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Page 13

Chapter 12 - Page 13



13. Optimal capital budget and divisional risk Answer: c Diff: E

Find the WACCs using both John’s and Becky’s methods. (WACC = ks because

there is no debt).


John’s WACC for Division B based on overall company’s beta:

k = kRF + RPM(b)

k = 5% + 5%(1.2)

k = 5% + 6%

k = 11%.


Therefore, John would only choose Project 1, because it is the only project

whose IRR exceeds its cost of capital. Consequently, the firm’s capital

budget (based on John’s WACC) is only $400 million.


Becky’s WACC for Division B:

k = kRF + RPM(b)

k = 5% + 5%(0.9)

k = 5% + 4.5%

k = 9.5%.


Becky would choose projects 1, 2, 3, and 4 because all of these projects have

an IRR that exceeds the Division’s 9.5 percent cost of capital. Based on

Becky’s WACC, the firm’s capital budget would be $1,270 million ($400 + $300 +

$250 + $320). Therefore, the firm’s capital budget based on Becky’s WACC is

$870 million ($1,270 - $400) larger than the one based on John’s WACC.



14. Replacement chain Answer: b Diff: E

Step 1: Determine each project’s cash flows during the 4-year period.


Year Project A Cash Flows Project B Cash Flows

0 ($120,000) ($100,000)

1 80,000 41,000

2 80,000 – 125,000 = (45,000) 41,000

3 80,000 41,000

4 80,000 41,000


Step 2: Determine each project’s NPV by entering the cash flows into the

cash flow register and using 10 percent for the cost of capital.


NPVA = $30,283.45  $30,283.

NPVB = $29,964.48  $29,964.


Therefore, Jayhawk should select Project A since it adds more

value.

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Chapter 12 - Page 23















35. Value of abandonment option Answer: e Diff: M

No abandonment:


Yr. 0 Prob 

1 2 3 4 5 Prob NPV NPV

| | | | |

110,000 110,000 110,000 110,000 110,000 0.5 $146,525 $73,263

-250,000

25,000 25,000 25,000 25,000 25,000 0.5 159,881 –79,941

E(NPV) = $-6,678

0.5

0.5




Abandonment:


Yr. 0 Prob 

1 2 3 4 5 Prob NPV NPV

| | | | |

110,000 110,000 110,000 110,000 110,000 0.5 $146,525 $73,263

-250,000

125,000 0.5 -138,393 –69,196

E(NPV) = $ 4,067

Value of Abandonment =

$4,067 – (-$6,678) = $10,745

0.5

0.5


36. New project NPV Answer: e Diff: E N

We can solve for NPV by entering the following data into the cash flow

register.


CF0 = -25000000; CF1 = 10000000; CF2 = 10000000; CF3 = 10000000; CF4 =

10000000; I/YR = 10; and then solve for NPV = $6,698,654  $6,700,000.



37. Investment timing option Answer: c Diff: M N

Fair will only invest if market conditions are favorable, hence the 20%

chance of receiving $2 million annual cash flows is really 0% because

the NPV < 0. Therefore, the NPV of the project as of t = 1, can be

found using the calculator and entering the following data:


CF0 = -26000000; CF1 = 12000000; CF2 = 12000000; CF3 = 12000000; CF4 =

12000000; I/YR = 10; and then solve for NPV = $12,038,385. But, there

is only an 80% chance of this occurring so expected NPV = 0.8 

$12,038,385 = $9,630,708.

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