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10-1 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. 10-2 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. 10-3 This question is related to Question 10-2 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. 10-4 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. 10-5 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. 10-6 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. 10-7 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 long-term project exceeds that of a short-term project, the higher Answers and Solutions: 10 - 1 Chapter 10 The Basics of Capital Budgeting ANSWERS TO END-OF-CHAPTER QUESTIONS
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future growth from the long-term 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 short-term project--one with a faster payback--reported profits would have been higher for a period of years. This is, of course, another reason why firms sometimes use the payback method. 10-8
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This note was uploaded on 02/07/2010 for the course ECON 101 taught by Professor Garton during the Spring '10 term at Edison College.

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