101
Project classification schemes can be used to indicate how much
analysis is required to evaluate a given project, the level of the
executive who must approve the project, and the cost of capital that
should be used to calculate the project’s NPV.
Thus, classification
schemes can increase the efficiency of the capital budgeting process.
102
The NPV is obtained by discounting future cash flows, and the
discounting process actually compounds the interest rate over time.
Thus, an increase in the discount rate has a much greater impact on a
cash flow in Year 5 than on a cash flow in Year 1.
103
This question is related to Question 102 and the same rationale
applies. With regard to the second part of the question, the answer is
no; the IRR rankings are constant and independent of the firm’s cost of
capital.
104
The NPV and IRR methods both involve compound interest, and the
mathematics of discounting requires an assumption about reinvestment
rates.
The NPV method assumes reinvestment at the cost of capital,
while the IRR method assumes reinvestment at the IRR.
MIRR is a
modified version of IRR that assumes reinvestment at the cost of
capital.
105
The statement is true.
The NPV and IRR methods result in conflicts
only if mutually exclusive projects are being considered since the NPV
is positive if and only if the IRR is greater than the cost of capital.
If the assumptions were changed so that the firm had mutually exclusive
projects, then the IRR and NPV methods could lead to different
conclusions.
A change in the cost of capital or in the cash flow
streams would not lead to conflicts if the projects were independent.
Therefore, the IRR method can be used in lieu of the NPV if the
projects being considered are independent.
106
Yes, if the cash position of the firm is poor and if it has limited
access to additional outside financing it might be better off to choose
a machine with a rapid payback.
But even here, the relationship
between present value and cost would be a better decision tool.
107
a. In general, the answer is no.
The objective of management should be
to maximize value, and as we point out in subsequent chapters, stock
values are determined by both earnings and growth.
The NPV
calculation automatically takes this into account, and if the NPV of
a longterm project exceeds that of a shortterm project, the higher
Answers and Solutions:
10  1
Chapter 10
The Basics of Capital Budgeting
ANSWERS TO ENDOFCHAPTER QUESTIONS
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View Full Documentfuture growth from the longterm project must be more than enough to
compensate for the lower earnings in early years.
b. If the same $100 million had been spent on a shortterm projectone
with a faster paybackreported profits would have been higher for a
period of years.
This is, of course, another reason why firms
sometimes use the payback method.
108
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 Spring '10
 Garton
 Net Present Value

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