s09 - Chapter 9: Capital Budgeting Decision Criteria and...

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Chapter 9: Capital Budgeting Decision Criteria and Real Option Considerations 9-1 Chapter 9 CAPITAL BUDGETING DECISION CRITERIA AND REAL OPTION CONSIDERATIONS ANSWERS TO QUESTIONS: 1. The net present value method computes the present worth of a project's benefits over its costs, and is evaluated by 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. This is most likely to occur when the two or more projects being considered are significantly different in size or have very different patterns of cash flows. 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 defines the number of dollars of present value benefits that are received for each dollar of net investment. Hence it provides a measure of relative profitability. This measure can be used to guide a ranking of investment projects in a capital rationing situation (see Table 9-5). 5. Strengths: Easy to use; may be used to consider a project's risk or its liquidity. Weaknesses: Does not consider cash flows beyond payback period; ignores time value of money; provides no objective criterion for decision making. 6. The objectives of a project post-audit/review are: a. To identify systematic biases or errors in the cash flow estimates by individuals, departments, plants or divisions. This analysis enables decision makers to make better evaluations of investment proposals submitted in the future. b. To determine whether a project which has not lived up to expectations should be continued or abandoned. 7. In an inflationary environment, the level of capital expenditures by private firms tends to decrease, because the cost of capital generally increases with inflation. It is possible that in some cases inflation might increase projected revenues from a project more than projected costs, thereby offsetting the increasing cost of capital. To the extent that this is not the case, there will be a decline in capital investments. 8. The major problem is placing a dollar value on all costs and benefits generated by a project. There tends to be more intangible costs and benefits in these types of projects. This makes analysis more difficult and less precise.
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s09 - Chapter 9: Capital Budgeting Decision Criteria and...

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