Chapter 11
Capital Budgeting
Decision Criteria
ANSWERS TO BEGINNINGOFCHAPTER QUESTIONS
111
The 7 criteria are discussed below.
All except the Accounting Rate of
Return are calculated and analyzed in the spreadsheet model for the
chapter.
Payback.
Easy to calculate and understand, but doesn’t tell us if
the project is economically profitable because it doesn’t take account
of either time value of money or cash flows beyond the payback period.
Discounted payback.
Does take account of time value of money, and
if the discounted payback is positive, then the project is economically
feasible—if it lasts just over its payback period, then NPV will be
positive.
It doesn’t take account of cash flows beyond the payback
period, hence could lead to mistakes when considering mutually
exclusive projects. Does provide a sense of liquidity and risk.
Accounting rate of return.
This method finds the average income
over a project’s life and then divides this income by the average
investment over the project’s life.
This method is flawed because it
does not take account of the time value of money.
NPV
is the most logical method, and the one that is most consistent
with value maximization.
It has gained acceptance by businesses
(finally), and is now used by most large corporations.
IRR
is a “reasonable” method that produces correct accept/reject
decisions for independent projects.
It always leads to the same
accept/reject decisions as NPV for independent projects (except where
multiple IRRs exist).
However, its rankings of mutually exclusive
projects can differ from NPV rankings if projects’ cash flow timing
patterns differ or if the projects differ in size.
In those cases, NPV
is theoretically better.
IRR is widely used—about as widely used as NPV by large companies.
A few years ago IRR was much more widely used, but NPV has caught up.
IRR does give people an idea of the margin of safety in a project,
i.e., cash inflows could fall quite a bit below forecast and a high IRR
project will still be profitable.
MIRR
is not as widely used as IRR, but it is actually superior to
the regular IRR because it is generally more logical to assume
reinvestment at the WACC (which the MIRR generally does) than at the
IRR (which the IRR does).
Also, the MIRR can be calculated with
whatever reinvestment rate is deemed most appropriate—we do not have to
use the WACC if there is reason to think that the actual reinvestment
rate will be different from the WACC.
In summary, the MIRR is superior
to the regular IRR because it gives better estimate of the rate of
return an investment will actually earn over its lifetime.
There cannot be multiple MIRR’s, which is another advantage over the
regular IRR.
Also, the MIRR and the NPV always agree on mutually
exclusive projects (if the MIRR is based on the WACC), but there can be
NPV and MIRR conflicts if mutually exclusive projects differ in size.
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 Spring '09
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 Net Present Value, Internal rate of return

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