# Answers to Concepts Review and Critical Thinking Questions

Save this PDF as:

Size: px
Start display at page:

## Transcription

1 Answers to Concepts Review and Critical Thinking Questions 1. A payback period less than the project s life means that the NPV is positive for a zero discount rate, but nothing more definitive can be said. For discount rates greater than zero, the payback period will still be less than the project s life, but the NPV may be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. 2. If a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a zero discount rate; thus the payback period must be less than the project life. If NPV is positive, then the present value of future cash inflows is greater than the initial investment cost; thus PI must be greater than 1. If NPV is positive for a certain discount rate R, then it will be zero for some larger discount rate R*; thus the IRR must be greater than the required return. 3. a. Payback period is simply the break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback. b. The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point. c. Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Materiality considerations often warrant a payback analysis as sufficient; maintenance projects are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important. 4. a. The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as some average profit measure due to the project divided by some average balance sheet value for the project. This text computes AAR as average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects. b. AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little semblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals. 5. a. NPV is simply the sum of the present values of a project s cash flows. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV.

2 b. NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well. A project with NPV = \$2,500 implies that the total shareholder wealth of the firm will increase by \$2,500 if the project is accepted. 6. a. The IRR is the discount rate that causes the NPV of a series of cash flows to be equal to zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate. b. IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and also ambiguously ranks some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques. c. IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as 12%, than in absolute terms, such as \$46,000. IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR would provide more information about the project than would NPV. 7. a. The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. b. PI = ( NPV + cost ) / cost = 1 + ( NPV / cost ). If a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the bang for the buck of each particular project. 8. PB = I / C ; I + C / R = NPV, 0 = I + C / IRR so IRR = C / I ; thus IRR = 1 / PB For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is the IRR. 9. There are a number of reasons. Two of the most important have to do with transportation costs and exchange rates. Manufacturing in the U.S. places the finished product much closer to the point of sale, resulting in significant savings in transportation costs. It also reduces inventories because goods spend less time in transit. Higher labor costs tend to offset these savings to some degree, at least compared to other possible manufacturing locations. Of great importance is the fact that manufacturing in the U.S. means that a much higher proportion of the costs are paid in dollars. Since sales are in dollars, the net effect is to immunize profits to a large extent against fluctuations in exchange rates. This issue is discussed in greater detail in the chapter on international finance.

3 10. The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the next several chapters. The payback approach is probably the simplest, followed by the AAR, but even these require revenue and cost projections. The discounted cash flow measures (NPV, IRR, and profitability index) are really only slightly more difficult in practice. 11. Yes, they are. Such entities generally need to allocate available capital efficiently, just as for-profits do. However, it is frequently the case that the revenues from not-for-profit ventures are not tangible. For example, charitable giving has real opportunity costs, but the benefits are generally hard to measure. To the extent that benefits are measurable, the question of an appropriate required return remains. Payback rules are commonly used in such cases. Finally, realistic cost/benefit analysis along the lines indicated should definitely be used by the U.S. government and would go a long way toward balancing the budget! Solutions to Questions and Problems Basic 1. Payback = 2 + (\$700 / \$900) = 2.78 years 2. Payback = 5(\$600) + (\$400 / \$600) = 5.67 years = 6(\$600) + (\$150 / \$600) = 6.25 years 8(\$600) = \$4,800; project never pays back if cost is \$5, A: Payback = 2 + (\$1,000 / \$18,000) = 2.06 years B: Payback = 3 + (\$15,000 / \$250,000) = 3.06 years Using the payback criterion and a cutoff of 3 years, accept project A and reject project B. 4. Average net income = (\$1,627,000 + \$1,512,000 + \$1,101,000 + \$1,313,000) / 4 = \$1,388,250 Average book value = (\$12M + 0) / 2 = \$6M AAR = Average net income / Average book value = 23.14% 5. 0 = \$80,000 + \$35,000 / (1 + IRR) + \$45,000 / (1 + IRR) 2 + \$40,000 / (1 + IRR) 3 IRR = 22.75% > R = 18%, so accept the project. 6. NPV = \$80,000 + \$35,000 / \$45,000 / \$40,000/ = \$20, NPV > 0 so accept the project. NPV = \$80,000 + \$35,000 / \$45,000 / \$40,000 / = \$ NPV < 0 so reject the project. 7. NPV = \$4,000 + \$900(PVIFA 8%, 8 ) = \$1, ; accept the project if R = 8% NPV = \$4,000 + \$900(PVIFA 24%, 8 ) = \$ ; reject the project if R = 24% 0 = \$4,000 + \$900(PVIFA IRR, 8 ); IRR = 15.29% ; indifferent about the project if R = 15.29% 8. 0 = \$2,400 + \$640 / (1 + IRR) + \$800 / (1 + IRR) 2 + \$2,000 / (1 + IRR) 3 ; IRR = 16.58%

