How is a crossover discount rate calculated, and how does it affect capital budgeting decisions?


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How would you judge the effectiveness and usefulness of the Silicon Economics Model?


1.Q. The decision to start your own firm and go into business can be thought of as a capital budgeting decision. You only go ahead if projected returns look attractive on a personal and financial basis.@ Discuss this statement.


2.Q.What major steps are involved in the capital budgeting process?


3.Q.OIBDA is an abbreviation for “operating income before depreciation and amortization.” Like its predecessor EBITDA (Aearnings before interest, taxes, depreciation and amortization@), OIBDA is used to analyze profitability before non-cash charges tied to plant and equipment investments. Can you see any advantages or disadvantages stemming from the use of OIBDA instead of net income as a measure of investment project attractiveness?


4.Q.Toyota Motor Corp., like most major multinational corporations, enjoys easy access to world financial markets. Explain why the NPV approach is the most appropriate tool for Toyota=s investment project selection process.


5.Q.Level 3 Communications, Inc., like many emerging telecom carriers, has only limited and infrequent access to domestic debt and equity markets. Explain the attractiveness of a Abenefit-cost ratio@ approach in capital budgeting for Level 3, and illustrate why the NPV, PI, and IRR capital budgeting decision rules sometimes provide different rank orderings of investment project alternatives.


6.Q.How is a crossover discount rate calculated, and how does it affect capital budgeting decisions?


7.Q.An efficient firm employs inputs in such proportions that the marginal product/price ratios for all inputs are equal. In terms of capital budgeting, this implies that the marginal cost of debt should equal the marginal cost of equity in the optimal capital structure. In practice, firms often issue debt at interest rates substantially below the
yield that investors require on the firm=s equity shares. Does this mean that many firms are not operating with optimal capital structures? Explain.


8.Q.Suppose that Black & Decker=s interest rate on newly-issued debt is 7.5% and the firm=s marginal federal-plus-state income tax rate is 40%. This implies a 4.5% after-tax component cost of debt. Also assume that the firm has decided to finance next year=s projects by selling debt. Does this mean that next year=s investment projects have a 4.5% cost of capital?


9.Q.Research in financial economics concludes that stockholders of target firms in takeover battles Awin@ (earn abnormal returns) and that stockholders of successful bidders do not lose subsequent to takeovers, even though takeovers usually occur at substantial premiums over pre-bid market prices. Is this observation consistent with
capital market efficiency?


10.Q.Risky projects are accepted for investment on the basis of favorable expectations concerning profitability. In the post-audit process, they must not be unfairly criticized for failing to meet those expectations.Discuss this statement.



1 NPV and Payback Period Analysis. Suppose that your college roommate has approached you with an opportunity to lend $25,000 to her fledgling home healthcare business. The business, called Home Health Care, Inc., plans to offer home infusion therapy and monitored in-the-home healthcare services to surgery patients in the Birmingham, Alabama, area. Funds would be used to lease a delivery vehicle, purchase supplies, and provide working capital. Terms of the proposal are that you would receive $5,000 at the end of each year in interest with the full $25,000 to be repaid at the end of a ten-year period.

A. Assuming a 10% required rate of return, calculate the present value of cash flows and the net present value of the proposed investment.

B. Based on this same interest rate assumption, calculate the cumulative cash flow of the proposed investment for each period in both nominal and presentvalue terms.

C. What is the payback period in both nominal and present-value terms?

D. What is the difference between the nominal and present-value payback period? Can the present-value payback period ever be shorter than the nominal payback period?



2. Decision Rule Conflict. Bob Sponge has been retained as a management consultant by Square Pants, Inc., a local speciality retailer, to analyze two proposed capital investment projects, projects X and Y. Project X is a sophisticated working capital and inventory control system based upon a powerful personal computer, called a
system server, and PC software specifically designed for inventory processing and control in the retailing business. Project Y is a similarly sophisticated working capital and inventory control system based upon a powerful personal computer and general- purpose PC software. Each project has a cost of $10,000, and the cost of capital for both projects is 12%. The projects= expected net cash flows are as follows:


A. Calculate each project=s nominal payback period, net present value (NPV), internal rate of return (IRR), and profitability index (PI).

