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CH5 - CHAPTER 5 Why Net Present Value Leads to Better...

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CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria Answers to Practice Questions 1. a. $90.91 .10) 0 (1 1000 1000 NPV A - = + + - = $4,044.73 10) (1. 1000 (1.10) 1000 (1.10) 4000 (1.10) 1000 (1.10) 1000 2000 NPV 5 4 3 2 B + = + + + + + - = $39.47 10) (1. 1000 .10) (1 1000 (1.10) 1000 (1.10) 1000 3000 NPV 5 4 2 C + = + + + + - = b. Payback A = 1 year Payback B = 2 years Payback C = 4 years c. A and B. 2. The discounted payback period is the number of periods a project must last in order to achieve a zero net present value. It is marginally preferable to the regular payback rule because it uses discounted cash flows, thereby overcoming the criticism that all cash flows prior to the cutoff date have equal weight. However, the discounted payback period still does not account for cash flows occurring after the cut-off date. 3. Book rate of return uses the accounting definition of income and investment (i.e., book value of assets). Both of these accounting concepts differ from cash flow measures. In addition, book rate of return does not recognize the time value of money. Hence, decisions based on book rate of return can, and often do, lead to choices that are unacceptable when analyzed on a net present value basis. 4. a. When using the IRR rule, the firm must still compare the IRR with the opportunity cost of capital. Thus, even with the IRR method, one must think about the appropriate discount rate. b. Risky cash flows should be discounted at a higher rate than the rate used to discount less risky cash flows. Using the payback rule is equivalent to using the NPV rule with a zero discount rate for cash flows before the payback period and an infinite discount rate for cash flows thereafter. 38
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5. In general, the discounted payback rule is slightly better than the regular payback rule. But, in this case , it might actually be worse: with the same cut-off period, fewer long-lived investment projects will make the grade.
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