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Unformatted text preview: Capital Budgeting Process and Techniques 93 Chapter 7: Capital Budgeting Process and Techniques Answers to questions 7-1. a. Type I error means rejecting a good project. Payback could lead to Type 1 errors when it rejects a good project that has large cash flows after the payback period cutoff. Payback ignores cash flows after the cutoff. b. Type II error means accepting a project that should have been rejected. Type II errors occur when payback says to accept a project that doesn't return enough to compensate for the risk taken. This occurs because payback makes no adjustments for risk or time value of money. c. If firms apply the payback rule with a fairly short cutoff period, then a type I error is more likely good projects with higher cash flows in later years may be rejected. On the other hand, if firms apply the payback rule but use a long cutoff period, then a Type II error becomes more likely because the payback method makes no adjustment for the time value of money. 7-2. Discounted payback has a more severe bias discounted cash flows will be smaller, making it even harder for a project to pass the payback hurdle. For example, if the cutoff period is four years, then every project that satisfies the discounting payback rule will also satisfy payback, but the reverse is not true. 7-3. The NPV approach is consistent with shareholder maximization because it suggests that firms should only accept projects that earn returns above the opportunity costs of the firms investors. The NPV in effect measures the dollar contribution that the given project is expected to make to the firms overall value. If a firm invests in a project with NPV > $0, then the share price will rise. Conversely, a firms share price will fall if it invests in projects with NPV < $0. 7-4. It is true that long-term projections are more prone to error than are short-term projections. However, there are two reasons why this simple truth does not lead to the conclusion that the payback approach is superior to NPV. First, the payback approach itself implicitly makes long- term cash flow projections. Specifically, the payback approach forecasts zero cash flows beyond the payback horizon. The real question is not whether long-term forecasts are more or less accurate than short-term forecasts are, but whether a long-term forecast can be more accurate than a nave guess of zero. Second, via discounting, the NPV approach makes an adjustment for the high degree of risk in long-term projections. The farther into the future that a given projects cash flows arrive, the less valuable those cash flows are in an NPV calculation. NPV automatically adjusts for project time by using an exponentially smaller discount rate applied to later cash flows....
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This note was uploaded on 02/23/2009 for the course BUSI 233 taught by Professor Harold during the Spring '07 term at Howard County Community College.
- Spring '07