Finance chapter 10

The goal of the capital budgeting decisions is to select capital projects that will decrease the value of the firm.(True/False) False
When two projects have cash flows that are tied to each other, the projects may be classified as independent.(True/False) False
When two projects are independent, accepting one project implicitly eliminates the other.(True/False) False
When two projects are mutually exclusive, accepting one project implicitly eliminates the other.(True/False) True
The net present value technique is an approach that goes against the goal of shareholder wealth maximization.(True/False) False
The NPV method determines how much the present value of cash inflows exceeds the present value of costs.(True/False) True
The payback method is consistent with the goal of shareholder wealth maximization.(True/False) False
The discounted payback period calculation calls for the future cash flows to be discounted by a firm’s cost of capital.(True/False) True
The accounting rate of return is not a true return because it simply utilizes some average figures from a firm’s balance sheet and income statement.(True/False) True
The decision criterion for the accounting rate of return is consistent with the goal of shareholder wealth maximization.(True/False) False
The IRR and NPV decisions are consistent with each other when a project’s cash flows follow a conventional pattern.(True/False) True
Unconventional cash flow patterns could lead to conflicting decisions by NPV and IRR.(True/False) True
When mutually exclusive projects are considered, both NPV and IRR will always produce the same acceptance decision.(True/False) False
When evaluating two projects that require different outlays, the IRR does not recognize the difference in the size of the investments.(True/False) True
What is true of an independent project? cash flows are unrelated.
Two projects are considered to be mutually exclusive if both selecting one would automatically eliminate accepting the other and the projects perform the same function.
The cost of capital is minimum return that a capital project must earn to be accepted
Capital rationing implies that a firm has constraint to fund all of the available projects.
Advantage of the payback method Both the technique is simple for managers to compute and interpret and it is a good measure of liquidity risk.
disadvantage of the payback method? -It is inconsistent with the goal of maximizing shareholder wealth.-It ignores cash flows beyond the payback period.-It ignores the time value of money.
Which of the following statements about IRR is NOT true? The IRR is the discount rate that makes the NPV greater than zero.
The internal rate of return is discount rate that makes the NPV equal to zero.
When evaluating capital projects, the decisions using the NPV method and the IRR method will agree if both the projects are independent and the cash flow pattern is conventional.
Which of the following cash flow patterns is NOT an unconventional cash flow pattern? A negative initial cash flow is followed by positive future cash flows.
Which of the following rates should be used to calculate a project’s net present value? Cost of capital
One of the main reasons why the discounted payback period is not widely used by managers is that: it ignores all cash flows that occur after the arbitrary cutoff period
The IRR is the discount rate that makes the NPV positive(True/False) False*The IRR is the discount rate that makes the NPV equal to zero.
Which of the following capital budgeting techniques, is the most appropriate one for evaluating projects? Net present value
A weakness of the accounting rate of return technique is, it: does not distinguish between revenue and cash flows.
The IRR and NPV methods always rank projects in the same order.(True/False) False*The IRR and NPV methods can give conflicting results
If a project’s IRR exceeds its _____, the project should be _____. cost of capital; accepted
The NPV and IRR methods will always agree when you are evaluating _____ projects and the project’s cash flows are _____. independent; conventional
The cost of capital for a project is its return on equity.(True/False) False*The cost of capital is the rate of return that a capital project must earn to be accepted by management.
key disadvantage of the IRR method? With mutually exclusive projects, the IRR method can lead to incorrect investment decisions.
Capital investments large cash outlays, long-term commitments, not easily reversed, and primary factors in a firm’s long-run performance
Capital budgeting techniques help management systematically analyze potential opportunities in order to decide which are worth undertaking
Independent Projects Projects for which the decision to accept or reject is not influenced by decisions about other projects being considered by the firm
Mutually exclusive projects Projects for which the decision to accept one project is simultaneously a decision to reject another project
Contingent projects Projects for which the decision to accept one project depends on acceptance of another project
Basic Capital Budgeting -Capital rationing-Capital Asset-Cost of Capital
Capital rationing firm with limited funds chooses the best projects to undertake
Capital Asset long-term assets
Cost of Capital rate of return that a project must earn to be accepted by management
Net Present Value (NPV) -goal of maximizing shareholder wealth-compares the present value of expected benefits and cash flows from a project to the present value of the expected costs; if the benefits are larger, the project is feasible
Valuation of Real Assets 1.Estimate future cash flows2.Estimate cost of capital/required-rate-of return3.Calculate present value of future cash flows
Practical difficulties in valuing real assets -Cash flow estimates must be prepared in-house and are not as readily available as those for financial assets with legal contracts-Estimating required-rates-of-return for real assets is more difficult than estimating required return for financial assets because no market data is available
Advantages of NPV 3 1.uses discounted cash flow valuation technique to adjust for time value of money.2.Provides direct (dollar) measure of how much a capital project will increase the value of the firm.3.Consistent with the goal of maximizing stockholder value.
Disadvantage of NPV Can be difficult to understand without an accounting and finance backround.
Payback Period -The Payback Period is the amount of time it takes for the sum of the net cash flows from a project to equal the project’s initial investment*Projects with shorter payback periods are more desirable
Negatives about Payback rule There is no economic rationale that makes the payback method consistent with shareholder wealth maximization-It ignores the time value of money-Does not account for differences in the overall risk of projects-Cash flows occurring after the payback period are not considered
ARR Flaws -is not a true rate of return; it is generated from the income statement and balance sheet-It ignores the time value of money-There is no economic rationale that makes it consistent with the goal of maximizing shareholder wealth
What method should be used when dealing with unconventional cash flows, IRR or NPV? NPVBecause,With unconventional cash flows, the IRR technique may provide more than one rate of return. This makes the calculation unreliable and it should not be used to determine whether a project should be accepted or rejected
Advantages of IRR Method 1.Intutive and easy to understand2.Based on discounted cash flow technique
Disadvantages of IRR 1.with non-conventional cash flows, IRR approach can yield no usable answer or multiple answers.2.A lower IRR can be better if a cash inflow is followed by cash outflows3.With mutually exclusive projects, IRR leadto incorrect investment descisions4.IRR calculation assumes cash flows are reinvested at the IRR.
Profitability Index (PI) The PI provides a measure of the value of project generates for each dollar invested in that project

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