rate of return ____ the firm's cost of capital.a. greater thanb. less thanc. equal tod. cannot be determined from the information givenarrow_forwardThe WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is only an appropriate discount rate for a project of average risk—in other words, a project that has the same beta as the company. If a project has less risk than the overall company risk, it should be evaluated with a lower discount rate; if a project is riskier than the overall company risk, it should be evaluated using a discount rate higher than the company WACC. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%.…arrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning