Chapter 8
Capital Budgeting Process and Technique
Answers to Concept Review Questions
1.
What characteristics would management desire in a capital budgeting technique?
Other things being equal, managers would prefer (1) an easily applied technique that (2)
consider cash flow, (3) recognizes the time value of money, (4) fully accounts for
expected risk and return, and (5) when applied leads to higher stock prices.
2.
Why do managers focus on the impact that an investment will have on reported earnings
rather than on the investment’s cash flow consequences?
Earnings or earnings per share are widely reported in the business press and companies
(and management) are penalized if they earn less than expected. Because of this
emphasis, managers tend to be very focused on earnings, sometimes incorrectly at the
expense of cash flow.
3.
What factors determine whether the annual accounting rate of return on a given project
will be high or low in the early years of the investment’s life? In the latter years?
Depreciation method can be a big factor. Accelerated depreciation can mean
substantially lower cash flows in the early years of a project.
4.
What factors account for the popularity of the payback method? In what situations is it
often used as the primary decision technique? Why?
Payback is popular because it is very easy to compute and to understand and because it
gives managers a rough measure of how soon they will receive intermediate cash flows
from a project that they could potentially invest in other projects.
5.
What are the major flaws of the payback and discounted payback approaches?
The major flaws of the payback and discounted payback methods are that they do not
take the time value of money into account and they ignore cash flows beyond the payback
period.
6.
If a project has an NPV of $1 million, what does that mean?
An NPV of $1 million means that $1 million in shareholder value (market capitalization)
is being added to the firm.
7.
At a given point in time, why might the discount rates used to calculate the NPVs of two
competing projects differ?
The discount rate reflects the risk of a project. It is possible for a project to have more
risk at its beginning and less as managers become more familiar with project operations.
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Describe how the IRR and NPV approaches are related.
IRR and NPV are related in that both use the time value of money and take risk into
account. NPV accounts for risk by using a risk-adjusted discount rate, while IRR uses a
risk-adjusted hurdle rate against which to compare the project and make the
accept/reject decision.
9.
If the IRR for a given project exceeds a firm’s hurdle rate, does that mean that the project
necessarily has a positive NPV? Explain.
Yes, for a single project with conventional cash flows, if IRR says accept the project, NPV
will also say accept the project. If a project has two IRRs, this says the project is positive
NPV whenever the hurdle rate lies between the two IRRs.
10.
Describe the “scale problem” and the “timing problem” and explain the potential effects
of these problems on the choice of mutually exclusive projects using IRR versus NPV.
You can use IRR with mutually exclusive projects by subtracting one set of cash flows
from the other and finding the IRR of the project that represents these differential cash
flows. If the differential project has conventional cash flows, then accept the project on
top if the IRR exceeds the hurdle rate. If the differential project has non-conventional
cash flows, then accept the project on the top of the subtraction if the hurdle rate exceeds
the IRR.
11.
How are the NPV, IRR, and PI approaches related?
All three methods are related because they adjust for the time value of money and risk.
Again, for a single project with conventional cash flows, all three methods will provide
the same accept/reject decision.
12.
What important flaw do both the PI and IRR share? Explain.
Choosing a project with the highest PI may not be the same as accepting a project with
the highest dollar NPV. To maximize shareholder wealth, a manager wants to add the
most possible risk-adjusted (positive NPV) dollars to the company.
Chapter 8/Capital Budgeting Process and Technique
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Answers to Self Test Questions
ST8-1. Nader International is considering investing in two assets – A and B. The initial outlay,
annual cash flows, and annual depreciation for each asset is shown in the table below for
assets’ assumed five-year lives. As can be seen, Nader will use straight-line depreciation
over each asset’s five-year life. The firm requires a 12% return on each of those equally
risky assets. Nader’s maximum payback period is 2.5 years; its maximum discounted
payback period is 3.25 years’ and its minimum accounting rate of return is 30%.