4 0%: NPV = \$2,400 + \$640 + \$800 + \$2,000 = NPV = \$2,400 + \$640 / \$800 / \$2,000 / = NPV = \$2,400 + \$640 / \$800 / \$2,000 / = NPV = \$2,400 + \$640 / \$800 / \$2,000 / = \$ a. A: \$17,000 = \$8,000/(1+IRR) + \$7,000/(1+IRR) 2 + \$5,000/(1+IRR) 3 + \$3,000/(1+IRR) 4 IRR = 15.86% B: \$17,000 = \$2,000/(1+IRR) + \$5,000/(1+IRR) 2 + \$9,000/(1+IRR) 3 + \$9,500/(1+IRR) 4 IRR = 14.69% IRR A > IRR B, so IRR decision rule implies accept project A. This may not be a correct decision however, because the IRR criterion has a ranking problem for mutually exclusive projects. To see if the IRR decision rule is correct or not, we need to evaluate the project NPVs. b. A: NPV = \$17,000 + \$8,000/ \$7,000/ \$5,000/ \$3,000/ = \$1, B: NPV = \$17,000 + \$2,000/ \$5,000/ \$9,000/ \$9,500/ = \$1, NPV A < NPV B, so NPV decision rule implies accept project B. c. Crossover rate: 0 = \$6,000/(1+R) + \$2,000/(1+R) 2 \$4,000/(1+R) 3 \$6,500/(1+R) 4 R = 12.18% At discount rates above 12.18% choose project A; for discount rates below 12.18% choose project B; indifferent between A and B at a discount rate of 12.18%. 11. X: \$4,000 = \$2,500/(1+IRR) + \$1,500/(1+IRR) 2 + \$1,800/(1+IRR) 3 ; IRR = 22.85% Y: \$4,000 = \$1,500/(1+IRR) + \$2,000/(1+IRR) 2 + \$2,600/(1+IRR) 3 ; IRR = 22.08% Crossover rate: 0 = \$1,000/(1+R) \$500/(1+R) 2 \$800/(1+R) 3 ; R= 17.87% R% \$NPV X \$NPV Y 0 1, , , , a. NPV = \$28M + \$53M/1.10 \$8M/ = \$13,570, ; NPV > 0 so accept the project. b. \$28M = \$53M/(1+IRR) \$8M/(1+IRR) 2 \$28M(1+IRR) 2 \$53M(1+IRR) + \$8M = 0 IRR = 72.75%, 83.46% When there are multiple IRRs, the IRR decision rule is ambiguous; in this case, if the correct IRR is 72.75%, then we would accept the project, but if the correct IRR is 83.46%, we would reject the project. 13. PI = [ \$3,000/ \$2,000/ \$1,200/ ] / \$5,000 = = [ \$3,000/ \$2,000/ \$1,200/ ] / \$5,000 = = [ \$3,000/ \$2,000/ \$1,200/ ] / \$5,000 = 0.893

5 14. a. PI I = \$10,000(PVIFA 9%,3 ) / \$20,000 = 1.266; PI II = \$2,500(PVIFA 9%,3 ) / \$3,000 = The profitability index decision rule implies accept project II, since PI II > PI I b. NPV I = \$20,000 + \$10,000(PVIFA 9%,3 ) = \$5, NPV II = \$3,000 + \$2,500(PVIFA 9%,3 ) = \$3, NPV decision rule implies accept I, since NPV I > NPV II c. Using the profitability index to compare mutually exclusive projects can be ambiguous when the magnitude of the cash flows for the two projects are of different scale. In this problem, project I is roughly twice as large as project II and produces a larger NPV, yet the profitability index criterion implies that project II is more acceptable. 15. a. PB A = 3 + (\$110K/\$380K) = 3.29 years; PB B = 2 + (\$2K/\$10K) = 2.20 years Payback criterion implies accept project B, because it pays back sooner than project A. b. A: NPV = \$170K + \$10K/ \$25K/ \$25K/ \$380K/ = \$91, B: NPV = \$18K + \$10K/ \$6K/ \$10K/ \$8K/ = \$6, NPV criterion implies accept project A, because project A has a higher NPV than project B. c. A: \$170K = \$10K/(1+IRR) + \$25K/(1+IRR) 2 + \$25K/(1+IRR) 3 + \$380K/(1+IRR) 4 IRR = 29.34% B: \$18K = \$10K/(1+IRR) + \$6K/(1+IRR) 2 + \$10K/(1+IRR) 3 + \$8K/(1+IRR) 4 ; IRR = 32.01% IRR decision rule implies accept project B, because IRR for B is greater than IRR for A. d. A: PI = [ \$10K/ \$25K/ \$25K/ \$380K/ ] / \$170K = B: PI = [ \$10K/ \$6K/ \$10K/ \$8K/ ] / \$18K = Profitability index criterion implies accept project A, because its PI is greater than project B s. e. In this instance, the NPV and PI criterion imply that you should accept project A, while payback period and IRR imply that you should accept project B. The final decision should be based on the NPV since it does not have the ranking problem associated with the other capital budgeting techniques. Therefore, you should accept project A. 16. a. M: \$25K = \$10K/(1+IRR) + \$21K/(1+IRR) 2 + \$12K/(1+IRR) 3 + \$10K/(1+IRR) 4 IRR = 39.55% N: \$550K = \$220K/(1+IRR) + \$250K/(1+IRR) 2 + \$240K/(1+IRR) 3 + \$195K//(1+IRR) 4 IRR = 23.83% b. M: NPV = \$25K + \$10K/ \$21K/ \$18K/ \$15K/ = \$14, N: NPV = \$550K + \$220K/ \$250K/ \$240K/ \$195K/ = \$126, c. Accept project N since the NPV is higher. IRR cannot be used to rank mutually exclusive projects. 17. a. Y: PI = \$10,000(PVIFA 12%,4 ) / \$25,000 = Z: PI = \$15,000(PFIFA 12%,4 ) / \$40,000 = The profitability index implies accept project Y. b. Y: NPV = \$25,000 + \$10,000(PVIFA 12%,4 ) = \$5, Z: NPV = \$40,000 + \$15,000(PFIFA 12%,4 ) = \$5, The NPV for project Z is larger, therefore accept Z since the profitability index cannot be used to rank mutually exclusive projects..

