Answers to EndofChapter Questions
Q82.
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 valuedecreasing 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.
A82.
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.
Q87.
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?
A87.
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.
Q811.
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?
A811.
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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 Spring '08
 TAVBIN
 Net Present Value

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