Principles Of Corporate Finance 13th Edition By Richard Brealey – Test Bank

Chapter 11 How to Ensure that Projects Truly Have Positive NPVs

1) The best way to uncover forecasting errors contained within NPV estimates is by looking at

I) book values;
II) historical values;
III) market values

A) I only
B) II only
C) III only
D) I and II only

Answer: C
Difficulty: 1 Easy
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

2) A new grocery store requires $50 million in initial investment. You estimate that the store will generate $5 million of after-tax cash flow each year for five years. At the end of five years, it can be sold for $60 million (ignore taxes). What is the NPV of the project at a discount rate of 10 percent?
A) $2.42 million
B) $10.82 million
C) $6.21 million
D) $2.82 million

Answer: C
Explanation: NPV = −50 + 5/1.1 + 5/(1.12) + 5/(1.13) + 5/(1.1)4 + 65/(1.15) = +$6.21.
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

3) A new grocery store requires $50 million in initial investment. You estimate that the store will generate $5 million of after-tax cash flow each year for five years. At the end of five years, it can be sold for $55 million (ignore taxes). What is the NPV of the project at a discount rate of 10 percent?
A) $2.4 million
B) $5.0 million
C) $3.1 million
D) $0.0 million

Answer: C
Explanation: NPV = −50 + 5/1.1 + 5/(1.12) + 5/(1.13) + 5/(1.14) + 60/(1.15) = +$3.1.
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

4) A rental property is providing an acceptable market rate of return of 13 percent. You expect next year’s rent to be $1 million and that rent is expected to grow at 3 percent per year forever. What is the current value of the property?
A) $7.7 million
B) $10.0 million
C) $33.3 million
D) $50.0 million

Answer: B
Explanation: Value = 1.0/(0.13 − 0.03) = $10 million.
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

5) A building is appraised at $1 million. This estimate is based on forecasted net rent of $100,000 per year discounted at a 10 percent cost of capital [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of repair and maintenance costs and taxes. Suppose the building is currently uninhabitable. It will take one year and $250,000 of work (spent at the end of the year) to bring it into rentable condition. How much would you be willing to pay for the building today?
A) $1,000,000
B) $681,818
C) $750,000
D) $909,090

Answer: B
Explanation: Value at end of year = 100,000/0.1 = $1,000,000.
Value today: (1,000,000 − 250,000)/(1.1) = $681,818.
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

6) USGOLD Company has an opportunity to invest in a gold mine. The initial investment is $250 million. Analysts estimate that the mine will produce 100,000 ounces of gold per year for the next 10 years. The extraction cost of gold is $150 per ounce and is expected to remain at that level. The current price of gold is $600 per ounce and is expected to increase 4 percent per year for the next 10 years. What is the NPV of the project at a discount rate of 10 percent? (Ignore taxes.)
A) −$3.8 million
B) $240.8 million
C) $257.8 million
D) $84.9 million

Answer: C
Explanation: NPV = −250 + (0.1)(600)(10) − (PV of $15 million per year at a 10% discount rate);
NPV = −250 + 600 − 92.2 = $257.8 million.
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

7) Suppose the current price of gold is $600 per ounce. The price of gold is expected to grow 4 percent per year for the foreseeable future. If the appropriate discount rate is 10 percent, then the current value of gold per ounce is
A) less than $600 per ounce.
B) $600 per ounce.
C) greater than $600 per ounce.
D) Not enough information is provided.

Answer: B
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

8) Suppose the current price of gold is $650 per ounce. The price of gold is expected to grow at 5 percent per year for the foreseeable future. If the appropriate discount rate is 8 percent, the present value of gold is
A) less than $650 per ounce.
B) greater than $650 per ounce.
C) $650 per ounce.
D) Not enough information is provided.

Answer: C
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

9) Suppose the current price of gold is $600 per ounce and the price of gold is expected to increase at a rate of 5 percent per year for the foreseeable future. What is the current value of 0.2 million ounces of gold to be produced each year for the next five years (the discount rate is 8 percent per year)?
A) $600.00 million
B) $521.64 million
C) $690.86 million
D) $3,000.00 million

Answer: A
Explanation: Current value = (0.2)(5)(600) = 600 million.
Difficulty: 2 Medium
Topic: Net Present Value
Learning Objective: 11-01 How Firms Organize the Investment Process
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

10) Goldsmith Labs recovers gold from printed circuit boards. It has developed new equipment for this purpose. You have the following data.
(1) The equipment costs $250,000.
(2) It costs $200,000 per year to operate.
(3) It has an economic life of five years and is depreciated using the straight-line method.
(4) It will recover 300 ounces of gold per year.
(5) The current price of gold is $900 per ounce.
(6) The tax rate is 30 percent.
(7) The cost of capital is 8 percent.

What is the NPV of installing this equipment?
A) $430,400
B) $520,510
C) $470,400
D) $195,911

Answer: D
Explanation: To find NPV: Subtract equipment cost; add in PV of depreciation tax effect; add in after-tax PV of revenue from gold recovery; and subtract PV of after-tax costs of operation.
= −250,000 + [PV of (0.3)(50,000) for five years at 8%] + (5)(900)(300)(1 − 0.3) − PV of (1 − 0.3)(200,000) for five years at 8%;
= −250,000 + 59,890 + 945,000 − 558,979;
= 195,911.
Difficulty: 3 Hard
Topic: Net Present Value
Learning Objective: 11-02 Look First to Market Values
Bloom’s: Apply
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation