$18.80 million at t = 0
Success
Failure
Success
Failure
$28million at t = 1
($25 million at t = 0)
$5 million at t = 1
($4.464 million at t = 0)
$28million at t = 0
$5 million at t = 0
Finance Exam 3 Homework Solutions
CHAPTER 7
Answers to Concept Questions
1.
Assuming conventional cash flows, a payback period less than the project’s life means that the NPV is positive for a zero discount rate, but
nothing more definitive can be said. For discount rates greater than zero, the payback period will still be less than the project’s life, but the
NPV may be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. The discounted
payback includes the effect of the relevant discount rate. If a project’s discounted payback period is less than the project’s life, it must be the
case that NPV is positive.
2.
Assuming conventional cash flows, if a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a zero
discount rate; thus, the payback period must be less than the project life. Since discounted payback is calculated at the same discount rate as is
NPV, if NPV is positive, the discounted payback period must be less than the project’s life. If NPV is positive, then the present value of future
cash inflows is greater than the initial investment cost; thus, PI must be greater than 1. If NPV is positive for a certain discount rate
R
, then it
will be zero for some larger discount rate
R
*; thus, the IRR must be greater than the required return.
3.
a.
Payback period is simply the accounting break-even point of a series of cash flows. To actually compute the payback period, it is
assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in
time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some
predetermined cutoff for the payback period, the decision rule is to accept projects that pay back before this cutoff, and reject projects
that take longer to pay back. The worst problem associated with the payback period is that it ignores the time value of money. In
addition, the selection of a hurdle point for the payback period is an arbitrary exercise that lacks any steadfast rule or method. The
payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point.
b.
The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as
some average profit measure attributable to the project divided by some average balance sheet value for the project. This text computes
AAR as average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to
accept projects with an AAR in excess of the target measure, and reject all other projects. AAR is not a measure of cash flows or market