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

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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.
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