B. Should both projects be accepted if they are interdependent?

C. Which project should be accepted if they are mutually exclusive?

D. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these two projects? At what values of k would this conflict exist? (Hint: Plot the NPV profiles for each project to find the crossover discount rate k.)

E. Why does a conflict exist between NPV and IRR rankings?



1 Cost of Capital. Identify each of the following statements as true or false, and explain your answers.

A. Information costs both increase the marginal cost of capital and reduce then internal rate of return on investment projects.

B. Depreciation expenses involve no direct cash outlay and can be safely ignored in investment-project evaluation.

C. The marginal cost of capital will be less elastic for larger firms than for smaller firms.

D. In practice, the component costs of debt and equity are jointly rather than independently determined.

E. Investments necessary to replace worn-out or damaged equipment tend to have low levels of risk.


2 Decision Rule Criteria. The net present value (NPV), profitability index (PI), and internal rate of return (IRR) methods are often employed in project valuation.Identify each of the following statements as true or false, and explain your answers.

A. The IRR method can tend to understate the relative attractiveness of superior investment projects when the opportunity cost of cash flows is below the IRR.

B. A PI = 1 describes a project with an NPV = 0.

C. Selection solely according to the NPV criterion will tend to favor larger rather than smaller investment projects.

D. When NPV = 0, the IRR exceeds the cost of capital.

E. Use of the PI criterion is especially appropriate for larger firms with easy access to capital markets.


3 Cost of Capital. Indicate whether each of the following would increase or decrease the cost of capital that should be used by the firm in investment project evaluation. Explain.

A. Interest rates rise because the Federal Reserve System tightens the money supply.

B. The stock market suffers a sharp decline, as does the company=s stock price, without (in management=s opinion) any decline in the company=s earnings potential.

C. The company=s home state eliminates the corporate income tax in an effort to keep or attract valued employers.

D. In an effort to reduce the federal deficit, Congress raises corporate income tax rates.

E. A merger with a leading competitor increases the company=s stock price substantially.


4 Present Value. New York City licenses taxicabs in two classes: (1) for operation by companies with fleets and (2) for operation by independent driver-owners having only one cab. Strict limits are imposed on the number of taxicabs by restricting the number of licenses, or medallions, that are issued to provide service on the streets of New York City. This medallion system dates from a Depression-era city law designed to address an overabundance of taxis that depressed driver earnings and congested city streets. In 1937, the city slapped a moratorium on the issuance of new taxicab licenses. The number of cabs, which peaked at 21,000 in 1931, fell from 13,500 in 1937 to 11,787 in May 1996, when the city broke a 59-year cap and issued an additional 400 licenses. However, because the city has failed to allow sufficient expansion, taxicab medallions have developed a trading value in the open market.
After decades of often-explosive medallion price increases, individually-owned licenses now trade for more than $200,000 each, and fleet licenses fetch more than $250,000 each.

A. Discuss the factors determining the value of a license. To make your answer concrete, estimate numerical values for the various components that together can be summarized in a medallion price of $200,000.

B. What factors would determine whether a change in the fare fixed by the city would raise or lower the value of a medallion?

C. Cab drivers, whether hired by companies or as owners of their own cabs, seem unanimous in opposing any increase in the number of cabs licensed. They argue that an increase in the number of cabs would increase competition for customers and drive down what they regard as an already unduly low return to drivers. Is their economic analysis correct? Who would gain and who would lose from an expansion in the number of licenses issued at a nominal fee?


