The following forecasts have been prepared for a new investment by Oxford Industries of $20 million with an 8-year life:Assume that Oxford employs straight-line depreciation, and that they are taxed at 35%. Assuming an opportunity cost of capital of 14%, what is the NPV of this project, based on expected outcomes?
Answer(s): B
The first step is to calculate the annual cash flows from the project for the base case (the expected values). These may be calculated as shown:This level of cash flow occurs for each of the 8 years of the project. The present value of an 8-year, $1 annuity is 4.639 at 14%. The NPV of the project is therefore given by:
Drillers Inc. is evaluating a project to produce a high-tech deep-sea oil exploration device. The investment required is $80 million for a plant with a capacity of 15.000 units a year for 5 years. The device will be sold for a price of $12,000 per unit. Sales are expected to be 12,000 units per year. The variable cost is $7,000 and fixed costs, excluding depreciation, are $25 million per year. Assume Drillers employs straight-line depreciation on all depreciable assets, and assume that they are taxed at a rate of 36%. If the required rate of return is 12%, what is the approximate NPV of the project?
Assume that the probability distribution of Nap's is normal. The firm considers true risk occurring if the project results in a NPV that is zero or less. If the expected NPV is $1,000 and the standard deviation of NPV is $500, what is the probability that the project has an NPV of 0 or less?
Answer(s): A
Since three standard deviations incorporate over 99% of all observations, and two standard deviations incorporate over 95% of observations, it means less than 5% will not be included within two standard deviations, and this is divided between both ends of the normal curve. Therefore, less than 2.5% of the observations will be in the negative portion of the curve.
Project 1 has an expected NPV of $120,000 and a standard deviation of $200,000. Project 2 has an expected NPV of $100,000 and a standard deviation of $150,000. The correlation between these two projects is 0.80. What is the coefficient of variation for the portfolio of projects?
Answer(s): C
The coefficient of variation is useful when the rates of return and standard deviations of two investments differ. It measures the risk per unit of return by dividing the standard deviation by the expected return. Thus, for Project 1, dividing $200,000 by $120,000 produces a coefficient of 1.67. For Project 2, the calculation is to divide $150,000 by $100,000, or 1.50. If the two projects had perfect correlation (=1.0), then you could combine the calculations ($350,000 + $220,000 = 1.59). However, with a correlation of less than one, the risk will be something less than 1.59.
When using the net present value method for capital budgeting analysis, the required rate of return is called all of the following except the
The rate used to discount future cash flows is sometimes called the cost of capital, the discount rate, the cutoff rate, or the hurdle rate. A risk-free rate is the rate available on risk-free investments such as government bonds. The risk-free rate is not equivalent to the cost of capital because the latter must incorporate a risk premium.
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