Concepts Review and Critical Thinking Questions

Payback Period and Net Present Value If a project with conventional cash flows has a payback period less than the project's life, can you definitively state the algebraic sign of the NPV? Why or why not? If you know that the discounted payback period is less than the project's life, what can you say about the NPV? Explain.

Net Present Value Suppose a project has conventional cash flows and a positive NPV. What do you know about its payback? Its discounted payback? Its profitability index? Its IRR? Explain. Payback Period Concerning payback:

a. Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule?

b. What are the problems associated with using the payback period as a means of evaluating cash flows?

c. What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain.

Discounted Payback Concerning discounted payback:

a. Describe how the discounted payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the discounted payback criterion decision rule?

b. What are the problems associated with using the discounted payback period as a means of evaluating cash flows?

c. What conceptual advantage does the discounted payback method have over the regular payback method? Can the discounted payback ever be longer than the regular payback? Explain.

Average Accounting Return Concerning AAR:

a. Describe how the average accounting return is usually calculated and describe the information this measure provides about a sequence of cash flows. What is the AAR criterion decision rule?

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria

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PART FOUR Capital Budgeting b. What are the problems associated with using the AAR as a means of evaluating a project's cash flows? What underlying feature of AAR is most troubling to you from a financial perspective? Does the AAR have any redeeming qualities?

6. Net Present Value Concerning NPV:

a. Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?

b. Why is NPV considered to be a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the firm's shareholders?

7. Internal Rate of Return Concerning IRR:

a. Describe how the IRR is calculated and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule?

b. What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain.

c. Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain.

8. Profitability Index Concerning the profitability index:

a. Describe how the profitability index is calculated and describe the information this measure provides about a sequence of cash flows. What is the profitability index decision rule?

b. What is the relationship between the profitability index and NPV? Are there any situations in which you might prefer one method over the other? Explain.

9. Payback and Internal Rate of Return A project has perpetual cash flows of C per period, a cost of I, and a required return of R. What is the relationship between the project's payback and its IRR? What implications does your answer have for long-lived projects with relatively constant cash flows?

10. International Investment Projects In 1996, Fuji Film, the Japanese manufacturer of photo film and related products, broke ground on a film plant in South Carolina. Fuji apparently thought that it would be better able to compete and create value with a U.S.-based facility. Other companies, such as BMW and Mercedes-Benz, have reached similar conclusions and taken similar actions. What are some of the reasons that foreign manufacturers of products as diverse as photo film and luxury automobiles might arrive at this same conclusion?

11. Capital Budgeting Problems What are some of the difficulties that might come up in actual applications of the various criteria we discussed in this chapter? Which one would be the easiest to implement in actual applications? The most difficult?

12. Capital Budgeting in Not-for-Profit Entities Are the capital budgeting criteria we discussed applicable to not-for-profit corporations? How should such entities make capital budgeting decisions? What about the U.S. government? Should it evaluate spending proposals using these techniques?

CHAPTER 9 Net Present Value and Other Investment Criteria 305

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