6 18. Crossover rate: 0 = \$5,000/(1+R) + \$1,000/(1+R) 2 \$3,000/(1+R) 3 \$7,000/(1+R) 4 ; R= 22.42% At a lower interest rate project J is more valuable because of the higher total cash flows. At a higher interest rate, project I becomes more valuable since the differential cash flows received in the first two years are larger than the cash flows for project J. 19. a. K: PI = [ \$18K/ \$17K/ \$16K/ \$15K/ \$14K/ ] / \$35K = S: PI = [ \$120K/ \$115K/ \$110K/ \$105K/ \$100K/ ] /\$35K = b. K: NPV = \$35K + \$18K/ \$17K/ \$16K/ \$15K/ \$14K/ = \$19, S: NPV = \$350K + \$120K/ \$115K/ \$110K/ \$105K/ \$100K/ = \$23, c. You should accept project S since the NPV is higher. The profitability index has a ranking problem with mutually exclusive investment projects. 20. If the payback period is exactly equal to the project s life then the IRR must be equal to zero since the project pays back exactly the initial investment. If the project never pays back its initial investment, then the IRR of the project must be < 0%. 21. R= 0% = \$323,580 + \$91,452 + \$172,148 + \$118,473 + \$88,612 = \$147,105 R= = \$323,580 NPV = 0 = \$323,580 + \$91,452/(1+IRR) + \$172,148/(1+IRR) 2 + \$118,473/(1+IRR) 3 + \$88,612/(1+IRR) 4 ; IRR = 17.25%; NPV = a. F: Payback = 2 + \$5,000/\$15,000 = 2.33 years G: Payback = 2 years H: Payback = 3 + \$5,000/\$80,000 = 3.06 years b. F: NPV = \$50K + \$30K/ \$15K/ \$15K/ \$10K/ \$10K/ = \$11, G: NPV = \$75K + \$45K/ \$30K/ \$25K/ \$25K/ \$20K/ = \$34, H: NPV = \$100K + \$30K/ \$35K/ \$30K/ \$80K/ \$50K/ = \$55, c. Even though project H does not meet the payback period of three years, it does provide the largest increase in shareholder wealth, therefore, choose project H. Payback period generally should be ignored in this situation. 23. a. M: \$50K = \$20K/(1+IRR) + \$30K/(1+IRR) 2 + \$40K/(1+IRR) 3 + \$30K/(1+IRR) 4 IRR = 42.39% N: \$100K = \$70K/(1+IRR) + \$50K/(1+IRR) 2 + \$40K/(1+IRR) 3 + \$30K//(1+IRR) 4 IRR = 38.36% b. M: NPV = \$50K + \$20K/ \$30K/ \$40K/ \$30K/ = \$35, N:NPV = \$100K + \$70K/ \$50K/ \$40K/ \$30K/ = \$44, c. Accept project N since the NPV is higher. IRR cannot be used to rank mutually exclusive projects.

