ch. 10

Question 1

IRR

Answer 1

internal rate of return. defined as the discount rate that forces a project’s NPV to equal 0. project should be accepted if the IRR is > than cost of capital

Question 2

NPV and IRR methods make the same accept-reject decisions for independent projects, but if projects are mutally exclusive then

Answer 2

ranking conflicts can arise. For such cases, NPV method should be relied on.

Question 3

NPV method

Answer 3

assumes that cash flows will be reinvested at the firm’s cost of capital, whereas IRR method assumes reinvestment at the project’s IRR.

Reinvestment at the cost of capital is generally a better assumption bc its closer to reality (thus NPV method is sensible)

Question 4

the modified IRR (MIRR) method

Answer 4

corrects some of the problems with the regular IRR. MIRR involves finding the terminal value (TV) of the cash inflows, compounding them at the firm’s cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows. Thus, the MIRR assumes reinvestment at the cost of capital, not at the IRR.

If management wants to know the rate of return on projects, the MIRR is a better estimate than the regular IRR

Question 5

profitability index

Answer 5

(PI) is calculated by (PV of cash inflows)/(initial cost), so it measures relative profitiability - that is, the amount of the present value per dollar of investment.

Question 6

the regular payback period

Answer 6

defined as the number of yeras required to recover a project’s cost. The regular payback method has 3 flaws

1. it ignores cash flows beyond the payback period
2. does not consider the time value of money
3. it doesnt give a precise acceptance rule

it does however, provide an indication of a project’s risk and liquidity, bc it shows how long the invested capital will be tied up.

Question 7

discounted payback

Answer 7

similar to regular payback, except that is discounts cash flows at the projects cost of capital. it considers the time value of money, but it still ignores cash flows beyond the payback period

Question 8

if mutually exclusive projects have unequal lives

Answer 8

it may be necessary to adjust the analysis to put the projects on an equal-life basis.

can be done using the replacement chain (common life) approach or the equivalent annual annuity (EAA) approach

Question 9

a projects true value may be gretear than the NPV

Answer 9

based on its physical life if it can be terminated at the end of its economic life

Question 10

flotation costs and increased risk associated with unually large expansion programs can cause the marginal cost of capital to

Answer 10

increase as the size of the capital budget increases

Question 11

capital rationing occurs

Answer 11

when management places a constraint on the size of the firm’s capital budget during a particular period