FIN Chapter 8

Assume you have two projects with different lives. Project A is expected to generate present value cash flows of $5.2 million and will last 7 years. Project B is expected to generate present value cash flows of $3.8 million and will last 5 years. Given a required return of 9%, Project A has an equivalent annual annuity of __________ which is __________ than Project B.

$1.03319 million, better You need to compute the EAA for each project in order to compare the two. To compute the EAA for projects A and B use the following inputs on your financial calculator: Project A: PV = -$5.2; N = 7; I / Y = 9%; FV = 0; CPT PMT and you get $1.03319 million Project B: PV = -$3.8; N = 5; I / Y = 9%; FV = 0; CPT PMT and you get $.97695 million Project A should be selected since it has a higher EAA.

Software Design Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. Which of the following methods should the company use to choose which projects to accept?

Rank the projects based on profitability index (PI) and select the highest PIs.

The relevant cash flows of a project are best described as:

incremental cash flows

The profitability index is a ratio of:

NPV to investment cost

When resources are limited you should select the projects with the:

highest NPVs

Which of the following decision rules is always correct because it is directly tied to the goal of maximizing shareholder wealth?

NPV rule

A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is:

-$2,000 The NPV is defined as the present value of the project's cash flows minus the initial investment. In this case: NPV = $6,000 - $8,000 = -$2,000.

Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as:

Independent projects

Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?

10% When you have a series of cash flows that represent an annuity it is very easy to calculate the IRR with your financial calculator using the following inputs: PV = -$16,000 N = 8; FV = 0 PMT = $3,000 CPT I/Y, which gives you 10.0082 or approximately 10%.

What is the discounted payback of a project that has an initial outlay of $20,000 and will generate $6,000 in year 1, $12,000 in year 2, $9,000 in year 3, and $14,000 in year 4 assuming the cost of capital is 10%?

2.68 years To compute the discounted payback you have to calculate the present value of each cash flow and subtract these values from the initial outlay to determine how long it takes to recover the investment after considering the time value of money. The PVs of each cash flow using a 10% discount rate are: PV of year 1 = $6,000/(1.1) = $5,455 PV of year 2 = $12,000/(1.1)2 = $9,917 PV of year 3 = $9,000/(1.1)3 = $6,762 PV of year 4 = $14,000/(1.1)4 = $9,562 So the discounted payback is equal to: Initial outlay = $20,000 - $5,455 - $9,917 = $4,628 remaining to be recovered after two years. So, discounted payback = 2 years + $4,628/$6,762 = 2.68 years.

A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:

3.5 years The payback period is the length of time it takes to recover the initial investment so in this case you see that a total of $40,000 is recovered in the first three years, which leaves $5,000 to be recovered. In the fourth year, you will generate $10,000 so the fraction of the year required to capture the remaining $5,000 investment is $5,000/$10,000 or 0.5. The payback period is, therefore, 3.5 years

To evaluate differences in project scale, a financial manager should always use ___________ as the primary capital budgeting evaluation tool.

NPV

Chris has been offered the chance to invest $120,000 in a partnership, which is expected to return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a payback of six years, should Chris invest?

No, because the payback period is 6.86 years. To calculate the payback you need to calculate Chris' annual cash return which is equal to $25,000 (1 - 0.30) = $17,500 per year in after-tax proceeds from the investment. Given that annual amount, his payback is equal to $120,000 / $17,500 = 6.86 years. Since the payback exceeds his six year cut off he should not make the investment.

MIRR is used when:

cash flows of a project change sign

An NPV profile is __________.

a graph of a project's NPV over a range of different discount rates

A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by:

a series of inflows

One method that can be used to evaluate capital budgeting projects with different lives is to convert the project's cash flows to a level annual cash flow that has the same present value as the project's overall cash flows. This annual cash flow is known as the:

equivalent annual annuity (EAA)

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:

firm's cost of capital The NPV uses the firm's cost of capital to discount the project cash flows back to the present. Therefore, any positive NPV project earns at least the firm's cost of capital.

The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have:

longer project lives

The first step in the capital budgeting process is:

proposal generation

The minimum return that must be earned on a project in order to leave the firm's value unchanged is:

the discount rate The firm selects a required rate of return that it must earn on any capital budgeting projects and then uses this rate as the discount rate to compute the present value of the project's cash flows. All projects must earn a minimum return equivalent to this discount rate.

The discounted payback period method takes __________ into consideration.

time value of money

Capital rationing is the process of:

using limited cash to select among investments available