7 Intermediate 24. \$10K = \$5K/(1 + R) \$5K/(1 + R) 2 \$5K/(1 + R) 3 \$10K/(1 + R) 4 \$5K/(1 + R) 2 ; R = 47.95% R: NPV = \$30K + \$15K/ \$10K/ \$15K/ \$5K/ \$5K/ = \$8,912 S: NPV = \$40K + \$20K/ \$15K/ \$20K/ \$15K/ \$10K/ = \$8, a. C: IRR: \$100K = \$30K/(1+IRR) \$30K/(1+IRR) 2 \$30K/(1+IRR) 3 \$20K/(1+IRR) 4 IRR = 4.16% D: IRR: \$150K = \$70K/(1+IRR) \$50K/(1+IRR) 2 \$60K/(1+IRR) 3 \$30K/(1+IRR) 4 IRR = 16.93% According to the IRR decision rule you should accept D since the IRR is higher than C. In fact, this is one time where the IRR decision rule is valid on mutually exclusive projects. Since the projects have conventional cash flows, we know that project C must be rejected since the IRR is below the required return, therefore we are left with only project D. Of course, these IRRs imply that project C will have a negative NPV and project D will have a positive NPV b. C: NPV = \$100K + \$30K/ \$30K/ \$30K/ \$20K/ = \$18, D: NPV = \$150K + \$70K/ \$50K/ \$60K/ \$30K/ = \$8, Accept project D since NPV D > NPV C. 26. IRR: \$25,000 = \$10,000/(1+IRR) \$21,000/(1+IRR) 2 ; IRR = NPV = \$25,000 \$10,000/ \$21,000/ = 0%: NPV = \$25,000 \$10,000 \$21,000 = NPV = \$25,000 \$10,000/ \$21,000/ = +\$3, The cash flows for the project are unconventional. Since the initial cash flow is positive and the remaining cash flows are negative, the decision rule for IRR in invalid in this case. The NPV profile is upward sloping, indicating that the project is more valuable when the interest rate increases. 27. \$252 = \$1,431/(1+IRR) \$3,035/(1+IRR) 2 + \$2,850/(1+IRR) 3 \$1,000/(1+IRR) 4 IRR = 25%, 33.33%, 42.86%, 66.67% Take the project when NPV > 0, for required returns between 25% and 33.33% or between 42.86% and 66.67%. 28. Since the NPV index has the cost subtracted in the numerator, NPV index = PI a. To have a payback equal to the project s life, given C is a constant cash flow for N years, C = I/N. b. To have a positive NPV, I < C (PVIFA R%, N ). Thus, C > I / (PVIFA R%, N ). c. Benefits = C (PVIFA R%,N ) = 2 costs = 2I C = 2I / (PVIFA R%, N )

### CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. A payback period less than the project s life means that the NPV is positive for

### CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. Assuming conventional cash flows, a payback period less than the project s life means

### \$1,300 + 1,500 + 1,900 = \$4,700. in cash flows. The project still needs to create another: \$5,500 4,700 = \$800

1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project has created: \$1,300 + 1,500 + 1,900 = \$4,700 in cash flows.

### Finance for Cultural Organisations Lecture 7. Net Present Value and Other Investment Criteria

Finance for Cultural Organisations Lecture 7. Net Present Value and Other Investment Criteria Lecture 6: Net Present Value and Other Investment Criteria Be able to compute payback and discounted payback

### Oklahoma State University Spears School of Business. NPV & Other Rules

Oklahoma State University Spears School of Business NPV & Other Rules Slide 2 Why Use Net Present Value? Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash

### Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of

1 Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of Return Problems with the IRR Approach The Profitability

### Chapter 5 Net Present Value and Other Investment Rules

University of Science and Technology Beijing Dongling School of Economics and management Chapter 5 Net Present Value and Other Investment Rules Oct. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Be

### CAPITAL BUDGETING. Net Present Value and Other Investment Criteria

CAPITAL BUDGETING Net Present Value and Other Investment Criteria Net Present Value (NPV) Net present value is the difference between an investment s market value (in today s dollars) and its cost (also

### Capital Budgeting: Decision. Example. Net Present Value (NPV) FINC 3630 Yost

Capital Budgeting: Decision Criteria Example Consider a firm with two projects, A and B, each with the following cash flows and a 10 percent cost of capital: Project A Project B Year Cash Flows Cash Flows

### Chapter 7: Net Present Value and Other Investment Criteria

FIN 301 Class Notes Chapter 7: Net Present Value and Other Investment Criteria Project evaluation involves: 1- Estimating the cash flows associated with the investment project (ch. 8) 2- Determining the

### 1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration.

Questions in Chapter 9 concept.qz 1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration. [A] Discounted payback analysis [B] The average accounting

### Chapter 2: Capital Budgeting Techniques

Chapter 2: Introduction 2.1 Introduction In order to assess the feasibility of any investment project, some capital budgeting techniques should be used to evaluate that project. This part illustrates the

### Net Present Value (NPV)

Investment Criteria 208 Net Present Value (NPV) What: NPV is a measure of how much value is created or added today by undertaking an investment (the difference between the investment s market value and

### Chapter 9: Net Present Value and Other Investment Criteria. Faculty of Business Administration Lakehead University Spring 2003 May 20, 2003

Chapter 9: Net Present Value and Other Investment Criteria Faculty of Business Administration Lakehead University Spring 2003 May 20, 2003 Outline 9.1 Net Present Value 9.2 The Payback Rule 9.3 The Average

### Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization

T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization! 9.1 Net Present Value! 9.2 The Payback Rule! 9.3 The Average Accounting Return! 9.4 The Internal Rate

### Lecture 5 (Chapter 9) Investment Criteria. Some Problems

Lecture 5 (Chapter 9) Investment Criteria Up to now, we have analyzed how to finance a firm (capital structure) Today we switch to analyzing what to do with the money once we ve got it (capital budgeting

### CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Basic 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After two years, the

### Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions

Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Chapter 8 Capital Budgeting Concept Check 8.1 1. What is the difference between independent and mutually

### CHAPTER 8 CAPITAL BUDGETING DECISIONS

CHAPTER 8 CAPITAL BUDGETING DECISIONS Q1. What is capital budgeting? Why is it significant for a firm? A1 A capital budgeting decision may be defined as the firm s decision to invest its current funds

### Net present value is the difference between a project s value and its costs.

1 2 Net present value is the difference between a project s value and its costs. We need to calculate the Present Value of future cash flows (discounted by the opportunity cost of capital) and subtract

### Lecture 7 - Capital Budgeting: Decision Criteria

Lecture 7 - Capital Budgeting: Decision Criteria What is Capital Budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to a firm s future. The Ideal

### Chapter 9 Capital Budgeting Decision Models

Chapter 9 Capital Budgeting Decision Models LEARNING OBJECTIVES (Slide 9-2) 1. Explain capital budgeting and differentiate between short-term and long-term budgeting decisions. 2. Explain the payback model

### Key Concepts and Skills. Net Present Value and Other Investment Rules. http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf.

McGraw-Hill/Irwin Net Present Value and Other Investment Rules 9-1 http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf Copyright 2010 by Charles Hodges and the McGraw-Hill Companies, Inc. All rights

### 5. What are the basic investment rules? If value >= price buy If expected return >= required return, buy

BUA321 Chapter 10 Class Notes Capital Budgeting Techniques 1. What kinds of projects are analyzed with capital budgeting? Expansion (easiest to forecast) Replacement (more complicated) We must forecast

### Chapter 10. Capital Budgeting Techniques. Copyright 2012 Pearson Prentice Hall. All rights reserved.

Chapter 10 Capital Budgeting Techniques Copyright 2012 Pearson Prentice Hall. All rights reserved. Overview of Capital Budgeting Capital budgeting is the process of evaluating and selecting long-term investments

### CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project

### NPV and Other Investment Criteria

Chapter 8 NPV and Other Investment Criteria CAPITAL BUDGETING TERMS Capital budgeting is where we start to pull all of the tools and techniques we ve learned so far together (TVM, cash flow analysis, etc.)

### Economic Feasibility Studies

Economic Feasibility Studies ١ Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. The difficulty with making these decisions

### BS2551 Money Banking and Finance

S2551 Money anking and Finance Capital udgeting Capital budgeting techniques are decision rules used by managers when undertaking investment decisions. The best techniques should satisfy the following

### Corporate Finance. Slide 1 咨询热线 : 学习平台 : lms.finance365.com

Corporate Finance Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases Working capital management Corporate Governance of Listed Companies Slide 1 Capital Budgeting Slide

### Investment Decision Analysis

Lecture: IV 1 Investment Decision Analysis The investment decision process: Generate cash flow forecasts for the projects, Determine the appropriate opportunity cost of capital, Use the cash flows and

### 2) A project should automatically be accepted when the project's base case net present value is positive.

Questions Chapter 11 1) Given a tax rate of zero, the accounting break-even point for a project: [A] indicates when the net present value turns positive. [B] excludes depreciation in its computation. [C]

### Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 13-1 a. The capital budget outlines the planned expenditures on fixed assets. Capital budgeting

### WHAT IS CAPITAL BUDGETING?

WHAT IS CAPITAL BUDGETING? Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial

### Chapter 9. Capital Budgeting Techniques

Chapter 9 Capital Budgeting Techniques 1 Learning Outcomes Chapter 9 Describe the importance of capital budgeting decisions and the general process that is followed when making investment (capital budgeting)

### Alternative Investment Rules. Data for Examples

Alternative Investment Rules (Text reference: Chapter 6) Topics data for examples net present value (NPV) rule internal rate of return (IRR) rule payback rule discounted payback rule average accounting

### CFA Level I. Study Session 11. Introduction. Dividends and Share Repurchases: Basics Working Capital Management The Corporate Governance

CFA Level I Study Session 11 Reading 36 Reading 37 Reading 38 Reading 39 Reading 40 Reading 41 Introduction Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases: Basics

### CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation

CHAPTER 10 & 11 The Basics of Capital Budgeting & Cash Flow Estimation Should we build this plant? 10-1 Capital Budgeting Overview Project Classifications Analysis Methods/Decision Rules Comparison of

### Chapter 10. What is capital budgeting? Topics. The Basics of Capital Budgeting: Evaluating Cash Flows

Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows 1 Topics Overview and vocabulary Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life 2 What

### Capital Budgeting Tools. Chapter 11. Capital Budgeting. Types of Capital Budgeting Projects. The Basics of Capital Budgeting: Evaluating Cash Flows

Capital Budgeting Tools () Payback Period (a) Discounted Payback Period Chapter The Basics of Capital Budgeting: Evaluating s () Net Present Value (NPV) (a) Profitability Index (PI) () Internal Rate of

### Chapter 11. Investment Decision Criteria. Copyright 2011 Pearson Prentice Hall. All rights reserved.

Chapter 11 Investment Decision Criteria Chapter 11 Contents Learning Objectives Principles Used in This Chapter 1. An Overview of Capital Budgeting 2. Net Present Value 3. Other Investment Criteria 4.

