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Unformatted text preview: CHAPTER 14 CAPITAL INVESTMENT DECISIONS DISCUSSION QUESTIONS 1. Independent projects are such that the ac- ceptance of one does not preclude the ac- ceptance of another. With mutually exclus- ive projects, acceptance of one precludes the acceptance of others. 2. The timing and quantity of cash flows de- termine the present value of a project. The present value is critical for assessing wheth- er a project is acceptable or not. 3. By ignoring the time value of money, good projects can be rejected and bad projects accepted. 4. The payback period is the time required to recover the initial investment. Payback = $80,000/$30,000 = 2.67 years. 5. (a) A measure of risk. Roughly, projects with shorter paybacks are less risky. (b) Obsol- escence. If the risk of obsolescence is high, firms will want to recover funds quickly. (c) Self-interest. Managers want quick pay- backs so that short-run performance meas- ures are affected positively, enhancing chances for bonuses and promotion. 6. The accounting rate of return is the average income divided by original or average invest- ment. ARR = $100,000/$300,000 = 33.33%. 7. Agree. Essentially, net present value is a measure of the return in excess of the in- vestment and its cost of capital. 8. NPV measures the increase in firm value from a project. 9. The cost of capital is the cost of investment funds and is usually viewed as the weighted average of the costs of funds from all sources. It should serve as the discount rate for calculating net present value or the benchmark for IRR analysis. 10. For NPV, the required rate of return is the discount rate. For IRR, the required rate of return is the benchmark against which the IRR is compared to determine whether an investment is acceptable or not. 11. If NPV > 0, then the investment is accept- able. If NPV < 0, then the investment should be rejected. 12. Disagree. Only if the funds received each period from the investment are reinvested to earn the IRR will the IRR be the actual rate of return. 13. Postaudits help managers determine if re- sources are being used wisely. Additional resources or corrective action may be needed. Postaudits serve to encourage managers to make good capital investment decisions. They also provide feedback that may help improve future decisions, The claims and benefits of advanced technology should especially be examined by a postaudit because of the uncertainty sur- rounding new technology. 14. NPV signals which investment maximizes firm value; IRR may provide misleading sig- nals. IRR may be popular because it provides the correct signal most of the time and managers are accustomed to working with rates of return. 15. Often, investments must be made in assets that do not directly produce revenues. In this case, choosing the asset with the least cost (as measured by NPV) makes sense....
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- Spring '08