Chapter 11
The Basics of Capital Budgeting:
Evaluating Cash Flows
ANSWERS TO ENDOFCHAPTER QUESTIONS
111
a.
Capital budgeting is the whole process of analyzing projects and deciding whether
they should be included in the capital budget.
This process is of fundamental
importance to the success or failure of the firm as the fixed asset investment decisions
chart the course of a company for many years into the future.
The payback, or
payback period, is the number of years it takes a firm to recover its project
investment.
Payback may be calculated with either raw cash flows (regular payback)
or discounted cash flows (discounted payback).
In either case, payback does not
capture a project's entire cash flow stream and is thus not the preferred evaluation
method.
Note, however, that the payback does measure a project's liquidity, and
hence many firms use it as a risk measure.
b.
Mutually exclusive projects cannot be performed at the same time.
We can choose
either Project 1 or Project 2, or we can reject both, but we cannot accept both
projects.
Independent projects can be accepted or rejected individually.
c.
The net present value (NPV) and internal rate of return (IRR) techniques are
discounted cash flow (DCF) evaluation techniques.
These are called DCF methods
because they explicitly recognize the time value of money.
NPV is the present value
of the project's expected future cash flows (both inflows and outflows), discounted at
the appropriate cost of capital.
NPV is a direct measure of the value of the project to
shareholders.
The internal rate of return (IRR) is the discount rate that equates the
present value of the expected future cash inflows and outflows.
IRR measures the
rate of return on a project, but it assumes that all cash flows can be reinvested at the
IRR rate.
d.
The modified internal rate of return (MIRR) assumes that cash flows from all projects
are reinvested at the cost of capital as opposed to the project's own IRR.
This makes
the modified internal rate of return a better indicator of a project's true profitability.
The profitability index is found by dividing the project’s PV of future cash flows by
its initial cost.
A profitability index greater than 1 is equivalent to a positive NPV
project.
e.
An NPV profile is the plot of a project's NPV versus its cost of capital.
The crossover
rate is the cost of capital at which the NPV profiles for two projects intersect.
Answers and Solutions:
11  1
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Capital projects with nonnormal cash flows have a large cash outflow either
sometime during or at the end of their lives.
A common problem encountered when
evaluating projects with nonnormal cash flows is multiple IRRs.
A project has
normal cash flows if one or more cash outflows (costs) are followed by a series of
cash inflows.
g.
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 Spring '10
 SENN
 Net Present Value, Internal rate of return

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