### Finance Management Session 5- Capital Budgeting. SHL Specialist Diploma in Events, Sports & Leisure Management

Finance Management Session 5- Capital Budgeting SHL Specialist Diploma in Events, Sports & Leisure Management Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project

### Capital Budgeting Capital Budgeting The process by which a business

Capital Budgeting 1 Capital Budgeting The process by which a business chooses which investments to make in capital equipment 2 Capital Investments Money markets: Short term Capital markets: Long term Capital

### Chapter 011 Project Analysis and Evaluation

Multiple Choice Questions 1. Forecasting risk is defined as the: a. possibility that some proposed projects will be rejected. b. process of estimating future cash flows relative to a project. C. possibility

### Project Valuation for Managers

Project Valuation for Managers An Essential Skill Corporate Finance By Cameron Hall Key Messages The job of managers is to create value. Value in a firm comes from two sources: current operations and new

### Chapter 8. Capital Budgeting Cash Flows. Learning Goals. Learning Goals (cont.)

Chapter 8 Capital Budgeting Cash Flows Learning Goals 1. Understand the motives for key capital budgeting expenditures and the steps in the capital budgeting process. 2. Define basic capital budgeting

### MODULE 2. Capital Budgeting

MODULE 2 Capital Budgeting Capital Budgeting is a project selection exercise performed by the business enterprise. Capital budgeting uses the concept of present value to select the projects. Capital budgeting

### Year Project A Project B 0 (50 000) (50 000)

Al Imam Mohammad Ibn Saud Islamic University College of Economics and Administrative Sciences Department of Finance and Investment Level 4: All branches Investment Decision Under Certainty Exercise 1 A

### MCQ of Corporate Finance

MCQ of Corporate Finance 1. Which of the following is not one of the three fundamental methods of firm valuation? a) Discounted Cash flow b) Income or earnings - where the firm is valued on some multiple

### 9 Decision criteria BCR NPV FYRR NPVI IBCR

4 9 Decision criteria The decision criteria provide an indication of the economic performance of the proposal. This section provides the formula used to calculate the decision criteria employed in CBA6.

### CORPORATE FINANCE EVENT PARTICIPANT INSTRUCTIONS

CAREER CLUSTER Finance CAREER PATHWAY Corporate Finance INSTRUCTIONAL AREA Financial Analysis CORPORATE FINANCE EVENT PARTICIPANT INSTRUCTIONS PROCEDURES 1. The event will be presented to you through your

### Capital investments are long-term investments

Capital Budgeting Basics File C5-240 August 2013 www.extension.iastate.edu/agdm Capital investments are long-term investments in which the assets involved have useful lives of multiple years. For example,

### 6 Investment Decisions

6 Investment Decisions After studying this chapter you will be able to: Learning Objectives Define capital budgeting and explain the purpose and process of Capital Budgeting for any business. Explain the

### 6 Investment Decisions

6 Investment Decisions BASIC CONCEPTS AND FORMULAE 1. Capital Budgeting Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the goal of investor s wealth

### FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored

FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored Find needed answers here - http://uoptutor.com/product/fin-534-quiz-8-30-questions-withanswers-9999-scored/ FIN 534 Quiz 8 (30 questions with answers)

### Capital Budgeting OVERVIEW

WSG12 7/7/03 4:25 PM Page 191 12 Capital Budgeting OVERVIEW This chapter concentrates on the long-term, strategic considerations and focuses primarily on the firm s investment opportunities. The discussions

### For 9.220, Term 1, 2002/03 02_Lecture9.ppt. Introduction Problems with IRR Special Considerations for DCF Techniques

Capital Budgeting For 9.22, Term, 22/3 2_Lecture9.ppt Outline Introduction Problems with IRR Special Considerations for DCF Techniques Mutually Exclusive Projects Capital Rationing Non-Discounted Cash

### USQ UNIVERSITY OF SOUTHERN QUEENSLAND

USQ UNIVERSITY OF SOUTHERN QUEENSLAND MBA - ACC5502 Accounting & Financial Management / S1 / 2013 M B G Wimalarathna (ACA, ACMA, ACIM, SAT, ACPM)(MBA USJ/PIM) Introduction Key management personnel of an

### The Reinvestment Assumption Dallas Brozik, Marshall University

The Reinvestment Assumption Dallas Brozik, Marshall University Every field of study has its little odd bits, and one of the odd bits in finance is the reinvestment assumption. It is an artifact of the

### Which projects should the corporation undertake

Which projects should the corporation undertake Investment criteria 1. Investment into a new project generates a flow of cash and, therefore, a standard DPV rule should be the first choice under consideration.

