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Unformatted text preview: End of Chapter 7 Questions, Problems and Solutions CORPORATE FINANCE Professor Megginson February 27, 2003 Questions [See problems in book] *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** Answers to End of Chapter 7 Questions 7.1) Payback period is unavoidably long in industries with long-lasting projects, for example, the oil exploration industry, where it might take a long time to find acceptable oil fields and make them produce. Some agricultural products take a long time for example starting an apple orchard would have a long payback, waiting for the trees to grow, mature and finally produce maximum produce. 7.2) AA) Payback could lead to Type 1 errors when it rejects a good project that has large cash flows after the payback period cutoff. B) Type II errors occur when payback says to accept a project that doesn't return enough to compensate for the risk taken. C) A type I error is more likely good project with higher cash flows in later years may be rejected. 7.3) Type 1 errors are still likely a bias against longer-lived projects with cash flows occurring after the payback period cutoff 7.4) 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. 7.5) If the firm consistently uses a too high discount rate, then it will reject good project that would add to shareholder value. 7.6) NPV automatically adjusts for project time by using an exponentially smaller discount rate applied to later cash flows. It gives these cash flows less importance in the final answer. 7.7) Any method can be manipulated. It would be hard to argue that accounting numbers cant be manipulated after all the accounting scandals, starting with Enron in late 2001. Managers should have incentives to provide the most accurate information possible. 7.8) The NPV approach is consistent with shareholder maximization because it suggests that firms should only accept projects which 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. 7.9) A firm that consistently earns returns higher than its opportunity cost of capital is adding value to the firm, and its stock price should increase. For the project returning 18%, as long as it returns enough to compensate for the risk of the project, it is adding value and shareholders will be happy about the decision to accept the project 1 7.10) The IRR suffers from several problems. The IRR is not well suited to ranking projects with very different scales or projects with very different cash flow timing patterns. The IRR method can...
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