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Chapter 7
Answers to Review Problems
Finance For Executives – 4th Edition
1. Investment criteria.
a.
Impact on earnings per share (EPS) is an accounting measure of performance. Its main drawbacks
are that it ignores capital investment required for the project, penalizes projects whose earnings
are not immediately realized, and is subject to accounting manipulation. Yet there is a strong
The payback period measures the number of years to recover the capital investment outlay. It is
easy to compute and understand. It is often considered a proxy for risk—the faster the payback,
Internal rate of return (IRR) takes into account all of the cash flows related to the project. It is
liked by managers because it provides a performance measure which can be easily compared to
Net present value (NPV) takes into account all of the cash flows related to the project and
discounts them at the cost of capital to account for the time value of money and risk. The result is
either a positive or negative number reflecting the creation or destruction of wealth that would
b.
Global Chemicals uses all of these measures, no doubt, because the various managers (and also
board members for large project decisions) want them. Some of those taking part in the
2. Relationship between investment criteria.
The information given tells:
Nothing about the discounted payback period
That the project’s internal rate of return is higher than its cost of capital
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3. Net present value and payback period.
If the payback period is less than the economic life of the project, its net present value can be
either positive or negative. This is because the relevant cash flows in the computation of the
payback period are actual cash flows while those in the computation of the net present value are
If the discounted payback period is less than the useful life of the project, its net present value is
always positive. This is because the project’s net present value being equal to zero at its
4. The internal rate of return of mutually exclusive projects.
a.
The intersection of Project A and Project B’s NPV lines represents the discount rate which
produces the same NPV for the two projects. Assuming the risk of each project is the same, and
b.
The point at which each project crosses the zero-NPV line represents the internal rate of return
c.
The difference in NPVs between the two projects at each discount rate is due to the size and
timing of the cash flows. Project A has larger cash flows during the latter part of the project
d.
The choice depends on the cost of capital. When the cost of capital is lower than the break-even
rate (the point where the project NPV lines intersect), Project A is better, and Project B is better
5. The case of multiple internal rate of return.
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This project shows cash flows with alternating negative and positive signs. Though the project is
a. and b.
Using a spreadsheet
There are two internal rates of return (IRR)—at 0 percent and 100 percent discount rates. Rates
between 0 percent and 100 percent produce positive net present values (NPV). Rates below 0
c.
The project should be accepted if its net present value is positive. This will be the case if the cost
6. The net present value rule versus the internal rate of return.
a.
Using a spreadsheet
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b.
Project B is a better choice based on internal rate of return, while project A is a better choice
c.
Project A is the larger of the two projects and promises to create more wealth. That it has a lower
internal rate of return reflects the timing and size of its cash flows. They are large enough to
d.
The net present value rule is the least ambiguous assuming that the cost of capital rate has been
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e.
The internal rate of return of the incremental cash flows (Project A’s minus Project B’s cash
flows) is 11.4 percent. At any discount rate below 11.4 percent, Project A will produce the highest
7. The internal rate of return rule and the net present value rule.
a and b
Using a spreadsheet
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c.
The three projects should be accepted since their net present value is positive and their internal
d.
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e.
Projects A and B should be selected since their accumulated net present values ($20,918 +
8. The net present value rule versus the profitability index rule.
a.
Using a spreadsheet
b.
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c.
Project A is the larger of the two projects and promises to create more wealth. That it has a lower
profitability index reflects the timing and size of its cash flows. They are large enough to produce
d.
The net present value rule is the least ambiguous assuming that the cost of capital rate has been
9. The average accounting return
Using a spreadsheet
According to the average accounting return rule, the machine should be bought since the average
1. The approach ignores the time value of money. To account for it, the approach should
2. The target return is not a market return which would be needed to discount the cash flows
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10. 10. Investment criteria.
a.
Using a spreadsheet
The discounted payback period at a 10 percent discount rate, given the expected annual cash
flows, might appear to be 4.34 years—if the final year’s cash flow were realized evenly over the
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b.
Considering the above measures, the project appears to be satisfactory since the net present value
is positive, the profitability index is greater than 1.0, the internal rate of return is above 10 percent
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