Ch 11 - CHAPTER 11 CAPITAL BUDGETING DECISION CRITERIA AND...

CHAPTER 11
CAPITAL BUDGETING DECISION CRITERIA AND RISK ANALYSIS
ANSWERS TO END OF CHAPTER QUESTIONS
:
1. The net present value method computes the present worth of a project's benefits over
its costs, evaluated using the firm's cost of capital. If a project has a positive net present
value it means that investors are receiving the minimum required rate of return, as measured
by the cost of capital, plus they are receiving something extra. This positive net present
value is an additional increment to shareholder wealth.
2. In the case of mutually exclusive investments it is possible for the net present value
and internal rate of return approaches to give conflicting rankings. One reason this occurs is
because of different reinvestment rate assumptions between net present value and internal
rate of return calculations. Net present value calculations assume that the cost of capital
(discount rate) is the reinvestment rate while the internal rate of return assumes the
reinvestment rate is equal to the internal rate of return itself.
3. Multiple rates of return are likely to occur when a project's cash flow stream contains
more than one sign change (from positive to negative or negative to positive). Under these
circumstances it is best to use the net present value approach.
4. The profitability index approach may be preferred if a firm is in a capital rationing
situation and capital budgeting is being done for only one period, because it will indicate
which projects will maximize the returns per dollar of investment —an appropriate
objective when a funds constraint exists.
5. Strengths: Easy to use, provides a crude or simple assessment of risk, useful in
assessing the liquidity of the investment (i.e., measured as how quickly the investment is
recovered).
Weaknesses: Does not consider cash flows beyond payback period; ignores time value of
money; provides no objective criterion for decision-making.
6. The cost of capital is the appropriate discount rate to use in evaluating a project that
is of similar risk to the average project of the firm . For projects riskier than the average a
higher discount rate than the firm’s cost of capital should be used while projects that are less
risky than the average should be evaluated using a discount rate lower than the firm’s cost of
capital.
7. Sensitivity analysis shows how sensitive a project’s Net Present Value (or some other
measure of project profitability) is to changes in a particular variable , for example, selling
price or sales volume. Thus, it shows how uncertainty with respect to certain variables
contributes to the riskiness of the project’s profitability. Simulation analysis develops a
probability distribution of the net present value of a project given estimates of probability
distributions of the input variables.