Chapter 11 - Capital Budgeting

other projects

This catch-all includes items such as office buildings, parking lots, and executive aircraft. How they are handled varies among companies.

NPV, IRR, MIRR, and payback.

What are all of the major capital budgeting criteria?

c

Which of the following statements about the modified internal rate of return is CORRECT? a. The modified internal rate of return overstates a project's true return, so that's why the internal rate of return is a better measure of a project's return. b. The modified internal rate of return (MIRR) is a better measure of a project's return than the internal rate of return (IRR) because MIRR assumes that the project's cash flows can be reinvested at the project's internal rate of return. c. The internal rate of return (IRR) is not a good measure of a project's true return. The IRR overstates a project's true return because it assumes that a project's cash flows can be reinvested at the project's internal rate of return. The Modified Internal Rate of Return, however, is a better measure of a project's return because it assumes that a project's cash flows are reinvested at the firm's weighted average cost of capital. d. Due to the mathematics involved in the equations used to solve for both the internal rate of return and the modified internal rate of return, the solutions for the returns are identical—the answers will always be the same. e. None of the statements is correct.

a

Which of the following statements suggests that assuming reinvestment at the WACC is a more reasonable reinvestment rate assumption? a. If firms use internally generated cash flows from past projects rather than external capital, then they will save their costs of capital. Thus, their costs of capital represent the opportunity costs of their cash flows; thus, the effective returns on their reinvested funds. b. Firms do not have reasonably good access to the capital markets, so firms cannot raise all the capital they need at the going interest rate. c. If firms have reinvestment opportunities with positive NPVs, they will be constrained in accepting them and financing them at their costs of capital.

independent project

A project whose acceptance or rejection is independent of the acceptance or rejection of other projects. the cash flows of one are unaffected by the acceptance of the other.

true

A project's payback gives us an idea of the project's liquidity because it indicates how long funds will be tied up in the project. True or false?

true

Among the conditions that may cause a project to have more than one IRR, one might be the situation in which a negative cash flow (or cost) occurs at the end of the project's life in addition to the initial investment at time = 0. True False

true

An NPV profile is a graph that shows a project's NPV on the vertical axis, the cost of capital on the horizontal axis, and a line that shows the project's NPV at each cost of capital. The point on the horizontal axis where the NPV crosses the axis—i.e., where the NPV is zero—is the IRR. True or false?

true

Assume that Project 2's cost of capital is 12% and analyze the following statement: "Even though Project 2's IRRs are both greater than the cost of capital, the project should still be rejected because its NPV is negative at the project's cost of capital, and consequently, the firm's value will be reduced if it is accepted." True or false?

merger and acquisition projects

Buying a whole firm is different from buying an asset such as a machine or investing in a new airplane, but the same principles are involved. The concepts of capital budgeting underlie merger analysis.

decrease, because the project has become less profitable.

Calculate a project's IRR by finding the cost of capital that would give the project an NPV of zero ($0). If the amount of a project's cash inflows decrease, and everything else stays the same, the IRR of the project will....

increase, because the project has become more profitable.

Calculate a project's IRR by finding the cost of capital that would give the project an NPV of zero ($0). If the amount of a project's cash inflows increase, and everything else stays the same, the IRR of the project will ...

true

Conflicts such as those between mutually exclusive projects can never occur between independent projects. One project might have the higher IRR and the other the higher NPV, but this does not lead to problems in deciding whether to invest in either, neither, or both of the projects. True or false?

safety/environmental projects

Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms fall into this category. How these projects are handled depends on their size, with small ones being treated much like the Category 1 projects.

Similarity: in both, we forecast a set of cash flows, find the present value of those flows, and make the investment only if the PV of the inflows exceeds the investment's cost. One important difference between capital budgeting and security analysis is that in security analysis the analyst must generally take the projected cash flows as given rather than something the analyst can influence, whereas firms can often influence the cash flows from projects by making operating changes

How is capital budgeting similar to security valuation? How is it different?

c

If a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT? If a project's NPV is greater than zero, then its IRR must be less than the WACC. If a project's NPV is greater than zero, then its IRR must be less than zero. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. The NPVs of relatively risky projects should be found using relatively low WACCs. A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.

false

If a project would lead to an increase in a firm's cost of capital (its WACC), it should not be accepted. True False

true

One important difference between capital budgeting and security analysis is that in security analysis the analyst must generally take the projected cash flows as given rather than something the analyst can influence, whereas firms can often influence the cash flows from projects by making operating changes. True or false?