### Simply put, investment

C H A P T E R10 Capital Budgeting: Introduction and Techniques Chapter Objectives By the end of this chapter you should be able to: Simply put, investment decisions have a 1. Introduce TVM concepts to

### Capital Budgeting Focus on cash flows, not profits. Focus on incremental cash flows. Account for time.

Capital Budgeting Virtually all managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple yes versus no choice about a capital investment. The following

### Capital Budgeting. Seminar report. Submitted in partial fulfillment of the requirement for the award of degree of MBA

A Seminar report on Capital Budgeting Submitted in partial fulfillment of the requirement for the award of degree of MBA SUBMITTED TO: SUBMITTED BY: www.studymafia.org www.studymafia.org www.studymafia.com1

### CHAPTER 4 DISCOUNTED CASH FLOW VALUATION

CHAPTER 4 DISCOUNTED CASH FLOW VALUATION Solutions to Questions and Problems NOTE: All-end-of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability

### Chapter 8 Capital Budgeting Process and Techniques

Chapter 8 Capital Budgeting Process and Techniques MULTIPLE CHOICE 1. The capital budgeting process involves a. identifying potential investments b. analyzing the set of investment opportunities, and identifying

### Tools for Project Evaluation. Nathaniel Osgood 1.040/1.401J 2/11/2004

Tools for Project Evaluation Nathaniel Osgood 1.040/1.401J 2/11/2004 Basic Compounding Suppose we invest \$x in a bank offering interest rate i If interest is compounded annually, asset will be worth \$x(1+i)

### Investment Decisions and Capital Budgeting

Investment Decisions and Capital Budgeting FINANCE 350 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University 1 Issues in Capital Budgeting: Investment How should capital

### Capital Budgeting Decisions Tools

Management Accounting 217 Capital Budgeting Decisions Tools In many businesses, growth is a major factor to business success. Substantial growth in sales may eventually means a need to expand plant capacity.

### USQ UNIVERSITY OF SOUTHERN QUEENSLAND

USQ UNIVERSITY OF SOUTHERN QUEENSLAND MBA - ACC5502 Accounting & Financial Management / S1 / 2015 M B G Wimalarathna [FCA, FCMA, MCIM, FMAAT, MCPM, (MBA PIM/USJ)] Introduction Decision on long term investments

### In Feb. 2000, Corning Inc., announced plans to spend \$750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component

CAPITAL BUDGETING In Feb. 2000, Corning Inc., announced plans to spend \$750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component of today s high speed communications

### Capital Budgeting Techniques: Certainty and Risk

Capital Budgeting Techniques: Certainty and Risk 340 LG1 LG2 LG3 LG4 LG5 LG6 Chapter 9 LEARNING GOALS Calculate, interpret, and evaluate the payback period. Apply net present value (NPV) and internal rate

### Chapters 11&12 -- Capital Budgeting

Chapters 11&12 -- Capital Budgeting Capital budgeting Project classifications Capital budgeting techniques Cash flow estimation Risk analysis in capital budgeting Optimal capital budget Capital budgeting

### CAPITOLO 15 LE DECISIONI DI LUNGO TERMINE: LA SCELTA DEGLI INVESTIMENTI

CAPITOLO 15 LE DECISIONI DI LUNGO TERMINE: LA SCELTA DEGLI INVESTIMENTI Approach Capital investment decisions are a special kind of alternative choice problem. They are analyzed in the same way as that

### Chapter 7. What s next? Topic Overview. Net Present Value & Other Investment Criteria

What s next? Capital Budgeting: involves making decisions about real asset investments. Chapter 7: Net Present Value and Other Investment Criteria Chapter 8: Estimating cash flows for a potential investment.

### Issues in Capital Budgeting

Lecture: Week V 1 Issues in Capital Budgeting What is Capital Budgeting? The process of making and managing expenditures on long-lived assets. Allocating available capital amongst investment opportunities.

### Review for Exam 2. Instructions: Please read carefully

Review for Exam 2 Instructions: Please read carefully The exam will have 20 multiple choice questions and 4 work problems. Questions in the multiple choice section will be either concept or calculation

### Prioritization of Climate Change Adaptation Options. The Role of Cost-Benefit Analysis. Session 7: Conducting CBA Step 6

Prioritization of Climate Change Adaptation Options The Role of Cost-Benefit Analysis Session 7: Conducting CBA Step 6 Accra (or nearby), Ghana October 25 to 28, 2016 8 steps Step 1: Define the scope of

### 9. Short-Term Liquidity Analysis. Operating Cash Conversion Cycle

9. Short-Term Liquidity Analysis. Operating Cash Conversion Cycle 9.1 Current Assets and 9.1.1 Cash A firm should maintain as little cash as possible, because cash is a nonproductive asset. It earns no

