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Mini_Case-_Chapter_10_7th_Edition_

Mini_Case-_Chapter_10_7th_Edition_ - Chapter 10 Mini Case...

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Chapter 10- Mini Case 7th Ed Page 299 a. Why is capital budgeting important? Can involve large cash investments at beginning of project and com firm to a particular course of action over a long time horizon. They are costly and difficult to reverse. b. Why is it difficult to find very profitable projects? Axiom 5- "The Curse of Competitive Markets". Exceptionally profitab investments involve the reduction of competition by creating barrier entry either through product differentiation or cost advantages. With barriers to entry, whenever exceptionally profitable projects are foun competition rushes in, driving prices and profits down. If it were easy to find and be successful in profitable projects then w would all be rich. Importance of Research & Development (R&D) 3M Drug Companies c. Payback Period Two non-mutually exclusive projects. Project A Project B Outlay -$110,000 -$110,000 Year 1 $20,000 $40,000 Year 2 $30,000 $40,000 Year 3 $40,000 $40,000 Year 4 $50,000 $40,000 Year 5 $70,000 $40,000 Required rate of return on each project is 12%. Irreleva How long does it take to recover the initial cash outlay?
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Project A Cash Flows Balance Outlay (Year 0) $110,000 -$110,000 Year 1 $20,000 -$90,000 Year 2 $30,000 -$60,000 Year 3 $40,000 -$20,000 Year 4 $50,000 $30,000 Need Period = 3.4 years Project B Cash Flows Balance Outlay (Year 0) $110,000 -$110,000 Year 1 $40,000 -$70,000 Year 2 $40,000 -$30,000 Year 3 $40,000 $10,000 Need Year 4 $40,000 Period = 2.75 years (Assuming that income regu Company has a 3 year payback requirement. Project A should be rejected. Project B should be accepted. d. What are the criticisms of the payback period? Ignores the time value of money. Ignores cash flows occuring after the payback period. Selection of the maximum acceptable payback period is arbitrary. Doesn't really make much sense. e. Net Present Value (NPV) Two non-mutually exclusive projects. Project A Project B
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Outlay -$110,000 -$110,000 Year 1 $20,000 $40,000 Year 2 $30,000 $40,000 Year 3 $40,000 $40,000 Year 4 $50,000 $40,000 Year 5 $70,000 $40,000 Required rate of return on each project is 12%. NPV = (∑CFn/((1+I)^n)) - Investment ∑CFn/((1+I)^n) = how much the project/investment is worth to you. Investment = how much it costs you If ∑CFn/((1+I)^n) - Investment>0, then it's worth more to you than it c NPVa = 20,000/(1+.12)^1 + 30,000/(1+.12)^2 + 40,000/(1+.12)^3 + 50,00 70,000/(1+.12)^5 - 110,000 NPVa = $31,739.95 (Look at formula in Excel- It's really the PV YOU BUY SOMETHING IF IT'S WORTH MORE TO YOU THAN NPVb = 40,000/(1+.12)^1 + 40,000/(1+.12)^2 + 40,000/(1+.12)^3 + 40,00 40,000/(1+.12)^5 - 110,000 NPVb = $34,191.05 (Look at formula in Excel- It's really the PV Accept both projects. Learn how to calculate NPV on financial calculator. f. Explain the logic behind the NPV.
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