Chapter 11: The Basics of Capital Budgeting
independent
projects with cash flows that are affected by the acceptance or non-acceptance of other projects
net present value profile
a graph showing the relationship between a project's NPV and the firm's cost of capital
strategic business plan
a long-run plan the outlines in broad terms the firm's basic strategy for the next 5 to 10 years
net present value (NPV)
a method of ranking investment proposals using the NPC, which is equal to the present value of the project's free cash flows discounted at the cost of capital
mutually exclusive
a set of projects where only one can be accepted
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 projects' sizes b. Differences in the timing of the projects' cash flows c. Both statements are true
c. Both statements are true
Which of the following statements is correct? a. If two projects are mutually exclusive, then the one with the higher IRR should be accepted. b. Mutually exclusive projects generally have higher NPVs than independent projects. c. 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.
c. 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.
Which of the following statements suggests that assuming reinvestment at the WACC is a 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.
c. If firms have reinvestment opportunities with positive NPVs, they will be constrained in accepting them and financing them at their costs of capital.
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. Statements a, b, c, and d are all true.
e. Statements a, b, c, and d are all true.
T/F "The regular payback is easy to calculate and to understand. However, it suffers from three flaws: (1) it ignores the time value of money, (2) it ignores cash flows after the investment has been recovered, and (3) given a project's payback, there is no generally accepted rule to decide if the project should be accepted. However, the discounted payback method corrects all of these flaws."
false
T/F For an NPV vs. IRR conflict to exist, two conditions must exist: (1) one project must be larger than the other, and (2) the larger project must receive most of its cash flows earlier than the smaller project.
false
T/F If two mutually exclusive projects are being compared, there may be a conflict between the projects' NPVs and their regular IRRs, but there can be no conflict between the projects' NPVs and MIRRs.
false
modified IRR (MIRR)
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
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
capital budgeting
the process of planning expenditures on assets with cash flows that are expected to extend beyond one year
multiple IRRs
the situation where a project has two or more IRRs
T/F "The primary difference between the MIRR and the regular IRR is that MIRR assumes that cash inflows are reinvested at the WACC, whereas the regular IRR assumes reinvestment at the IRR. Since reinvestment is generally at the rate to close the WACC, the MIRR is generally closer to the "true" rate of return a project will provide."
true
T/F A firm's growth, and even its ability to remain competitive and to survive, depends on a constant flow of ideas relating to new products, to improvements in existing products, and to ways of operating more efficiently. Accordingly, well-managed firms go to great lengths to develop good capital budgeting proposals.
true
T/F 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
T/F 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
T/F Analyzing capital expenditure proposals is not costless--benefits can be gained, but analysis does not have a cost. For certain types of projects, an extremely detailed analysis may be warranted, while for other projects, simpler procedures are adequate. Accordingly, firms generally categorize projects and then analyze them in each category somewhat differently.
true
T/F Capital budgeting is similar to security valuation in the sense that future cash flows must be estimated, a discount rate (the cost of capital) must be determined, future cash flows must be discounted to find the project's value and then this vale must be compared with the project's cost to determine whether the investment should be made.
true
T/F 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
T/F If a firm does not have a good access to external capital, and if it has many potential projects with high IRRs, it might be reasonable to assume that a project's cash flows could be reinvested at a rate close to its IRR. However, that situation rarely exists: Firms with good investment opportunities generally do have good access to capital markets.
true
T/F If you draw NPV profiles for two mutually exclusive projects on a single graph, and if the profile lines do not cross in the upper right quadrant, then there is no meaningful conflict between the projects--either one dominates the other or neither should be accepted at any positive cost of capital.
true
crossover rate
the cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects' NPVs are equal
internal rate of return (IRR)
the discount rate that forces a project's NPV to equal zero
T/F The NPV method is based on the assumption that a project's cash flows will be reinvested at the weighted average cost of capital, whereas the IRR method is based on the assumption that cash flows will be reinvested at the IRR. The textbook indicated that reinvestment at the cost of capital is generally the better assumption; hence, the NPV method is generally better.
true
T/F The text recommends that firms examine a number of capital budgeting criteria, but states that for most decisions the greatest weight should be given to the NPV.
true
T/F 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.
false
T/F The NPV and IRR criteria always produce conflicting recommendations for normal, independent projects.
false
T/F The NPV assumes reinvestment at the internal rate of return, while the IRR assumes reinvestment at the WACC. For most firms, assuming reinvestment at the IRR is reasonable, so the NPV is the better decision criterion.
false
T/F There has been a strong trend in recent years toward the use of the regular payback as the primary capital budgeting criterion.
false
T/F Two important project classifications are expansion of existing projects or markets, and expansion into new projects or markets. Both types of projects are fairly routine, so projects in either category do not require an elaborate decision process, and the final decision is typically made by lower level management.
false
The NPV should be used as the primary capital budgeting decision criterion because
it tells us how much the project is expected to add or subtract from a firm's value
T/F If you draw the NPV profile lines for two mutually exclusive projects with normal cash flows on a single graph, then it is possible that the lines will cross in the upper right quadrant. The discount rate at which the lines cross (and at which the projects' NPVs are equal) is called the "crossover rate." If the cost of capital is less than the crossover rate, then there will be a conflict between the NPV and IRR methods because one project will have the higher IRR but the other will have the higher NPV.
true
T/F Managers are supposed to maximize the value of their firms. The net present value (NPV) tells us how much a project contributes to shareholder wealth--the larger the NPV, the more value the project adds; and added value means a higher stock price. Thus, NPV is the best selection criterion.
true
T/F On an NPV profile graph, the vertical axis intercept is equal to the sum of the undiscounted cash inflows minus the project's cost.
true
T/F 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
T/F The NPV and IRR criteria can never lead to conflicting recommendations for normal, independent projects, because if the NPV is positive, the IRR must be greater than the cost of capital.
true
T/F 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
T/F 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
T/F 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
T/F Two important project classifications are (1) replacement: needed to continue current operations and (2) replacement: cost reduction. Projects of the second type are likely to require a more detailed analysis than those of the first type.
true