5 NPV and PI. The Pacific Princess luxury cruise line is contemplating leasing an additional cruise ship to expand service from the Hawaiian Islands to Long Beach or San Diego. A financial analysis by staff personnel resulted in the following projections for a five-year planning horizon:


A. Calculate the net present value for each service. Which is more desirable according to the NPV criterion?

B. Calculate the profitability index for each service. Which is more desirable according to the PI criterion?

C. Under what conditions would either or both of the services be undertaken?


6 NPV and PI. Louisiana Drilling and Exploration, Inc. (LD&E) has the funds necessary to complete one of two risky oil and gas drilling projects. The first, Permian Basin 1, involves the recovery of a well that was plugged and abandoned five years ago but that may now be profitable, given improved recovery techniques. The second, Permian Basin 2, is a new onshore exploratory well that appears to be especially promising. Based on a detailed analysis by its technical staff, LD&E projects a ten-year life for each well with annual net cash flows as follows:


In the recovery-project valuation, LD&E uses an 8% riskless rate and a standard 12% risk premium. For exploratory drilling projects, the company uses larger risk premiums proportionate to project risks as measured by the project coefficient of variation. For example, an exploratory project with a coefficient of variation one and one-half times that for recovery projects would require a risk premium of 18% (= 1.5 Η 12%). Both projects involve land acquisition, as well as surface preparation and subsurface drilling costs of $3 million each.

A. Calculate the expected value, standard deviation, and coefficient of variation for annual net operating revenues from each well.

B. Calculate and evaluate the NPV for each project using the risk-adjusted discount rate method.

C. Calculate and evaluate the PI for each project.


7 Investment Project Choice. Carrie Bradshaw=s Manhattan Café, Inc., is considering investment in two alternative capital budgeting projects. Project A is an investment of $75,000 to replace working but obsolete refrigeration equipment. Project B is an investment of $150,000 to expand dining room facilities. Relevant cas h flow data for the two projects over their expected two-year lives are:


A. Calculate the expected value, standard deviation, and coefficient of variation of cash flows for each project.

B. Calculate the risk-adjusted NPV for each project using a 15% cost of capital for the riskier project and a 12% cost of capital for the less risky one. Which project is preferred using the NPV criterion?

C. Calculate the PI for each project, and rank the projects according to the PI criterion.

D. Calculate the IRR for each project, and rank the projects according to the IRR criterion.

E. Compare your answers to parts B, C, and D, and discuss any differences.



8 Cash Flow Estimation. Cunningham=s Drug Store, a medium-size drugstore located in Milwaukee, Wisconsin, is owned and operated by Richard Cunningham. Cunningham=s sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Cunningham=s most recent annual net income statement is as follows:


Cunningham=s sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Cunningham is considering using some floor space for a small soda fountain. Cunningham would operate the soda fountain for an initial three-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $20,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down. The soda fountain is expected to have annual sales of $100,000 and food and materials expenses of $20,000 per year. The soda fountain is also expected to increase wage and salary
expenses by 8% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of nonsoda fountain items are expected to decline by 10%.


A. Calculate net incremental cash flows for the soda fountain.

B. Assume that Cunningham has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not?


9 Cash Flow Analysis. The Nigelwick Press, Inc. (NPI) is analyzing the potential profitability of three printing jobs put up for bid by the State Department of Revenue:

Assume that (1) the company=s marginal city-plus-state-plus-federal tax rate is 50%; (2) each job is expected to have a six-year life; (3) the firm uses straight-line depreciation; (4) the average cost of capital is 14%; (5) the jobs have the same risk as the firm=s other business; and (6) the company has already spent $60,000 on developing the preceding data. This $60,000 has been capitalized and will be amortized over the life of the project.


A. What is the expected net cash flow each year? (Hint: Cash flow equals net profit after taxes plus depreciation and amortization charges.)

B. What is the net present value of each project? On which project, if any, should NPI bid?

C. Suppose that NPI=s primary business is quite cyclical, improving and declining with the economy, but that job A is expected to be countercyclical. Might this have any bearing on your decision?


10 Cost of Capital. Eureka Membership Warehouse, Inc., is a rapidly growing chain of retail outlets offering brand-name merchandise at discount prices. A security analyst=s report issued by a national brokerage firm indicates that debt yielding 13% composes 25% of Eureka=s overall capital structure. Furthermore, both earnings and dividends are expected to grow at a rate of 15% per year.

Currently, common stock in the company is priced at $30, and it should pay $1.50 per share in dividends during the coming year. This yield compares favorably with the 8% return currently available on risk-free securities and the 14% average for all common stocks, given the company=s estimated beta of 2.

