Why does capital budgeting rely on analysis of cash flows rather than on net income?

1. Why does capital budgeting rely on analysis of cash flows rather than on net income?

2.  X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

Year

Project A                                     Project B

1……………….$12,000               $10,000

2………………….8,000                       6,000

3………………….6,000                      16,000

a. Which of the two projects should be chosen based on the payback method?

b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c. Should a firm normally have more confidence in answer a or answer b?

3. Gracie Corporation pays an 11 percent coupon rate on debentures that are due in 10 years. The current yield to maturity on bonds of similar risk is 8 percent. The bonds are currently callable at $1,110. The theoretical value of the bonds will be equal to the present value of the expected cash flow from the bonds.

a. Find the market value of the bonds using semiannual analysis.

b. Do you think the bonds will sell for the price you arrived at in part a? Why?

4. Lurch Fuel Pumps, Inc.  had sales of $2,500,000 and cost of goods sold of $1,710,000. Selling and administrative expenses represented 10 percent of sales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’s operating profit?

5. Wrecks Inc. has $20 million in earnings, pays $2.75 million in interest to bondholders, and $1.80 million in dividends to preferred stockholders.

a.      What are the common stockholders’ residual claims to earnings?

b.      What are the common stockholders’ legal, enforceable claims to dividends?

6. Your aunt offers you a choice of $20,100 in 20 years or $870 today. If money is discounted at 17 percent, which should you choose?

7. Jim Short’s Company makes clothing for schools. Sales in 2013 were $4,820,000. Assets were as follows:

Cash……………………………………….$   163,000

Accounts receivable………………….   889,000

Inventory…………………………………..   411,000

Net plant and equipment……………..520,000

Total assets………………………………$1,983,000

a.    Compute the following:

1.  Accounts receivable turnover

2.  Inventory turnover

3.  Fixed asset turnover

4.  Total asset turnover

8. Given the following information, calculate the weighted average cost of capital for Digital Processing Inc. Line up the calculations in the order shown in Table 11-1.

Percent of capital structure:

Preferred stock…………….      20%

Common equity……………       40

Debt……………………………….       40

Additional information:

Corporate tax rate………………………..          34%

Dividend, preferred………………………       $8.50

Dividend, expected common……….      $2.50

Dividend, preferred……………………….     $105.00

Growth rate…………………………………….      7%

Bond yield……………………………………….      9.5

Flotation cost, preferred………………    $3.60

Price, common………………………………..    $75.00