CHAPTER 25
CAPITAL INVESTMENT ANALYSIS
CLASS DISCUSSION QUESTIONS
1.
The principal objections to the use of the
average rate of return method are its failing
to consider the expected cash flows from
the proposals and the timing of these flows.
2.
The principal limitations of the cash pay
back method are its failure to consider cash
flows occurring after the payback period
and its failure to use present value con
cepts.
3.
The average rate of return is not based on
cash flows, but on operating income. Thus,
for example, the average rate of return will
include the impact of depreciation, but the
internal rate of return will not. In addition,
the internal rate of return approach will use
time value of money concepts, while the
average rate of return does not.
4.
The cash payback period ignores the cash
flows that occur after the cash payback
period, while the net present value method
includes all cash flows in the analysis. The
cash payback period also ignores the time
value of money, which is also included in
the net present value method.
5.
A oneyear payback will not equal a 100%
average rate of return because the payback
period is based on cash flows, while the av
erage rate of return is based on income.
The depreciation on the project will prevent
the two methods from reconciling.
6.
The cash payback period ignores cash
flows occurring after the payback period,
which will often include large salvage val
ues.
7.
The majority of the cash flows of a new mo
tion picture are earned within two years of
release. Thus, the time value of money as
pect of the cash flows is less significant for
motion pictures than for projects with time
extended cash flows. This would favor the
use of a cash payback period for evaluating
the cash flows of the project.
8.
The $9,750 net present value indicates that
the proposal is desirable because the pro
posal is expected to recover the investment
and provide more than the minimum rate of
return.
9.
The net present values indicate that both
projects are desirable, but not necessarily
equal in desirability. The present value in
dex can be used to compare the two pro
jects. For example, assume one project re
quired an investment of $10,000 and the
other an investment of $100,000. The
present value indexes would be calculated
as 0.5 and 0.05, respectively, for the two
projects. That is, a $5,000 net present
value on a $10,000 investment would be
more desirable than the same net present
value on a $100,000 investment.
10.
The computations for the net present value
method are more complex than those for
the methods that ignore present value.
Also, the method assumes that the cash re
ceived from the proposal during its useful
life will be reinvested at the rate of return
used to compute the present value of the
proposal. This assumption may not always
be reasonable.
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 Spring '11
 WILLIAMS
 Net Present Value, .........

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