A. Calculate Eureka=s component cost of equity using both the capital asset pricing model and the dividend yield plus expected growth model.

B. Assuming a 40% marginal federal-plus-state income tax rate, calculate Eureka=s weighted average cost of capital.


Sophisticated NPV Analysis at Level 3 Communications, Inc.

Level 3 Communications, LLC, provides integrated telecommunications services including voice, Internet access, and data transmission using rapidly improving optical and Internet protocol technologies (i.e., Abroadband@). Level 3 is called a facilities-based provider because it owns a substantial portion of the fiber optic plant, property, and equipment necessary to serve its customers.

The company traces its roots to Peter Kiewit Sons,= Inc., which was incorporated in Delaware in 1941 to continue a construction business founded in Omaha, Nebraska, in 1884. In subsequent years, Kiewit invested a portion of the cash flow generated by its construction activities in a variety of other businesses. Kiewit entered the coal mining business in 1943, the telecommunications business [consisting of Metropolitan Fiber Systems (MFS) and related investments] in 1988, the information services business in 1990, and the alternative energy business in 1991. Kiewit has also made investments in several development-stage ventures. In 1995, Kiewit distributed its MFS holdings to stockholders. In the seven years from 1988 to 1995, the company had invested approximately $500 million in MFS. At the time of the distribution to stockholders in 1995, the company=s holdings in MFS had grown to a market value of approximately $1.75 billion. In December 1996, MFS was purchased by WorldCom in a transaction valued at $14.3 billion, more than a 28:1 payout and a 52% annual rate of return over 8 years for investors. Following its enormously successful investment in MFS, Kiewit decided to sell unrelated assets and focus its energies on the telecommunications business. In December 1997, the company=s stockholders ratified the decision of the bBoard to effect a splitoff from the Kiewit Construction Group. As a result of the split-off, which was completed on March 31, 1998, the company no longer owns any interest in the Construction Group and adopted the name ALevel 3 Communications, Inc.@ The Kiewit Construction Group changed its name to APeter Kiewit Sons,= Inc.@ The term Level 3 comes from the layered set of protocols, or standards that are often used in the industry to describe telecommunications networks. The company=s strategy generally calls for services to be provided in the first three levels of these technical specifications.

During the first quarter of 2001, Level 3 completed construction activities relating to its North American intercity network. In 2003, the company added approximately 2,985 miles to its North America intercity network through acquisition of certain assets of Genuity Inc., a Massachusetts-based provider of communications services. Level 3 has also completed construction of an approximately 3,600 mile fiber optic intercity network that connects many major European cities, including Amsterdam, Berlin, Copenhagen, Frankfurt, Geneva, London, Madrid, Milan, Munich, Paris, Stockholm, Vienna, and Zurich. Level 3’s European network is linked to the North American intercity network by a transatlantic cable system that went into service during 2000.

In December 2000, the company signed an agreement to collaborate with FLAG Telecom on the development of the Northern Asia undersea cable system connecting Hong Kong, Japan, Korea, and Taiwan. During the fourth quarter of 2001, the company announced the disposition of its Asian operations in a sale transaction with Reach, Ltd. Although the company believed that Asia represented an attractive longer-term investment opportunity, given current volatile market and economic conditions the company determined that it was necessary to focus its resources, both capital and managerial, on the immediate opportunities provided by the company=s operational assets in North America and Europe. This transaction closed on January 18, 2002. As part of the agreement, Reach and Level 3 agreed that Level 3 would provide capacity and services to Reach over Level 3’s North American intercity network, and Level 3 would buy capacity and services from Reach in Asia. This arrangement allowed Level 3 to
continue to service its customer base with capacity needs in Asia and provide Reach access to the Level 3 intercity networks in North America and Europe.

