Chapter 13
Practice Quiz 2-Answer Key
- Cotner Clothes Inc. is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: (a) Machine 190-3, which has a cost of $190,000, a 3-year expected life, and after-tax cash flows (labor savings and depreciation) of $87,000 per year; and (b) Machine 360-6, which has a cost of $360,000 a 6-year life, and after-tax cash flows of $98,300 per year. Assume both projects can be repeated. Knitting machine prices are not expected to rise, because inflation will be offset by cheaper components (microprocessors) used in the machines. Assume that Cotner’s cost of capital is 14%. Should the firm replace its old knitting machine, and, if so, which new machine should it use?
- No don’t replace.
- Yes replace: Model 190-3
- Yes replace: Model 360-6- ANSWER
- Zappe Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce net cash flows of $30 million per year. Plane B has a life of 10 years, will cost $132 million, and will produce net cash flows of $25 million per year. Zappe plans to serve the route for 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company’s cost of capital is 12 percent. By how much would the value of the company increase if it accepted the better project?
- $9.26 million
- $10.11 million
- $11.54 million
- $12.76 million-ANSWER
- The Bush Oil Company is deciding to drill for oil on a tract of land that the company owns. The company estimates that the project would cost $8 million today. Bush estimates that once drilled, the oil will generate positive net cash flows of $4 million a year at the end of each of the next 4 years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it would have more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project would cost $9 million. Moreover, if it waits 2 years, there is a 90 percent chance that the net cash flows would be $4.2 million a year for 4 years, and there is a 10 percent chance that the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 10 percent. If the company chooses to drill today, what is the project’s net present value?
- $4.43 million
- $4.68 million-ANSWER
- $4.74 million
- $4.81 million
- Using the information from #3, would it make sense to wait 2 years before deciding whether to drill?
- Yes, wait 2 years
- No, drill today-ANSWER
- Both are equally as good
