Title 4.5 Capital Investments and Capital Allocation.pdf ✅

1. A company is building a new plant. The NPV of the plant is projected to be €8 million if demand is high, and −€3 million if demand is low. Both scenarios are equally likely. The company has also secured a 1-year lease on some adjoining land, with an option to buy, to expand the facility if demand is high. The costs of the lease and expected cash flows from the expansion option are: Option cost (1-year lease expense) 0.5 million Annual net cash inflows over 5 years (Years 2–6), if exercised 0.4 million Required rate of return 8% The value of the plant with the option (in EUR) is closest to: A. 2.50 million.  B. 2.74 million. C. 3.48 million. Explanation  HP 12c  TI BA II Plus Real option classifications Real option type Flexibility offered to: Timing Delay an investment decision until more information becomes available (eg, project sequencing) Fundamental Undertake projects only when fundamentals of underlying asset are favorable (eg, oil refineries) Sizing Abandon a project (ie, abandonment option) Expand (ie, growth option) Price-setting Increase prices with demand Production-flexibility Change output volume Use alternative input Produce different output A real option arises during normal business activities or operations when management has some flexibility in the investment decision process. Real options give management either: timing flexibility (ie, timing or fundamental options) or operational flexibility (ie, sizing options, pricing options, or production flexibility options). When evaluating investment projects, management should consider if there are any real options linked to a project, and the value that they add to the project. In this instance, the lease is a production-flexibility option that allows management to alter production capacity to manage demand-supply mismatches. It will be exercised only when demand is high, of which there is a 50% probability. The NPV of the plant with the option is calculated as the NPV without options, adjusted for the cost and value of the option, as follows: Step 1: Determine the value of the plant without the option by summing the NPV under the different scenarios: Expected NPV = P (NPV ) + P (NPV ) = 0.5 (8.0 million) + 0.5 (−3.0 million) = €2.5 million Step 2: Calculate the NPV of cash flows from the option if exercised: Step 3: Determine the NPV of the plant with the option: = NPV without options − Cost of options + Value of options where the option's value accounts for the probability of high demand = 2.5 − 0.5 + 0.5(1.48) = €2.74 million (Choice A) €2.50 million is the expected NPV of the plant without the option. (Choice C) €3.48 million results from ignoring the probability that demand level might remain low, whereby the option would not have any additional value. Describe types of real options relevant to capital investments LOS high demand high demand low demand low demand
2. A corporation is evaluating two projects with the following cash flows (INR million): Year 0 1 2 3 Project 1 −10 3 6 8 Project 2 −10 8 6 3 Project 1 has a required rate of return of 3% and an internal rate of return (IRR) of 26.9%, while Project 2 has a required rate of return of 8% and an IRR of 38.8%. If the projects are mutually exclusive, the most appropriate investment decision is to invest in:  A. Project 1. B. Project 2. C. both projects. Explanation  HP 12c  TI BA II Plus Net present value (NPV) analysis evaluates investments based on the present value of a project's cash flows. NPV is the difference between the present values of the project's cash outflows and inflows. The projected cash flows are discounted to the present using the required rate of return (r) as the discount rate. As a result, projects with a positive NPV add to company value. Project 1 is the most appropriate investment choice in this scenario since it has a higher NPV than Project 2 and will therefore add more shareholder value to the corporation. (Choice B) Project 2 seems to be the better choice based on its higher internal rate of return (IRR); however, the NPV is a superior decision criterion since NPV measures the actual value added to the company, whereas IRR measures a percentage return. A project can have a higher percentage return but a smaller NPV, based on the timing of the cash flows and their discount rate, resulting in less value added to the corporation. (Choice C) Since the projects are mutually exclusive, the corporation cannot invest in both projects, although each has a positive NPV and would add value. Things to remember: Net present value (NPV) is the difference between the present value of a project's cash inflows and outflows. NPV is a superior investment criterion to IRR since it measures actual value added to a company, whereas IRR measures a percentage return. Describe the capital allocation process, calculate net present value (NPV), internal rate of return (IRR), and return on invested capital (ROIC), and contrast their use in capital allocation LOS Copyright © UWorld. Copyright CFA Institute. All rights reserved.
3. A street vendor sells pizza from a food truck. To accommodate rapidly rising customer demand, the vendor seeks to replace the food truck with a much larger restaurant building. Which of the following capital budgeting categories best describes this project? A. Regulatory  B. Expansion C. Replacement Explanation Categories of capital projects Project type Rationale for undertaking project Replacement To replace existing equipment due to wear and tear, or to improve efficiency Expansion To expand business volume through scaling New products and services To produce new products and provide new services Regulatory, safety, and environmental To comply with regulation Capital projects take years to complete and require large amounts of monetary investment. Companies group capital projects into various categories, as shown above. In this scenario, the vendor plans to scale up the business by moving it into a restaurant building that would be much larger than the truck. This expansion project would allow the vendor to meet growing demand for the product and increase sales. (Choice A) The vendor is not undertaking the project for regulatory compliance purposes. (Choice C) Replacement projects are undertaken when existing equipment is worn out. In this scenario, the food truck is being replaced with a restaurant building due to rising customer demand, not due to equipment wear and tear. Things to remember: Companies group capital projects into various categories: replacement projects; expansion projects; new products and services; and regulatory, safety, and environmental projects. An expansion project is undertaken when a business needs to scale up its sales volume. Describe types of capital investments LOS Copyright © UWorld. Copyright CFA Institute. All rights reserved.
4. A company is using net present value analysis to evaluate an investment that it will finance with borrowed funds. The most appropriate discount rate to use in evaluating the project is the: A. project's internal rate of return.  B. project's opportunity cost of funds. C. cost of debt capital borrowed to finance the project. Explanation Net present value (NPV) analysis evaluates investments based on the present value of a project's cash flows. NPV is the difference between the present values of the cash outflows and inflows generated by the project. The present values are the nominal cash flows discounted by the opportunity cost of funds. The opportunity cost of funds (r) is the rate of return that could be earned on another investment of equivalent risk. Every project must earn at least the return available from comparable projects, given that return also meets the investors' requirements. Therefore, the opportunity cost of funds is the investors' required rate of return and the project's cost of capital and is used as the discount rate in NPV analysis. (Choice A) Since the internal rate of return (IRR) does not reflect the investors' required return or the opportunity cost of funds, it is not an appropriate discount rate for NPV analysis. The IRR is an alternative to NPV analysis in capital budgeting. (Choice C) Discounting by the cost of debt capital borrowed to finance a project is inappropriate since it does not reflect the return necessary to compensate all sources of funds for a project's risk. Things to remember: Net present value (NPV) analysis evaluates investments based on the present value of project cash flows. A project's NPV is the difference between cash outflows and inflows discounted by the opportunity cost of funds. The opportunity cost of funds is the rate of return required to compensate investors' for the project's risk and is the project's cost of capital. Describe the capital allocation process, calculate net present value (NPV), internal rate of return (IRR), and return on invested capital (ROIC), and contrast their use in capital allocation LOS Copyright © UWorld. Copyright CFA Institute. All rights reserved.