Today, Level 3 has grown to become an international communications and information services powerhouse headquartered in Broomfield, Colorado. Level 3 is one of the largest providers of wholesale dial-up service to Internet service providers (ISPs) in North America, and is the primary provider of Internet connectivity for millions of broadband subscribers through its cable and DSL partners. The company operates one of the largest communications and Internet backbones in the world. Level 3 provides services to the world=s ten largest telecom carriers, the top largest ISPs in North America, and Europe=s ten largest telecom carriers. A key contributor to the company=s success is its highly sophisticated approach to capital budgeting.

To help investors, employees, customers, and the general public understand the economics of its business and the company=s approach to capital budgeting, Level 3 has posted on the Internet what it calls a ASilicon Economics Model@ ( Level 3 has developed this model in an effort to demonstrate in a simplified format the dynamic relationships that exist between pricing strategies, cost compression, demand growth, and capital budgeting in an optimized net present value discounted cash flow model. In other words, the model represents an effort to demonstrate the effects of important economic relationships on capital budgeting decisions and the value of the firm. Because of its simplified nature, the Silicon Economics Model should not be interpreted as an attempt to predict Level 3’s future operating performance or financial results. Level 3’s internal optimization model contains tens of thousands of variables and relationships that for the sake of simplicity are not duplicated in
this model.

In order to produce a model for public use that is not overly complex, several simplifying assumptions have been made in the Silicon Economics Model. The effects of market competition are not explicitly modeled, and only a single service offering is considered. In practice, Level 3 offers a wide variety of services in various geographic locations that have differing degrees of demand elasticity. The model places no limits on demand growth, such as would be imposed by limitations on Level 3’s internal operating systems or external supply chain requirements. Capital expenditures (CAPEX) are modeled using an initial (one-time) infrastructure cost plus an incremental cost per unit. Cost-saving improvements in technology are modeled as a reduction in unit cost, or annual cost compression rate. Operational expenses (OPEX) are modeled using a fixed annual infrastructure cost, variable cost represented as a percentage of revenue, per-incremental-unit cost (activation related), and per-total-unit cost (support related).
Cost reductions over time in these latter two categories can be modeled by specifying an annual productivity improvement factor. Network expenses (NETEX) are modeled as a cost per incremental unit. This unit cost is reduced at the same rate as the activation and support-related operational expenses.

Users can see the effects of varying assumptions on operating and financial performance by choosing different input parameters on the AData Entry@ worksheet. All default input values can be changed. The model will produce the net present value of consolidated cash flow for any choice of input parameters. Details concerning the calculation of expected revenue, capital expenses, operational expenses, and cash flow that are graphed by the model can be reviewed and are displayed on the ADetails@ tab of the model. Five three-dimensional charts are automatically produced to illustrate the sensitivity of net present value to four primary input parameters, including the annual price reduction rate, price elasticity of demand, annual CAPEX compression (cost-reduction) rate, and annual OPEX and NETEX compression (costreduction) rate. For simplicity, all other operating and financial parameters are held constant. The price and elasticity chart displays model sensitivity to the pace of price reduction and price elasticity; price and CAPEX illustrates effects of price reductions on capital spending. Price and OPEX and NETEX shows impacts of the price reduction rate and operational and network expense compression rates; price and total cost shows sensitivity to the price reduction rate and total cost compression rate. CAPEX and OPEX and NETEX, shown in Figure 18.4 gives the relationship between the capital expense compression rate and operational and network expense compression rates. For illustration purposes, input assumptions are an initial demand of 8.5 million units, an initial price of $200, annual price reductions of 25%, a discount rate of 25%, and a 2.25 price elasticity of demand.

Figure 18.4 here

Table 18.7 here

Finally, Table 18.7 shows the net present value implications of these model input assumptions for the discounted net present value of the enterprise. It is important to remember that these data are for illustration purposes only. They are not predictions of actual operating and financial results for Level 3 or any other company.

A. Describe the essential components of Level 3’s Silicon Economics Model.

B. Explain how Level 3’s Silicon Economics Model differs from more standard and simplified approaches to capital budgeting. For comparison purposes, you may want to consider valuation spreadsheets compiled and maintained by various independent analysts and investors on the Internet

C. How would you judge the effectiveness and usefulness of the Silicon Economics Model?

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