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1. Shareholder wealth maximization occurs when projects are chosen with a rate of
return greater than the market-determined rate of return or the cost of capital of
the firm. Stated in other words, profit maximization occurs when the firms
marginal costs equal its marginal revenue. Shareholder wealth maximization and
profit maximization are synonymous with maximizing the value of the firm.
The relevant cash flows to examine are the expected cash inflows from the
project over time and the initial and continuing outflows or costs associated with
the project. The future cash flows that are incremental to the project or that accrue
to the firm only as a result of the specific project in question should be examined.
In addition, any decrease in cash flows to the company caused by the project in
question, e.g., the tax depreciation benefit when old equipment is replaced by
equipment, must be considered as well.
Accounting regulations attempt to adjust cash flows over several periods; e.g.,
the expense of an asset is depreciated over several time periods. Hence, project
costs associated with the project are matched with the project revenues in the
periods in which those revenues are expected to accrue. Because this time frame
may span the life of the project, accounting for cash flows at a given point in time
for capital budgeting purposes is accomplished by using economic cash flows.
Economic cash flows are calculated as they occur to the firm.
2.
a. The incremental after-tax operating cash flow (net cash inflow) in a given
period t is defined as the after tax incremental operating cash flow, (1 t)COt
plus the incremental depreciation tax subsidy, tdept, where COt represents the
pretax incremental operating cash flow, t represents the marginal tax rate, and
dept represents the incremental depreciation. Incremental means the change in
a particular item as a result of the firm undertaking the project.
d. The accounting rate of return (ARR) method is the ratio of the investment's
annual net income after taxes to either total outlay or average outlay. (See page
462 of text.)
e. The reinvestment rate is that rate at which cash flows from a project are
reinvested.
g. Capital rationing refers to the scenario where a firm sets limits on the amount
of funds it will spend on fixed assets due to the large number of available
(profitable) investments.
3. In estimating cash flows without debt, the following equation expresses the
necessary tax adjustments:
CF = ICFBT (1 T) + TD,
where ICFBT = incremental CF before tax,
T = corporate tax rate,
D = incremental annual change in depreciation (DEP) (i.e., DEP of new
DEP of old).
Included in the CF, then, are the increase in income due to the new project,
adjustments to the CF for additional taxes due to the increased income and due to
the difference in DEP per year.
With debt financing we must also adjust the increased interest payments per
year, net of tax savings. The first and last year CF will include investment, set-up
costs, and salvage value, respectively.
4. Professor Pinches suggests the following process:
a. Identification of areas of opportunity
b. Development of information
c. Selection of the best alternative or courses of action to be implemented, and
d. Control or feedback of the degree of success or failure of both the project and
the decision process itself
5. Both the IRR and the NPV have advantages relative to the ARR and the PBP in
that they account for the time value of money. A disadvantage of both the IRR and
the NPV is that they do not explicitly account for the risk of the project.
Furthermore, the IRR and NPV can give conflicting accept/reject decisions
estimated for the projects life. The cumulative time period is calculated at the
point where the sum of annual cash inflows equals the initial investment. The time
period is the payback period.
b) The accounting rate-of-return method averages the after-tax profit from an
investment for every period over the initial outlay.
N
ARR
t 0
APt
N
I,
NPV
t 0
CFt
I,
(1 IRR)
NPV
t 0
CFt
I
(1 K)t
PI
t 0
CFt
(1 K)t
I.
between the NPV and IRR rankings depends on whether the discount rate used by
the firm is less than the cross-over rate (point C) or the rate that equates the
projects NPVs.
9. a) Multiple rates of return can occur using IRR if the cash flows change sign.
When this occurs, there will be a new root solution to the IRR problem. It is also
possible for the IRR solution to be imaginary. Multiple or imaginary roots make
interpretation of the capital budgeting solution difficult.
b) IRR calculations use the assumption that the shareholder can reinvest the cash
flows at the IRR. This causes two problems: (1) it divorces the discounting
process from the cost of capital and (2) it implies that reinvestment rates are
contingent on individual projects. In a world of certainty where each project has
the same risk, it is illogical to assume that shareholders can invest funds for
instance at both 14% and 25% depending on the IRR of the two projects.
c) When groups of projects are considered, IRR can lead to conflicting capital
budgeting solutions, depending on what combination of projects are considered.
Ideally, a decision rule should allow the manager to choose projects independently
of one another. With this in mind, the IRRs legitimacy is weakened.
Although these arguments are valid, the viability of using the IRR method
should be evaluated only within the corporate or business context. The IRR may
be the most appropriate return measure depending upon the firms specific
policies, goals, and constraints. For example, in considering two mutually
exclusive projects, firm policy may set a planning horizon of 4 to 5 years,
regardless of what the length of the projects useful life is. Given this constraint,
the IRR is most appropriate. Although there are drawbacks implicit in the
assumptions of IRR in real-world problems, IRR is often used in conjunction with
other capital budgeting methods so that these assumptions are somewhat
counterbalanced.
10. Inflation has a major impact upon all financial decisions of the firm mainly
because tax deductibility of depreciation charges is based upon historical costs.
