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Warren%20SMChap25_10_ - CHAPTER 25(FIN MAN CHAPTER 10(MAN...

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461 CHAPTER 25 (FIN MAN); CHAPTER 10 (MAN) CAPITAL INVESTMENT ANALYSIS EYE OPENERS 1. The principal objections to the use of the average rate of return method are its failure to consider the expected cash flows from the proposals and the timing of these flows. 2. The principal limitations of the cash payback method are its failure to consider cash flows occurring after the payback period and its failure to use present value concepts. 3. The average rate of return is not based on cash flows, but on operating income. Thus, for example, the average rate of return will include the impact of depreciation, but the internal rate of return will not. In addition, the internal rate of return approach will use time value of money concepts, while the average rate of return does not. 4. The cash payback period ignores the cash flows that occur after the cash payback pe- riod, while the net present value method in- cludes all cash flows in the analysis. The cash payback period also ignores the time value of money, which is also included in the net present value method. 5. A one-year payback will not equal a 100% average rate of return because the payback period is based on cash flows, while the av- erage rate of return is based on income. The depreciation on the project will prevent the two methods from reconciling. 6. The cash payback period ignores cash flows occurring after the payback period, which will often include large residual values. 7. The majority of the cash flows of a new mo- tion picture are earned within two years of release. Thus, the time value of money as- pect of the cash flows is less significant for motion pictures than for projects with time extended cash flows. This would favor the use of a cash payback period for evaluating the cash flows of the project. 8. The $7,900 net present value indicates that the proposal is desirable because the pro- posal is expected to recover the investment and provide more than the minimum rate of return. 9. The net present values indicate that both projects are desirable, but not necessarily equal in desirability. The present value index can be used to compare the two projects. For example, assume one project required an investment of $10,000 and the other an investment of $100,000. The present value indexes would be calculated as 0.9 and 0.09, respectively, for the two projects. That is, a $9,000 net present value on a $10,000 investment would be more desirable than the same net present value on a $100,000 investment. 10. The computations for the net present value method are more complex than those for the methods that ignore present value. Also, the method assumes that the cash received from the proposal during its useful life will be reinvested at the rate of return used to com- pute the present value of the proposal. This assumption may not always be reasonable.
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