ICE COMM 303 Suggested Answers to Chapter 7 Questions and Pr

ICE COMM 303 Suggested Answers to Chapter 7 Questions and...

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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. 7-5. Any method can be manipulated. Smart managers must be aware of this and must be prepared to press analysts to justify their numbers. Opportunities to manipulate the numbers are not unique to the NPV approach and can therefore not be used to justify
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This note was uploaded on 03/18/2008 for the course ICE 303 taught by Professor Roberts during the Spring '08 term at UVA.

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ICE COMM 303 Suggested Answers to Chapter 7 Questions and...

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