Nelson goes on to isolate 5 areas in which inflation has impact on capital
budgeting decisions:
a) The optimal level of capital investment will typically decrease as the rate of
inflation increases. The higher the rate of inflation, the larger the discount rate,
and thus the lower the marginal present value for successive dollars invested.
b) High rates of inflation result in lower capital/labor ratios and thus influence the
firms choice of technology. The price of labor does not depend on the rate of
inflation, whereas the price of investment does depend on inflation. Thus the
level of inflation corresponds to different price ratios between labor and capital,
and influences the chosen amount of each factor.
c) Inflations impact on mutually exclusive projects deals with depreciation in the
sense that depreciation rates are based on historical costs and the distribution of
these charges over the life span of the projects determines the net present value.
d) When inflation is high, projects with shorter life spans will be favored over
those with longer expected lives because those with shorter life spans will have
their depreciation costs restated in current dollars more frequently as they are
replaced.
e) This proposition relates to those projects whose lifetime is influenced by
managerial decisions about replacement. In these cases, higher inflation will work
against current replacement. This occurs because the present value of the
replacement is directly influenced by the effect of inflation on future tax savings
from depreciation. Thus, although with low inflation an investment may be
replaced because of high operating costs, with high inflation the present value of
the old project may be higher than that of the replacement project.
11. Practitioners face the problem of managing uncertainty when performing capital
budgeting. Tuttle and Litzenberger suggest that returns on investment projects can
be made risk-equivalent to the firms cost of equity capital by financing the
projects with the proper amount of borrowing or lending. Assuming a competitive
market with many small, risk-averse investors, the price of the firms common
stock (its market trade-off point) is a function of its expected rate of return and
estimated standard error of return. With perfect correlation of projected returns,
acceptance criteria are obvious with two exceptions. These occur when the
expected IRR of project i exceeds the firms equity capitalization rate, but the
standard error of the estimate of the projects IRR exceeds the firms standard
error; or when IRRi < Ri, but Si < Sf. Then capital budgeting decision is not so
clear. In these instances, the return is made risk-equivalent by neutralizing the
risk inherent in the project through a specific debt-equity ratio or through longterm borrowing and lending. The risk-adjusted rate of return equals the yield to
maturity of the firms long-term debt plus the financing mix factor multiplied by
the expected IRR less the yield to maturity. This then becomes the discount rate
that reflects the risk-adjusted cost of financing the project, allowing for net present
value analysis in the risk-equivalent context.
If the perfect correlation assumption is removed, the new cost of financing is
determined through the financing ratio that equates the estimated standard error of
returns after acceptance of the project with the error calculated before acceptance.
In markets dominated by large institutional investors, systematic risk is the
relevant risk measure. In this framework, the relevant discount rate can be
determined to make projects risk-equivalent.
Semi-variance is also used as a risk measure in capital budgeting because many
managers are concerned only with downside risk. Probability of excess returns is
not considered risk in this case.
The two methods most commonly used to quantify risk in this context are the
certainty equivalent approach and the risk-adjusted discount rate approach.
Hastie feels the major problems for practitioners include capital rationing,
judgment errors in estimation, and the failure of the financial analyst to be
objective or realistic. Capital rationing may be caused by limits on borrowing; but
theory does not offer a method of ranking projects with different risks, strategic
purposes, and the quality of analytic support. Errors in judgment in estimating
uncertain future profits may come from excessive pessimism or optimism or just
bad judgment in general.
In dealing with these problems, overall corporate strategy should be clear and
communicated to all involved planners and analysts. The analytic techniques
employed should be well understood by all who work with them and should
generate the relevant information a firm uses in its decision making. Perhaps
academicians should place more attention on the non-quantitative aspects of the
problem. That is, the project definition, estimation of CF, and implementation and
review stages should be considered more by theoreticians.
NPV ( k ) R (t ) C (t ) e dt
0
where NPV(k) = net present value of the project discounted at the cost-of-capita1
rate, k.
Curves are drawn on the assumptions that total nonrecurring costs are (R + I) =
$900mm, average = 15.5, 3 products/month are produced and sold, development
and initial investment phase = 42 months, corporate tax rate = 50%, and that costs
will always have positive revenues. Discount rates are an important factor in
dynamic break-even analysis. Here the break-even sales levels are 287, 360 and
510 units. In this model, finance theory, accounting information and mathematical
tools are incorporated to make the project decision analysis more acceptable.
15. a) NPV(A) = ($4,351)(5.650)=$24,853.15 25,000 = $(146.85)
NPV(B) = ($6,990)(3.605)=$25,198.95 25,000 = $ 198.95
b) NPB(A) = ($4,351)(5.216)=$22,694.82 25,000 =$2,305.18)
NPV(B) = ($6,990)(3.443)=$24,066.47 25,000 = $(933.43)
c) NPV(A) = ($4,351)(6.145)=$26,736.89 25,000 =$1,736.89
NPV(B) = ($6,990)(3.791)=$26,499.09 25,000 =$1,499.09
Since the initial cost for both projects is $25,000, in Cash (a), Project B should
be accepted, in Cash (b) neither project should be accepted, and in Cash (c)
project A should be accepted.