false

Suppose a project has a negative cash flow (a cost), then a series of positive cash inflows, and then another cost at the end of its life. In this situation it would be impossible for the project to have more than one IRR. True or false?

a

Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don't need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker's statement? a. No, the NPV calculation will take into account not only the projects' cash inflows but also the timing of cash inflows and outflows. Consequently, project B could have a larger NPV than project A, even though project A has larger cash inflows. b. No, the NPV calculation is based on percentage returns, so the size of a project's cash flows does not affect a project's NPV. c. Yes, project A will always have the largest NPV, because its cash inflows are greater than project B's cash inflows.

true

T or F: The IRR is the internal rate of return, or the project's expected return if intermediate cash flows earn the same return as the IRR. The IRR is the cost of capital that forces the NPV to equal zero; hence, the calculated IRR is independent of a project's cost of capital.

true

T or F: The same concepts used in security valuation are also used in capital budgeting, but there are two major differences. First, stocks and bonds exist in the security markets, and investors select from the available set; firms, however, create capital budgeting projects. Second, for most securities, investors have no influence on the cash flows produced by their investments, whereas corporations have a major influence on projects' results. Still, in both security valuation and capital budgeting, we forecast a set of cash flows, find the present value of those flows, and make the investment only if the PV of the inflows exceeds the investment's cost.

true

T or F: in both security valuation and capital budgeting, we forecast a set of cash flows, find the present value of those flows, and make the investment only if the PV of the inflows exceeds the investment's cost.

rejected

The IRR identifies the cost of capital where NPV equals zero (where the project breaks even). The IRR is the project's expected rate of return, assuming that intermediate cash flows also earn the IRR. If the IRR is less than the cost of the capital invested in the project, shareholders will lose value on the investment. Therefore, projects whose IRR is less than the WACC should be ACCEPTED OR REJECTED?

b

The NPV should be used as the primary capital budgeting decision criterion because: a. It tells us how long it will take to recover the investment in a project. b. It tells us how much the project is expected to add or subtract from a firm's value. c. It tells us what rate of return is expected on a project

Replacement Projects

The firm replaces existing assets generally to reduce costs •Worn out machines •Cost reduction / technology improvement

true

The inputs used in most capital budgeting analyses are not known with certainty; hence, the results of a quantitative analysis may be quite different from the actual, after-the-fact results. Also, five capital budgeting criteria are commonly used, and each provides a somewhat different bit of information. Therefore, it is rational for a firm to calculate and give some consideration to each of the five criteria. For most decisions, the greatest weight should be given to the NPV, but it would be foolish to ignore the information provided by the other criteria. True or false?

payback period

The length of time required for an investment's cash flows to cover its cost.

discounted payback

The length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost.

multiple IRRs

The situation where a project has two or more IRRs.

required return

You would accept a project if the IRR is greater than the ...

true

There has been a strong trend in recent years toward the use of the NPV and IRR methods as the primary criteria, and away from the regular payback as the primary criterion for selecting capital budgeting projects. True or false?

true

True or False: The NPV and IRR methods can lead to conflicting decisions for mutually exclusive projects.

non-normal cash flow stream

Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Examples include nuclear power plant, strip mine, etc.

•Replacement: •Cost reduction / technology improvement •Expansion: •Existing products, services or markets •New products, services or markets •Mergers and Acquisitions •Safety/Environmental •Other: Office buildings, other real estate, executive perqs •

What are some ways that firms generate ideas for capital projects?

c

Which of the following factors could lead to a conflict between the NPV and IRR methods for two mutually exclusive projects? a. Differences in the timing of the projects' cash flows. b. Differences in the projects' sizes. c. both statements are true

c

Which of the following statements about IRR and WACC is CORRECT? For a project to have more than one IRR, then both IRRs must be greater than the WACC. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon. Multiple IRRs can only occur if the signs of the cash flows change more than once. Two projects are likely to have multiple IRRs if they are mutually exclusive. A project cannot have multiple IRRs if it is independent.

b

Which of the following statements about the relationship between the IRR and the MIRR is correct? A typical firm's IRR will be equal to its MIRR. A typical firm's IRR will be greater than its MIRR. A typical firm's IRR will be less than its MIRR.

c

Which of the following statements best describes the difference between the IRR method and the MIRR method? The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR. The IRR method uses the present value of the initial investment to calculate the IRR. The MIRR method uses the terminal value of the initial investment to calculate the MIRR. The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital

b

Which of the following statements best explains what it means when a project has an NPV of $0? When a project has an NPV of $0, the project is earning a profit of $0. A firm should reject any project with an NPV of $0, because the project is not profitable. When a project has an NPV of $0, the project is earning a rate of return equal to the project's weighted average cost of capital. It's OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return. When a project has an NPV of $0, the project is earning a rate of return less than the project's weighted average cost of capital. It's OK to accept the project, as long as the project's profit is positive.

