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CHAPTER 18 INTERNATIONAL CAPITAL BUDGETING SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Why is capital budgeting analysis so important to the firm? Answer: The fundamental goal of the financial manager is to maximize shareholder wealth. Capital investments with positive NPV or APV contribute to shareholder wealth. Additionally, capital investments generally represent large expenditures relative to the value of the entire firm. These investments determine how efficiently and expensively the firm will produce its product. Consequently, capital expenditures determine the long-run competitive position of the firm in the product marketplace. 2. What is the intuition behind the NPV capital budgeting framework? Answer: The NPV framework is a discounted cash flow technique. The methodology compares the present value of all cash inflows associated with the proposed project versus the present value of all project outflows. If inflows are enough to cover all operating costs and financing costs, the project adds wealth to shareholders. 3. Discuss what is meant by the incremental cash flows of a capital project. Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash outflows that can be traced directly to the project under analysis.
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4. Discuss the nature of the equation sequence, Equation 18.2a to 18.2f. Answer: The equation sequence is a presentation of incremental annual cash flows associated with a capital expenditure. Equation 18.2a presents the most detailed expression for calculating these cash flows; it is composed of three terms. Equation 18.2b shows that these three terms are: i) incremental net profit associated with the project; ii) incremental depreciation allowance; and, iii) incremental after-tax interest expense associated with the borrowing capacity created by the project. Note, the incremental “net profit” is not accounting profit but rather net cash actually available for shareholders. Equation 18.2c cancels out the after-tax interest term in 18.2a, yielding a simpler formula. Equation 18.2d shows that the first term in 18.2c is generally called after-tax net operating income. Equation 18.2e yields yet a computationally simpler formula by combining the depreciation terms of 18.2c. Equation 18.2f shows that the first term in 18.2e is generally referred to as after-tax operating cash flow. 5. What makes the APV capital budgeting framework useful for analyzing foreign capital expenditures? Answer: The APV framework is a value-additivity technique. Because international projects frequently have cash flows not encountered in domestic projects, the APV technique easily allows the analyst to add terms to the model that represent the special cash flows. 6.
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