(d) Using the information from (a), (b), and (c), students can graph the NPV
profiles following the example given on page 467of the text.
16.
Project A
(50 50 60 60) 100 220
.55 or 55%
4
400
Project B
.50 or 50%
4
400
Project C
.50 or 50%
4
400
A is the best project.
17.
Project A: PBP = 2 years
Project B: PBP = 2 + (40/60) = 2
Project C: PBP = 100/120 =
2
years
3
5
years
6
18.
200
40
60
50
100
1000
2
3
4
(1 rA ) (1 rA ) (1 rA ) (1 rA ) (1 rA )5
200
100
100
50
60
40
2
3
4
(1 rB ) (1 rB ) (1 rB ) (1 rB ) (1 rB )5
Using the trial and error method, the IRRs of projects A and B are given as
follows:
rA = 53.63%
rB = 27.09%
19.
80
70
a. NPVX 100
NPVY 100
20
30
50
100
2
3
1.1 (1.1) (1.1) (1.1)4
b. Infinite Replication
NPVX 30.58
30.58 30.58
K K
(1.1)2 (1.1)4
30.58 (30.58)(
1
1
K K )
2
(1.1) (1.1)4
30.58 (30.58)[
(1 1.1)2 0
]
1 (1 1.1)2
30.58 (30.58)(4.7606)
$176.16
NPVY 48.84 48.84[
1
1
K K ]
4
(1 .1) (1 .1)8
48.84 (48.84)[
(1 1.1)4 0
]
1 (1 1.1)4
48.84 (48.84)(
0.683
)
0.317
$154.07
20.
110 121
1.1 (1.1)2
IRRA = 10%
Project Bs IRR
200
121 108.9
1.1 (1.1)2
IRRB = 10%
CASE 1: If the discount rate is 8%, which is less than the IRR of 10%, then the
projects are both acceptable.
NPVA 200
110
121
NPVB 200
121 108.90
Since the NPV of B is less than the NPV of A, project A is the better of the two.
CASE 2
If the discount rate is 12% which is larger than the IRR of 10%, then the projects
are unacceptable.
NPVA = 5.33
NPVB = 5.15
NPVA < NPVB but both projects have negative) NPVs and are therefore
unacceptable.
21.
NPV 500, 000
22.
a. Initial Net Cash Outlay
Cost of System
Installation Expenses
Net Cash Outlay
$200,000
50,000
$250,000
Additional Expenses:
Salaries of Specialists
Maintenance Expenses
Incremental Cash flow (173,000 92,000) = $81,000
Net Operating Cash flow = $81,000 (1 .40) + (.40)(50,000)
$150,000
8,000
12,000
3,000
$173,000
$ 80,000
12,000
$92,000
68, 600
250, 000
t
t 1 (1 .12)
5
c. NPV
d. IRR (r):
68, 600
250, 000 0
t
t 1 (1 r )
5
NPV
68, 600
250, 000
t
t 1 (1 .115)
5
0.989
IO
250, 000
f. Payback Period = 3
2
Years
3
$25,000
10,000
$15,000
1
15, 000
250, 000
t
t 1 (1 .12)
(1 .12)5
5
Project is acceptable.
23.
$ 20,000
0
$20,000
$8,000
$ 30,000
14,000
6.400
$20,400
Initial Outlay
Cost of New Truck
$90,000
$20,400
Net Outlay
$69,600
$ 8,000
Breakdowns
15,000
Total Savings
$23,000
$20,000
8,000
$12,000
1
12000
69, 600
t
t 1 (1 .10)
(1 .10)t
5
e. PI
71,894.40
1.0329
69, 600
24.
NPV = (PI 1.0) I
= (2 1)(5000)
= $5000
25.
Initial Cash Outlay :
Land
Building
Equipment
Total Outlay
$ 40,000
80,000
20,000
$140,000
$ 90,000
27,000
25,000
$38,000
1
73, 000
140, 000
t
t 1 (1 .10)
(1 .10)10
10
c. NPV 26,800
$95,000
40,000
$55,000
$95,000
22,000
$73,000
1
73, 000
140, 000
t
t 1 (1 .17)
(1 .17)10
26,800(4.6586) 73, 000(0.2080) 140, 000
$34
10
26,800
PI
159, 479.58
1.139
140, 000
d. This would not affect the initial cash outlay. However, the operating cashflows
would be reduced by $13,000(1 .40) = $78,000 resulting in annual operating
cash flows of $19,000. The terminal value cash flow would not change either.
NPV = 19,000(5.2161) + 73,000(0.2697) 140,000
= $118,794 140,000
= $21,206
PI
118, 794
0.8485
140, 000
adjustment only.
26.
Initial Outlay
Depreciation
Cash flow/year
Alpha (A)
$105,000
105,000/10
= $10,500
$10,500
Gamma (B)
$ 90,000
90,000/10
= $9,000
$ 9,000
1
105, 000
t
t 1 (1 .10)
2100(6.1446) 105, 000
$117,903.66
10
NPVA 2100