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Unformatted text preview: PV less intuitive because it does not measure benefits relative to the 7. For example, see Harold Bierman, Jr., “Capital Budgeting in 1992: A Survey,” Financial Management (Autumn 1993), p. 24, and Lawrence J. Gitman and Charles E. Maxwell, “A Longitudinal Comparison of Capital Budgeting Techniques Used by Major U.S. Firms: 1986 versus 1976,” Journal of Applied Business Research (Fall 1987), pp. 41–50, for discussions of evidence with respect to capital budgeting decision-making practices in major U.S. firms. 412 PART 3 Long-Term Investment Decisions amount invested. Because a variety of techniques are available for avoiding the pitfalls of the IRR, its widespread use does not imply a lack of sophistication on the part of financial decision makers. Review Questions 9–9 How is a net present value profile used to compare projects? What causes conflicts in the ranking of projects via net present value and internal rate of return? 9–10 Does the assumption concerning the reinvestment of intermediate cash inflow tend to favor NPV or IRR? In practice, which technique is preferred and why? S U M M A RY FOCUS ON VALUE After estimating the relevant cash flows, the financial manager must apply appropriate decision techniques to assess whether the project creates value for shareholders. Net present value (NPV) and internal rate of return (IRR) are the generally preferred capital budgeting techniques. Both use the cost of capital as the required return needed to compensate shareholders for undertaking projects with the same risk as that of the firm. The appeal of NPV and IRR stems from the fact that both indicate whether a proposed investment creates or destroys shareholder value. NPV clearly indicates the expected dollar amount of wealth creation from a proposed project, whereas IRR provides the same accept-or-reject decision as NPV. As a consequence of some fundamental differences, NPV and IRR do not necessarily rank projects the same. Although the potential conflicting rankings can be reconciled, NPV is the theoretically preferred approach. In practice, however, IRR is preferred because of its intuitive appeal. Regardless, the application of NPV and IRR to good estimates of relevant cash flows should enable the financial manager to recommend projects that are consistent with the firm’s goals of maximizing stock price. REVIEW OF LEARNING GOALS Understand the role of capital budgeting techniques in the capital budgeting process. Capital budgeting techniques are used to analyze and assess project acceptability and ranking. They are applied to each project’s relevant cash flows to select capital expenditures that are consistent with the firm’s goal of maximizing owners’ wealth. LG1 Calculate, interpret, and evaluate the payback period. The payback period is the amount of time required for the firm to recover its initial investment, as calculated from cash inflows. The formula and decision criteria for the payback period are summarized in Table...
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This document was uploaded on 01/19/2014.

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