Chapter12 - Chapter 12 Capital Budgeting: Decision Criteria...

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Chapter 12 Capital Budgeting: Decision Criteria ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 12-1 The 7 criteria are discussed below. All except the Accounting Rate of Return are calculated and analyzed in the spreadsheet model for the chapter. Payback. Easy to calculate and understand, but doesn’t tell us if the project is economically profitable because it doesn’t take account of either time value of money or cash flows beyond the payback period. Discounted payback. Does take account of time value of money, and if the discounted payback is positive, then the project is economically feasible—if it lasts just over its payback period, then NPV will be positive. It doesn’t take account of cash flows beyond the payback period, hence could lead to mistakes when considering mutually exclusive projects. Does provide a sense of liquidity and risk. Accounting rate of return. This method finds the average income over a project’s life and then divides this income by the average investment over the project’s life. This method is flawed because it does not take account of the time value of money. NPV is the most logical method, and the one that is most consistent with value maximization. It has gained acceptance by businesses (finally), and is now used by most large corporations. IRR is a “reasonable” method that produces correct accept/reject decisions for independent projects. It always leads to the same accept/reject decisions as NPV for independent projects (except where multiple IRRs exist). However, its rankings of mutually exclusive projects can differ from NPV rankings if projects’ cash flow timing patterns differ or if the projects differ in size. In those cases, NPV is theoretically better. IRR is widely used—about as widely used as NPV by large companies. A few years ago IRR was much more widely used, but NPV has caught up. IRR does give people an idea of the margin of safety in a project, i.e., cash inflows could fall quite a bit below forecast and a high IRR project will still be profitable. MIRR is not as widely used as IRR, but it is actually superior to the regular IRR because it is generally more logical to assume reinvestment at the WACC (which the MIRR generally does) than at the IRR (which the IRR does). Also, the MIRR can be calculated with whatever reinvestment rate is deemed most appropriate—we do not have to use the WACC if there is reason to think that the actual reinvestment rate will be different from the WACC. In summary, the MIRR is superior to the regular IRR because it gives better estimate of the rate of return an investment will actually earn over its lifetime. Answers and Solutions: 12- 1
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There cannot be multiple MIRR’s, which is another advantage over the regular IRR. Also, the MIRR and the NPV always agree on mutually exclusive projects (if the MIRR
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Chapter12 - Chapter 12 Capital Budgeting: Decision Criteria...

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