Chapter 8 Capital Budgeting Process and Technique

Answers to Concept Review Questions

1. What characteristics would management desire in a capital budgeting technique? Other things being equal, managers would prefer (1) an easily applied technique that (2) consider cash flow, (3) recognizes the time value of money, (4) fully accounts for expected risk and return, and (5) when applied leads to higher stock prices. 2. Why do managers focus on the impact that an investment will have on reported earnings rather than on the investments cash flow consequences? Earnings or earnings per share are widely reported in the business press and companies (and management) are penalized if they earn less than expected. Because of this emphasis, managers tend to be very focused on earnings, sometimes incorrectly at the expense of cash flow. 3. What factors determine whether the annual accounting rate of return on a given project will be high or low in the early years of the investments life? In the latter years? Depreciation method can be a big factor. Accelerated depreciation can mean substantially lower cash flows in the early years of a project. 4. What factors account for the popularity of the payback method? In what situations is it often used as the primary decision technique? Why? Payback is popular because it is very easy to compute and to understand and because it gives managers a rough measure of how soon they will receive intermediate cash flows from a project that they could potentially invest in other projects. 5. What are the major flaws of the payback and discounted payback approaches? The major flaws of the payback and discounted payback methods are that they do not take the time value of money into account and they ignore cash flows beyond the payback period. 6. If a project has an NPV of $1 million, what does that mean? An NPV of $1 million means that $1 million in shareholder value (market capitalization) is being added to the firm. 7. At a given point in time, why might the discount rates used to calculate the NPVs of two competing projects differ? The discount rate reflects the risk of a project. It is possible for a project to have more risk at its beginning and less as managers become more familiar with project operations.
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8.

Describe how the IRR and NPV approaches are related. IRR and NPV are related in that both use the time value of money and take risk into account. NPV accounts for risk by using a risk-adjusted discount rate, while IRR uses a risk-adjusted hurdle rate against which to compare the project and make the accept/reject decision.

9.

If the IRR for a given project exceeds a firms hurdle rate, does that mean that the project necessarily has a positive NPV? Explain. Yes, for a single project with conventional cash flows, if IRR says accept the project, NPV will also say accept the project. If a project has two IRRs, this says the project is positive NPV whenever the hurdle rate lies between the two IRRs.

10.

Describe the scale problem and the timing problem and explain the potential effects of these problems on the choice of mutually exclusive projects using IRR versus NPV. You can use IRR with mutually exclusive projects by subtracting one set of cash flows from the other and finding the IRR of the project that represents these differential cash flows. If the differential project has conventional cash flows, then accept the project on top if the IRR exceeds the hurdle rate. If the differential project has non-conventional cash flows, then accept the project on the top of the subtraction if the hurdle rate exceeds the IRR.

11.

How are the NPV, IRR, and PI approaches related? All three methods are related because they adjust for the time value of money and risk. Again, for a single project with conventional cash flows, all three methods will provide the same accept/reject decision.

12.

What important flaw do both the PI and IRR share? Explain. Choosing a project with the highest PI may not be the same as accepting a project with the highest dollar NPV. To maximize shareholder wealth, a manager wants to add the most possible risk-adjusted (positive NPV) dollars to the company.

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Answers to Self Test Questions

ST8-1. Nader International is considering investing in two assets A and B. The initial outlay, annual cash flows, and annual depreciation for each asset is shown in the table below for assets assumed five-year lives. As can be seen, Nader will use straight-line depreciation over each assets five-year life. The firm requires a 12% return on each of those equally risky assets. Naders maximum payback period is 2.5 years; its maximum discounted payback period is 3.25 years and its minimum accounting rate of return is 30%. Asset A Initial Outlay (CFo) Year (t) 1 2 3 4 5 $70,000 80,000 90,000 90,000 100,000 $200,000 Cash Flow (CFt) Depreciation $40,000 40,000 40,000 40,000 40,000 $80,000 90,000 30,000 40,000 40,000 Asset B $180,000 Cash Flow (CFt) Depreciation $36,000 36,000 36,000 36,000 36,000

a. Calculate the accounting rate of return from each asset, assess its acceptability, and indicate which asset is best using the accounting rate of return. b. Calculate the payback period for each asset, assess its acceptability, and indicate which asset is best using the payback period. c. Calculate the discounted payback for each asset, assess its acceptability, and indicate which asset is best using the discounted payback. d. Compute and contrast your findings in parts (a), (b), and (c). Which asset would you recommend to Nader, assuming that they are mutually exclusive? Why?