Initial Outlay (CFo)
Asset A
Asset B
$200,000
$180,000
Year (t)
Cash Flow (CFt)
Depreciation
Cash Flow (CFt)
Depreciation
1
$70,000
$40,000
$80,000
$36,000
2
80,000
40,000
90,000
36,000
3
90,000
40,000
30,000
36,000
4
90,000
40,000
40,000
36,000
5
100,000
40,000
40,000
36,000
a. Calculate the accounting rate of return from each asset, assess its acceptability, and
indicate which asset is best using the accounting rate of return.
b. Calculate the payback period for each asset, assess its acceptability, and indicate
which asset is best using the payback period.
c. Calculate the discounted payback for each asset, assess its acceptability, and indicate
which asset is best using the discounted payback.
d. Compute and contrast your findings in parts (a), (b), and (c). Which asset would you
recommend to Nader, assuming that they are mutually exclusive? Why?
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Invest
Year
1
2
3
4
5
CF
$70,000
80,000
90,000
90,000
100,000
A
$200,000
12% PV
62,500
63,776
64,060
57,196
Depr.
$40,000
40,000
40,000
40,000
40,000
CF
$80,000
90,000
30,000
40,000
40,000
B
$180,000
12% PV
71,429
71,747
21,353
25,420
Depr.
$36,000
36,000
36,000
36,000
36,000
a)
Accounting
Rate of
Return
Year
1
2
3
4
5
Max
2.50
3.25
NPAT
$70,000-$40,000 = $30,000
80,000-40,000 = 40,000
90,000-40,000 = 50,000
90,000-40,000 = 50,000
100,000-40,000 = 60,000
Average = $46,000
NPAT
$80,000-$36,000 = $44,000
90,000-36,000 = 54,000
30,000-36,000 = -6,000
40,000-36,000 = 4,000
40,000-36,000 = 4,000
Average = 20,000
$46, 000
= 46%
100, 000
$20, 000
= 22.22% Not acceptable
90, 000
Acceptable
b) Payback
2.56 years / Not acceptable
c)Discounted
3.17 years/Acceptable
payback at 12%
2.33 years / Acceptable
3.62 years / Not Acceptable
d) They should take asset A because its accounting rate of return is acceptable as is its
discounted payback.
ST8-2. JK Products, Inc. is considering investing in either of two competing projects that will
allow the firm to eliminate a production bottleneck and meet the growing demand for its
products. The firm’s engineering department narrowed the alternatives down to tow –
Status Quo (SQ) and High Tech (HT). Working with the accounting and finance
personnel, the firm’s CFO developed the following estimates of the cash flows for SQ
and HT over the relevant 6-year time horizon. The firm has an 11 percent required return
and views these projects as equally risky.
Chapter 8/Capital Budgeting Process and Technique
Initial Outflow (CFo)
Year (t)
a.
b.
c.
d.
e.
Project SQ
Project HT
$670,000
$940,000
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Cash Inflows (CFt)
1
$250,000
$170,000
2
200,000
180,000
3
170,000
200,000
4
150,000
250,000
5
130,000
300,000
6
130,000
550,000
Calculate the net present value (NPV) of each project, assess its acceptability,
and indicate which project is best using NPV.
Calculate the internal rate of return (IRR) of each project, assess its acceptability,
and indicate which project is best using IRR.
Calculate the profitability index (PI) of each project, assess its acceptability, and
indicate which project is best using PI.
Draw the NPV profile for project SQ and HT on the same set of axes and use this
diagram to explain why the NPV and IRR show different preferences for these
two mutually exclusive projects. Discuss this difference in terms of both the
“scale problem” and the “timing problem”.
Which of the two mutually exclusive projects would you recommend JK
Products undertake? Why?
a. NPV
b. IRR
c. PI
Project SQ
$87,313.87
16.07%*
1.13
All measures indicate project acceptability
NPV > 0
IRR >11%
PI > 1.00
The star * indicates the preferred project using each measure.
Project HT
$142,254.07*
15.17%
1.15*
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d.
750
HT
NPV
($000)
500
SQ
250
0
-250
5
10
15
20
Required return %
Rate
0%
11%
15.17%
16.07%
Project
SQ
$360,000
87,313.87
0
HT
$710,000
142,254.07
0
-
At 11% HT is preferred over SQ, but because the profiles cross somewhere beyond
11% and before the functions cross the required return axis the IRR of SQ exceeds
the IRR of HT. This behavior can be explained by the fact that HT’s larger scale
causes its NPV to exceed that of SQ. The smaller project and the timing of SQ’s cash
flows – more in the early years – causes its IRR to exceed that of HT, which has more
of its cash flows in later years.
e. Project HT is recommended because it has the higher NPV, the better technique. In
addition its PI is higher than that of Project SQ.