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Unformatted text preview: Answers to End-of-Chapter Questions Q8-1. Can you name some industries where the payback period is unavoidably long? A8-1. 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. Q8-2. In statistics, you learn about Type I and Type II errors. A Type I error occurs when a statistical test rejects a hypothesis when the hypothesis is actually true. A Type II error occurs when a test fails to reject a hypothesis that is actually false. We can apply this type of thinking to capital budgeting. A Type I error occurs when a firm rejects an investment project that would actually enhance shareholder wealth. A Type II error occurs when a firm accepts a value-decreasing investment, an investment it should have rejected. a. Describe the features of the payback rule that could lead to Type I errors. b. Describe the features of the payback rule that could lead to Type II errors. c. Which error do you think is more likely to occur when firms use payback analysis? Does your answer depend on the length of the cutoff payback period? You can assume a typical project cash flow stream, meaning that most cash outflows occur in the early years of a project. A8-2. a. 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. Q8-3. Holding the cutoff period fixed, which method has a more severe bias against long-lived projects, payback or discounted payback? A8-3. 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. Q8-4. For a firm that uses the NPV rule to make investment decisions, what consequences result if the firm misestimates shareholders required returns and consistently applies a discount rate that is too high? A8-4. If the firm consistently uses a too high discount rate, then it will reject good project that would add to shareholder value. Q8-5. Cash flow projections more than a few years out are not worth the paper theyre written on. Therefore, using payback analysis, which ignores long-term cash flows, is more reasonable than making wild guesses as one has to do in the NPV approach. Respond to this comment. A8-5. 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....
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- Spring '08