b and c

Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply. The payback period is calculated using net income instead of cash flows. The payback period does not take the project's entire life into account. The payback period does not take the time value of money into account.

c

Which of the following statements is CORRECT? a. The Internal Rate of Return is one of the measures that companies look at when they're trying to decide on projects to undertake. The Internal Rate of Return measures the absolute dollars that the project is expected to generate for shareholders. b. The Net Present Value is one of the measures that companies look at when they're trying to decide on projects to undertake. The Net Present Value measure the percentage, or rate of return, we can expect from a project relative to its cost. c. When a company is deciding between two mutually exclusive projects, it's possible that the better decision for the firm is to accept the project that has a higher Net Present Value but a lower Internal Rate of Return rather than the project with a lower Net Present Value but a higher Internal Rate of Return. This is because the Net Present Value shows directly how much dollar value a project adds to the firm. d. Statements a, b, and c are correct. e. None of the statements is correct.

a

Which of the following statements is correct? a. If a firm is considering 5 independent projects, then as a general rule it should invest in all 5 of them if the analysis shows that each of them has a positive NPV. If it were considering 5 mutually exclusive projects (i.e., 5 ways of performing a given task), then as a general rule it should not invest in all 5 of them even if they all have positive NPVs. b. Mutually exclusive projects generally have higher NPVs than independent projects. c. If two projects are mutually exclusive, then the one with the higher IRR should be accepted.

less than some preset limit

You would accept a project if the payback period or discounted payback period is ...

MIRR

assumes reinvestment at the opportunity cost = WACC. Reinvesting cash flows at the WACC is prudent. Arbitrarily picking reinvestment rates or MIRR methods in order to get a number that looks good is not. By reinvesting the cash flows at the WACC and moving them all to the end, this also avoids the multiple IRR problem if you have multiple sign changes in your cash flows.

internal rate of return

most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

mutually exclusive projects

projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function If the cash flows of one can be adversely impacted by the acceptance of the other. Only enough available cash to fund one project, not both - Regulatory restrictions prevent investing in both

crossover rate

the point or interest rate on the Net Present Value Profile at which the net present values of two projects are equal. To the right of this point, when the cost of capital is greater than the crossover rate, both the net present value and the internal rate of return will give the firm the same decision about the project.

net present value

the present value of current and future benefits minus the present value of current and future costs

capital budgeting

the process of planning and managing a firm's long-term investments

NPV profiles

A graphical representation of project NPVs at various different costs of capital.

a

Capital budgeting is used to determine: a. If projects should be funded or killed. b. If a stock should be bought or sold. c. If interest rates will increase or decrease. d. If a corporation should issue stocks or bonds.

d

In capital budgeting independent projects are projects that: a. Are not done by the firm. b. Projects that are paid for the producer of the project. c. Are done by a private firm, not the government. d. Have cash flows that do not depend on the other project.

internal rate of return

The discount rate that forces a project's NPV to equal zero.

true

The rate at which the NPV profile lines of two mutually exclusive projects cross is called the "crossover rate." If the cost of capital is greater than the crossover rate, then no conflict will occur because the project with the higher NPV will also have the higher IRR. True or false?

e

Which of the following statements is correct? More than one statement may be correct. a. A project's IRR is conceptually similar to a bond's YTM. b. A project's IRR is the discount rate that causes the project's NPV to equal zero. c. If an independent project's IRR exceeds its cost of capital, then the project should be accepted. d. If an independent project's IRR is less than its cost of capital, then the project should be rejected. e. All of these are all true.

What are the 5 steps in Capital Budgeting?

1.Estimate CFs (inflows & outflows). 2.Assess riskiness of CFs. 3.Determine the appropriate cost of capital. 4.Find NPV and/or IRR. 5.Accept if NPV > 0 and/or IRR > WACC.

normal cash flow stream

Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

c

In capital budgeting if the present value of the cash inflows are LESS than the costs, then what should happen? a. The project should be funded. b. Market interest rates should fall. c. The project should be killed. d. The stock or equity should be purchased.

a

Mutually Exclusive projects are projects that: a. Cannot be done together. b. Are not profitable given current market conditions. c. Are not affordable at this time. d. Cannot be completed at this time.

expansion projects

New products, services or markets. These projects involve strategic decisions and explicit forecasts of future demand and require full analysis

modified IRR

The discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital.