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Unformatted text preview: Chapter 11: The Basics of Capital Budgeting Integrated Case 1 Chapter 11 The Basics of Capital Budgeting Answers to EndofChapter Questions 111 Project classification schemes can be used to indicate how much analysis is required to evaluate a given project, the level of the executive who must approve the project, and the cost of capital that should be used to calculate the projects NPV. Thus, classification schemes can increase the efficiency of the capital budgeting process. 112 The regular payback method has three main flaws: (1) Dollars received in different years are all given the same weight. (2) Cash flows beyond the payback year are given no consideration whatever, regardless of how large they might be. (3) Unlike the NPV, which tells us by how much the project should increase shareholder wealth, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we get our investment back. The discounted payback corrects the first flaw, but the other two flaws still remain. 113 The NPV is obtained by discounting future cash flows, and the discounting process actually compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1. 114 Mutually exclusive projects are a set of projects in which only one of the projects can be accepted. For example, the installation of a conveyorbelt system in a warehouse and the purchase of a fleet of forklifts for the same warehouse would be mutually exclusive projects accepting one implies rejection of the other. When choosing between mutually exclusive projects, managers should rank the projects based on the NPV decision rule. The mutually exclusive project with the highest positive NPV should be chosen. The NPV decision rule properly ranks the projects because it assumes the appropriate reinvestment rate is the cost of capital. 115 The first question is related to Question 113 and the same rationale applies. A high cost of capital favors a shorterterm project. If the cost of capital declined, it would lead firms to invest more in longterm projects. With regard to the last question, the answer is no; the IRR rankings are constant and independent of the firms cost of capital. 116 The statement is true. The NPV and IRR methods result in conflicts only if mutually exclusive projects are being considered since the NPV is positive if and only if the IRR is greater than the cost of capital. If the assumptions were changed so that the firm had mutually exclusive projects, then the IRR and NPV methods could lead to different conclusions. A change in the cost of capital or in the cash flow streams would not lead to conflicts if the projects were independent. Therefore, the IRR method can be used in lieu of the NPV if the projects being considered are independent....
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 Spring '07
 Chen

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