### Solutions to Chapter 8. Net Present Value and Other Investment Criteria

Solutions to Chapter 8 Net Present Value and Other Investment Criteria. NPV A = \$00 + [\$80 annuity factor (%, periods)] = \$00 \$80 \$8. 0 0. 0. (.) NPV B = \$00 + [\$00 annuity factor (%, periods)] = \$00 \$00

### Industrial and investment analysis as a tool for regulation

Industrial and investment analysis as a tool for regulation Marina Di Giacomo, Università di Torino Turin School of Local Regulation International Summer School on Regulation of Local Public Services 1

### Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14

Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14 I. Additional Issues in Capital Budgeting. A. Capital rationing: Use profitability index

### 2. CAPITAL BUDGETING TECHNIQUES

2. CAPITAL BUDGETING TECHNIQUES 2.1 Introduction 2.2 Capital budgeting techniques under certainty 2.2.1 Non-discounted Cash flow Criteria 2.2.2 Discounted Cash flow Criteria 2.3 Comparison of NPV and IRR

### Review Solutions FV = 4000*(1+.08/4) 5 = \$4416.32

Review Solutions 1. Planning to use the money to finish your last year in school, you deposit \$4,000 into a savings account with a quoted annual interest rate (APR) of 8% and quarterly compounding. Fifteen

### Evaluating Mutually Exclusive Projects with Capital Budgeting Techniques. (Case Study)

Evaluating Mutually Exclusive Projects with Capital Budgeting Techniques (Case Study) Introduction Michael Strahan had started working for a mining company. His company is evaluating two projects: One

### CHAPTER 29. Capital Budgeting

CHAPTER 9 Capital Budgeting Meaning The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the purpose of maximizing return on investments. The capital

### Alternative Investment Criteria

Alternative Investment Criteria Second Criterion: Internal Rate of Return (IRR) IRR is the discount rate (K) at which the present value of benefits are just equal to the present value of costs for the

### Answers to Warm-Up Exercises

Answers to Warm-Up Exercises E10-1. Answer: E10-2. Answer: Payback period The payback period for Project Hydrogen is 4.29 years. The payback period for Project Helium is 5.75 years. Both projects are acceptable

### CHAPTER 10. EVALUATING PROPOSED CAPITAL EXPENDITURES Table of Contents

CHAPTER 10 EVALUATING PROPOSED CAPITAL EXPENDITURES Table of Contents Section Description Page 1000 INTRODUCTION... 10-1 1001 ANALYZING THE CURRENT SITUATION... 10-2.2 Using a Diagnostic Approach... 10-3.4

### Planning for Capital Investments

12-1 Planning for Capital Investments Managerial Accounting Fifth Edition Weygandt Kimmel Kieso 12-2 study objectives 1. Discuss capital budgeting evaluation, and explain inputs used in capital budgeting.

### Republic Polytechnic Continuing Education & Training Course Structure for : Finance Management

Republic Polytechnic Continuing Education & Training Course Structure for : Finance Management Module Finance Management Description Finance Management is a module that serves to cover key financial aspects

### CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS

CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concepts Review and Critical Thinking Questions 1. In this context, an opportunity cost refers to the value of an asset or other input that will

### Essential Learning for CTP Candidates TEXPO Conference 2016 Session #03

TEXPO Conference 2016: Essential Learning for CTP Candidates Session #3 (Mon.1:45 3:00 pm) Overview of Basic CTP Math from ETM4 Chap 07: Earnings Credits Chap 09: Working Capital Chap 18: Fin. Statements

### Week- 1: Solutions to HW Problems

Week- 1: Solutions to HW Problems 10-1 a. Payback A (cash flows in thousands): Annual Period Cash Flows Cumulative 0 (\$5,000) (\$5,000) 1 5,000 (0,000) 10,000 (10,000) 3 15,000 5,000 4 0,000 5,000 Payback

### Capital Budgeting Processes and Wealth Maximization Objective: Implications for Firms in Nigeria.

Capital Budgeting Processes and Wealth Maximization Objective: Implications for Firms in Nigeria. Uwem Etim Uwah (M.Sc, ACA) 1* Akabom Ita Asuquo (PhD,FCCA) 2 1. National Teachers Institute, P.M.B. 1058,

### Fahmi Ben Abdelkader HEC, Paris Fall Student version 9/19/ :28 PM 1

Financial Economics Fundamentals of Capital Budgeting Fahmi Ben Abdelkader HEC, Paris Fall 2012 Student version 9/19/2012 12:28 PM 1 Introduction Preambule How did Steve Jobs arrive at the decision to

### Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions

Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Chapter 7 Capital Investments and Cash Flow Analysis Concept Check 7.1 1. What is capital budgeting?

### Homework #3 BUSI 408 Summer II 2013

Homework #3 BUSI 408 Summer II 2013 This assignment is due 12 July 2013 at the beginning of class. Answer each question with numbers rounded to two decimal places. For relevant questions, identify the

### How will the firm's total after-tax cash flows change if the new project is accepted?

NPV and Capital Budgeting: A Short Note on Estimation of Project Cash Flows (Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) KC Chow The most important value-driving decisions