HW8_Answers

HW8_Answers - Answers to End-of-Chapter Questions Q8-2. In...

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Answers to End-of-Chapter Questions Q8-2. In statistics, you learn about Type I and Type II errors. A Type I error occurs when a statistical test rejects a hypothesis when the hypothesis is actually true. A Type II error occurs when a test fails to reject a hypothesis that is actually false. We can apply this type of thinking to capital budgeting. A Type I error occurs when a firm rejects an investment project that would actually enhance shareholder wealth. A Type II error occurs when a firm accepts a value-decreasing investment, an investment it should have rejected. a. Describe the features of the payback rule that could lead to Type I errors. b. Describe the features of the payback rule that could lead to Type II errors. c. Which error do you think is more likely to occur when firms use payback analysis? Does your answer depend on the length of the cutoff payback period? You can assume a “typical” project cash flow stream, meaning that most cash outflows occur in the early years of a project. A8-2. a. Payback could lead to Type 1 errors when it rejects a good project that has large cash flows after the payback period cutoff. b. Type II errors occur when payback says to accept a project that doesn't return enough to compensate for the risk taken. c. A type I error is more likely – good project with higher cash flows in later years may be rejected. Q8-7. In what way is the NPV consistent with the principle of shareholder wealth maximization? What happens to the value of a firm if a positive- NPV project is accepted? If a negative- NPV project is accepted? A8-7. The NPV approach is consistent with shareholder maximization because it suggests that firms should only accept projects which earn returns above the opportunity costs of the firm’s investors. The NPV in effect measures the dollar contribution that the given project is expected to make to the firm’s overall value. If a firm invests in a project with NPV > $0, then the share price will rise. Conversely, a firm’s share price will fall if it invests in projects with NPV < $0. Q8-11. Outline the differences between NPV , IRR , and PI. What are the advantages and disadvantages of each technique? Do they agree with regard to simple accept or reject decisions? A8-11. The NPV is calculated by discounting all of a project’s cash flows to the present. The IRR is calculated by finding the discount rate which equates the NPV to zero. The profitability index is the ratio of the present value of a project’s cash flows (excluding the initial cash outflow) divided by the initial cash outflow. All three methods lead to the same accept/reject decision when evaluating a single project, but IRR and PI have problems when ranking projects. NPV generally overcomes these problems.
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HW8_Answers - Answers to End-of-Chapter Questions Q8-2. In...

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