978-0133507690 Chapter 10 Solution Manual Part 1

Unlock access to all the studying documents.

View Full Document

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

NPV (1 )

CF I

= –

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

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

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

Project C—PV of Cash Inflows

Reject

Project D

Project E—PV of Cash Inflows

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%