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Part 5
Long-Term Investment Decisions
Chapters in This Part
Chapter 10 Capital Budgeting Techniques
Chapter 11 Capital Budgeting Cash Flows
Chapter 12 Risk and Refinements in Capital Budgeting
Integrative Case 5: Lasting Impressions Company
Chapter 10
Capital Budgeting Techniques
nInstructor’s Resources
Overview
This chapter is the first of three that deal with long-term investment decisions. This chapter covers capital
budgeting techniques, Chapter 11 deals with the basic principles of determining relevant cash flows, and
Chapter 12 considers risk and refinements in capital budgeting. Both the sophisticated [net present value
(NPV) and the internal rate of return (IRR)] and unsophisticated (average rate of return and payback
period) capital budgeting techniques are presented here. Discussion centers on the calculation and
evaluation of the NPV and IRR in investment decisions, with and without a capital rationing constraint.
Several illustrations exist explaining why capital budgeting techniques will be useful to students in their
professional and personal lives.
nSuggested Answers to Opener-in-Review Questions
a. The chapter opener reported that the project had an NPV of $66 million and an internal rate
of return of 20%. From those two facts alone, what can you conclude about Seafield’s cost of
capital? (Hint: Is it more or less than 20%?)
b. Given the information above about the project’s initial cost and subsequent cash flows, as well
as the information from part (a), can you estimate Seafield’s cost of capital?
nAnswers to Review Questions
1. Once the relevant cash flows have been developed, they must be analyzed to determine whether the
2. The payback period is the exact time it takes to recover a firm’s initial investment in a project. In
3. The weaknesses of using the payback period are (1) no explicit consideration of shareholders’
4. NPV computes the present value of all relevant cash flows associated with a project. For
5. Acceptance criterion for the NPV method is if NPV > 0, accept; if NPV < 0, reject. If the firm
6. NPV, PI, and EVA are all based on the same underlying idea, that investments should earn a rate of
7. Answers will vary for question because values are algorithmically generated in MyFinanceLab.
8. The IRR on an investment is the discount rate that would cause the investment to have a NPV of
0
1
NPV (1 )
nt
t
t
CF I
r
=
= -
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9. If a project’s IRR is greater than the firm’s cost of capital, the project should be accepted; otherwise,
10. The NPV and IRR always provide consistent accept/reject decisions. These measures, however, may
11. An NPV is a graphic representation of the NPV of a project at various discount rates. The NPV profile
12. The reinvestment rate assumption refers to the rate at which reinvestment of intermediate cash flows
nSuggested Answer to Focus on Practice Box:
Limits on Payback Analysis
In your view, if the payback period method is used in conjunction with the NPV method, should it
be used before or after the NPV evaluation?
While the payback method is simple to use and can be used to initially screen projects, the major
nSuggested Answer to Focus on Ethics Box: Nonfinancial
Considerations for Project Selection
What are the potential risks to a company of unethical behaviors by employees? What are potential
risks to the public and to stakeholders?
The consequences to the company may include prosecution, fines, and other penalties for the improper
nAnswers to Warm-Up Exercises
E10-1. Payback period
Answer: The payback period for Project Hydrogen is 4.29 years. The payback period for Project
E10-2. NPV
Answer:
Year Cash Inflow Present Value
1 $400,000 $ 377,358.49
E10-3: NPV comparison of two projects
Answer: Project Kelvin
Present value of expenses –$45,000
E10-4: IRR
Answer: You may use a financial calculator to determine the IRR of each project. Choose the project
with the higher IRR.
Project T-Shirt
Project Board Shorts
PV 25,000, N 5, PMT 12,000
E10-5: NPV
Answer: Note: The IRR for Project Terra is 10.68% while that of Project Firma is 10.21%.
0% 5% 10% 15% 20% 25%
-10,000
-5,000
0
5,000
10,000
PROJECT FIRMA PROJECT TERRA
Discount Rat e
NPV ($000)
nSolutions to Problems
Note to instructor: In most problems involving the IRR calculation, a financial calculator has been used.
P10-1. Payback period
LG 2; Basic
P10-2. Payback comparisons
LG 2; Intermediate
a. Machine 1: $14,000 ¸ $3,000 4 years, 8 months
b. Only Machine 1 has a payback faster than 5 years and is acceptable.
c. The firm will accept the first machine because the payback period of 4 years, 8 months is less
d. Machine 2 has returns that last 20 years while Machine 1 has only 7 years of returns.
P10-3. Choosing between two projects with acceptable payback periods
LG 2; Intermediate
a.
Project A Project B
Year
Cash
Inflows
Investment
Balance Year
Cash
Inflows
Investment
Balance
0$100,000 0 $100,000
1 $10,000 90,000 1 40,000 60,000
b. Based on the minimum payback acceptance criteria of 4 years set by John Shell, both
c. Project B is preferred over A because the larger cash flows are in the early years of the
P10-4. Personal finance: Long-term investment decisions, payback period
LG 4
a. and b.
Project A Project B
Year
Annual
Cash Flow
Cumulative
Cash Flow
Annual
Cash Flow
Cumulative
Cash Flow
0 $(9,000) $(9,000) $(9,000) $(9,000)
Payback Period 3 1,800/2,000 3.9 years 4 1,000/4,000 4.25 years
c. The payback method would select Project A because its payback of 3.9 years is lower than
d. One weakness of the payback method is that it disregards expected future cash flows as in
P10-5. NPV
LG 3; Basic
NPV PVn Initial investment
a. N 15, I 9%, PMT $150,000
b. N 15, I 9%, PMT $320,000
c. N 15, I 9%, PMT $365,000
P10-6. NPV for varying cost of capital
LG 3; Basic
a. 10%
b. 12%
c. 14%
P10-7. NPV—independent projects
LG 3; Intermediate
Project A
Reject
Project B—PV of Cash Inflows
Accept
Project C—PV of Cash Inflows
Reject
Project D
Accept
Project E—PV of Cash Inflows
Accept
P10-8. NPV
LG 3; Challenge
a. N 5, I 9%, PMT $385,000
b. N 5, I 9%, PV $1,500,000
c. Present valueAnnuity Due PVordinary annuity ´ (1 discount rate)
d. No, the cash flows from the project will not influence the decision on how to fund the
P10-9. NPV and maximum return
LG 3; Challenge
a. N 4, I 10%, PMT $44,400
b. As the cost of capital gets lower, the NPV gets higher, so the investment becomes more
attractive. Using a financial calculator, CF0 = –150,000, C01 = 44,400, F01 = 4,
IRR = 7.12%