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Invest Year 1 2 3 4 5

CF $70,000 80,000 90,000 90,000 100,000

A $200,000 12% PV 62,500 63,776 64,060 57,196

Depr. $40,000 40,000 40,000 40,000 40,000

CF $80,000 90,000 30,000 40,000 40,000

B $180,000 12% PV 71,429 71,747 21,353 25,420

Depr. $36,000 36,000 36,000 36,000 36,000

a) Accounting Rate of Return Year 1 2 3 4 5 NPAT $70,000-$40,000 = $30,000 80,000-40,000 = 40,000 90,000-40,000 = 50,000 90,000-40,000 = 50,000 100,000-40,000 = 60,000 Average = $46,000 NPAT $80,000-$36,000 = $44,000 90,000-36,000 = 54,000 30,000-36,000 = -6,000 40,000-36,000 = 4,000 40,000-36,000 = 4,000 Average = 20,000

$46, 000 = 46% 100, 000

Max 2.50 3.25

Acceptable

$20, 000 = 22.22% Not acceptable 90, 000

b) Payback 2.56 years / Not acceptable c)Discounted 3.17 years/Acceptable payback at 12%

2.33 years / Acceptable 3.62 years / Not Acceptable

d) They should take asset A because its accounting rate of return is acceptable as is its discounted payback. ST8-2. JK Products, Inc. is considering investing in either of two competing projects that will allow the firm to eliminate a production bottleneck and meet the growing demand for its products. The firms engineering department narrowed the alternatives down to tow Status Quo (SQ) and High Tech (HT). Working with the accounting and finance personnel, the firms CFO developed the following estimates of the cash flows for SQ and HT over the relevant 6-year time horizon. The firm has an 11 percent required return and views these projects as equally risky.

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Project SQ Initial Outflow (CFo) Year (t) 1 2 3 4 5 6 a. b. c. d. $670,000 $250,000 200,000 170,000 150,000 130,000 130,000

Project HT $940,000 $170,000 180,000 200,000 250,000 300,000 550,000

Cash Inflows (CFt)

e.

Calculate the net present value (NPV) of each project, assess its acceptability, and indicate which project is best using NPV. Calculate the internal rate of return (IRR) of each project, assess its acceptability, and indicate which project is best using IRR. Calculate the profitability index (PI) of each project, assess its acceptability, and indicate which project is best using PI. Draw the NPV profile for project SQ and HT on the same set of axes and use this diagram to explain why the NPV and IRR show different preferences for these two mutually exclusive projects. Discuss this difference in terms of both the scale problem and the timing problem. Which of the two mutually exclusive projects would you recommend JK Products undertake? Why? a. NPV b. IRR c. PI Project SQ $87,313.87 16.07%* 1.13 Project HT $142,254.07* 15.17% 1.15*

All measures indicate project acceptability NPV > 0 IRR >11% PI > 1.00 The star * indicates the preferred project using each measure.

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d. 750 HT NPV ($000) 500 SQ 250 0 -250 5 10 15 20 Required return %

Rate 0% 11% 15.17% 16.07%

Project SQ $360,000 87,313.87 0

HT $710,000 142,254.07 0 -

At 11% HT is preferred over SQ, but because the profiles cross somewhere beyond 11% and before the functions cross the required return axis the IRR of SQ exceeds the IRR of HT. This behavior can be explained by the fact that HTs larger scale causes its NPV to exceed that of SQ. The smaller project and the timing of SQs cash flows more in the early years causes its IRR to exceed that of HT, which has more of its cash flows in later years. e. Project HT is recommended because it has the higher NPV, the better technique. In addition its PI is higher than that of Project SQ.