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
Instructor Resources
Chapter Overview
This chapter is the first of three dealing with long-term investment decisions; the focus is on the basics of
capital budgeting. The discussion begins with an overview of the capital-budgeting process and then moves to
a detailed exploration of the three approaches to project evaluation—Payback Period, Net Present Value
(NPV), and Internal Rate of Return (IRR). After reviewing the pros and cons of each approach, the chapter
concludes by endorsing the NPV method—noting that it is more closely aligned with a financial-manager’s
goal of maximizing shareholder wealth.
Suggested Answers to Opener-in-Review
a. The project has a Net Present Value (NPV) of $44.2 million and an internal rate of return (IRR) of
34.8%. From those two facts alone, what can you conclude about Maritime’s cost of capital?
IRR is the discount rate that makes project NPV equal zero. Put another way, when IRR = cost of capital,
b. Given the information above about the project’s NPV, its initial cost, and the subsequent cash flows that
it generates, can you estimate Maritime’s cost of capital?
Trial-and-error will yield the discount rate generating an NPV of $44.2 million (given an initial project
outlay of $67.8 million and 5 years of $30.45 million cash inflows. Another approach is to use the
following steps:
(ii) Put the values to the right of the equal sign in the equation immediately above in cells
c. What is the project’s payback period?
The project brings in $60.9 million in two years, so an additional $6.9 million is needed from
Answers to Review Questions
10-1 The financial manager’s goal is to maximize shareholder wealth. To do so, she should accept
all long-term investment projects that add to shareholder wealth (and, hence, boost the firm’s
pursue, (iv) undertaking acceptable projects, and (v) monitoring project performance.
10-2 The payback period is the time necessary for project cash inflows to cover the firm’s initial
dollar investment. When annual cash inflows are constant, payback period in years is
calculated by dividing the initial investment by annual cash inflow. In case of a mixed
10-3 Weaknesses of payback-period criterion for capital budgeting include (1) lack of a firm
project profitability).
10-4 Net present value (NPV) is the sum of the present values of all relevant cash outflows and
inflows associated with a project. In the conventional case, project NPV is the present value
of all cash inflows minus the initial investment at time zero.
10-5 Under the NPV method, the firm should accept a project if its NPV > 0, and reject a project if
its
negative, subtract from) the value of the firm. If, for example, a firm undertakes a project with a
10-6 NPV, PI, and EVA all reflect the same underlying idea—namely, the firm’s long-term
investment projects should earn a rate of return exceeding investors’ expectations.
Specifically, the profitability index (PI) is the present value of all cash inflows from a project
10-7 Student answers will vary because “given” values are algorithmically generated in
MyFinanceLab.
10-8 The internal rate of return (IRR) on an investment is the discount rate that makes project NPV
equal zero, that is the “r” that makes the following NPV equation hold:
NPV
=
CF
t
(1
+
r
)
t
t
=
0
n
å
, where CFt are cash inflows/outflows in each period “t” of the project’s
life.
10-9 If project IRR exceeds the firm’s cost of capital, the project should be accepted; otherwise,
project will boost the market value of the firm.
10-10 NPV and IRR will produce consistent accept/reject decisions (provided project cash flows
generate a unique IRR), but may not produce identical project rankings. Discrepancies in
10-11 Student answers will vary because “given” values are algorithmically generated in
MyFinanceLab.
10-12 An NPV Profile is a graphic representation of a project’s NPV at various discount rates; it can
be useful in assessing project desirability when IRR and NPV produce different rankings. Such
conflicts occur because of differences in (i) assumptions about the reinvestment rate for
10-13 On top of differences in the timing of cash flows and magnitude of initial investment, another
capital whereas the IRR method assumes intermediate cash flows are reinvested at the IRR.
Suggested 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 NPV evaluation?
While the payback method is simple to apply and useful in screening projects, its major disadvantage is that a
highly profitable project could be overlooked if its life extends past the arbitrary payback period. The
Suggested Answer to Focus on Ethics Box:
“Baby You Can Drive My Car—Just Not a VW Diesel”
What role did VW’s desire to be the world’s largest automaker play in the emissions scandal?
The U.S. offers the world’s largest auto market but also the world’s toughest emission standards. VW could
not surpass Toyota without increasing U.S. market share, which required meeting U.S. emission standards.
What role did insider succession play in the scandal?
Insider succession made it less likely the CEO’s direct subordinates would internally challenge his goal of
industry leadership (which was supported by Ferdinand Piëche, the grandson of VW’s founder and board
Answers to Warm-Up Exercises
E10-1 Payback period
Answer: The payback period for Project Hydrogen is 4.29 years. [In four years, cumulative payback is
because their payback periods are less than the maximum acceptable payback period of 6 years.
E10-2 NPV
Answer:
Year Cash Inflows Present Value
(6% Discount
Rate)
1 $400,000 $377,358.4
9
2 375,000 333,748.67
E10-3 NPV comparison of two projects
Answer: Project Kelvin
Project cost (year 0) = $52,500
Project Thompson
Project cost (year 0) = $265,000
Axis should undertake project Thompson because it has the higher NPV (and hence will add more
to shareholder wealth).
E10-4 IRR
Answer: IRR is the discount rate which makes the NPV of a given set of cash inflows/outflows zero. You
may use a financial calculator or Excel to determine the IRR of each project. To obtain IRR for
project T-Shirt in Excel, begin by putting the cash outflows/inflows in individual adjacent cells in
Similarly for project Board Shorts, begin by putting the cash outflows/inflows in individual cells
Under the IRR approach to capital budgeting, the decision criterion for mutually exclusive
projects is to choose the one with the higher IRR. Here, that is project T-Shirt.
E10-5: NPV
Answer: The IRRs for Projects Terra and Firm are 10.68% and 10.21%, respectively. At those discount
rates, the NPV for each project is 0. At a discount rate of 0%, NPVs for projects Terra and Firma