Chapter 11

Question 1

What is capital budgeting?

Answer 1

• Analysis of potential additions to fixed assets
• Long-term decisions; involve large expenditures
• Very important to firm’s future

Question 2

Steps to Capital Budgeting

Answer 2

1. Estimate CFs (inflows & outflows)
2. Assess riskiness of CFs
3. Determine the appropriate cost of capital
4. Find NPV and/or IRR
5. Accept if NPV > 0 and/or IRR > WACC

Question 3

Independent Projects

Answer 3

If the cash flows of one are unaffected by the acceptance of the other

Question 4

Mutually Exclusive Projects

Answer 4

If the cash flows of one can be adversely impacted by the acceptance of the other

Question 5

Normal Cash Flow Stream

Answer 5

• Cost (negative CF) followed by a series of positive cash inflows
• One change of signs

***Cost (negative CF), then string of positive CFs, then cost to close project

Question 6

Nonnormal Cash Flow Stream

Answer 6

Two or more changes of signs

Question 7

Net Present Value (NPV)

Answer 7

Sum of the PVs of all cash inflows and outflows of a project

Question 8

Rationale for the NPV Method

Answer 8

NPV= PV of inflows – Cost= Net gain in wealth

• If projects are independent, accept if the project NPV > 0
• If projects are mutually exclusive, accept project with the highest positive NPV, one that adds the most value

Question 9

How is a project’s IRR similar to a bond’s YTM?

Answer 9

• They are the same thing

- Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project

Question 10

Rationale for the IRR Method

Answer 10

• If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns
• If IRR > WACC, accept project
• If IRR < WACC, reject project

Question 11

Independent Projects (NPV/IRR)

Answer 11

NPV and IRR always lead to the same accept/reject decision for any given independent project

Question 12

Finding the Crossover Rate

Answer 12

• Find cash flow differences between the projects. See Slide 11-8
• Enter the CFs in CFj register, then press IRR
• If profiles don’t cross, one project dominates the other

Question 13

Reasons Why NPV Profiles Cross

Answer 13

• Size (scale) differences: The smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects
• Timing differences: The project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL

Question 14

Reinvestment Rate Assumptions

Answer 14

• NPV method assumes CFs are reinvested at the WACC
• IRR method assumes CFs are reinvested at IRR
• Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects
• Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed

Question 15

Managers prefer the IRR to the NPV method; is there a better IRR measure?

Answer 15

• Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC
• MIRR assumes cash flows are reinvested at the WACC

Question 16

Why use MIRR versus IRR?

Answer 16

• MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids the multiple IRR problem
• Managers like rate of return comparisons, and MIRR is better for this than IRR

Question 17

What is the payback period?

Answer 17

• The number of years required to recover a project’s cost, or “How long does it take to get our money back?”
• Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive

Question 18

Discounted Payback Period

Answer 18

Uses discounted cash flows rather than raw CFs

Question 19

Strengths of Payback

Answer 19

• Provides an indication of a project’s risk and liquidity

- Easy to calculate and understand

Question 20

Weaknesses of Payback

Answer 20

• Ignores the time value of money (TVM)
• Ignores CFs occurring after the payback period
• No relationship between a given payback and investor wealth maximization

***Discounted payback considers TVM, but other 2 flaws remain

Question 21

Why are there multiple IRRs?

Answer 21

• At very low discount rates, the PV of CF2 is large and negative, so NPV < 0
• At very high discount rates, the PV of both CF1and CF2 are low, so CF0 dominates and again NPV < 0
• In between, the discount rate hits CF2 harder than CF1, so NPV > 0

Question 22

When to use the MIRR instead of the IRR?

Answer 22

When there are nonnormal CFs and more than one IRR, use MIRR