Chapter 10The Basics of Capital Budgeting: Evaluating Cash FlowsANSWERS TO END-OF-CHAPTER QUESTIONS10-1a.Capital budgeting is the whole process of analyzing projects and deciding whetherthey should be included in the capital budget.This process is of fundamentalimportance to the success or failure of the firm as the fixed asset investment decisionschart the course of a company for many years into the future.The payback, orpayback period, is the number of years it takes a firm to recover its projectinvestment.Payback may be calculated with either raw cash flows (regular payback)or discounted cash flows (discounted payback).In either case, payback does notcapture a project’s entire cash flow stream and is thus not the preferred evaluationmethod.Note, however, that the payback does measure a project’s liquidity, andhence many firms use it as a risk measure.b.Mutually exclusive projects cannot be performed at the same time.We can chooseeither Project 1 or Project 2, or we can reject both, but we cannot accept bothprojects.Independent projects can be accepted or rejected individually.c.The net present value (NPV) and internal rate of return (IRR) techniques arediscounted cash flow (DCF) evaluation techniques.These are called DCF methodsbecause they explicitly recognize the time value of money.NPV is the present valueof the project’s expected future cash flows (both inflows and outflows), discounted atthe appropriate cost of capital.NPV is a direct measure of the value of the project toshareholders.The internal rate of return (IRR) is the discount rate that equates thepresent value of the expected future cash inflows and outflows.IRR measures therate of return on a project, but it assumes that all cash flows can be reinvested at theIRR rate.The profitability index is the ratio of the present value of future cash flowsto the project’s initial cost.It shows the relative profitability of any project.Aprofitability index greater than 1 is equivalent to a positive NPV project.d.The modified internal rate of return (MIRR) assumes that cash flows from all projectsare reinvested at the cost of capital as opposed to the project’s own IRR.This makesthe modified internal rate of return a better indicator of a project’s true profitability.e.An NPV profile is the plot of a project’s NPV versus its cost of capital.The crossoverrate is the cost of capital at which the NPV profiles for two projects intersectindicating that at that point their NPVs are equal.
f.Capital projects with nonnormal cash flows have a large cash outflow eithersometime during or at the end of their lives.A common problem encountered whenevaluating projects with nonnormal cash flows is multiple IRRs.A project hasnormal cash flows if one or more cash outflows (costs) are followed by a series ofcash inflows.g.The mathematics of the NPV method imply that project cash flows are reinvested atthe cost of capital while the IRR method assumes reinvestment at the IRR.Since
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