Chapter 12: Capital Budgeting: Decision Criteria (Intermediate Financial Management)
Overview of Capital Budgeting: Accordingly, a well-managed firm will go to great lengths to encourage _____
good capital budgeting proposals from its employees
Profitability Index: A project is acceptable if its PI is ____, and the higher the PI, the higher the project's ranking.
greater than 1.0
Evaluating Mutually Exclusive Projects: For example, if one project costs more than the other, then the firm will have more money at t = 0 to invest elsewhere if ____
he firm will have more money at t = 0 to invest elsewhere if it selects the smaller project.
NPV Rankings Depend on the Cost of Capital: But a project whose cash flows come later will be severely penalized by ______
high capital costs.
Evaluating Mutually Exclusive Projects: Thus, a conflict exists if the cost of capital is _____
less than the crossover rate.
Conclusions on Capital Budgeting Methods: Like the IRR, it gives an indication of the project's risk, because _____
a high PI means that cash flows could fall quite a bit and the project would still be profitable.
Conclusions on Capital Budgeting Methods: In this same vein, managers should ask sharp questions about any project that has _____
a large NPV, a high IRR, or a high PI
The Post Audit: For example, many firms require that the operating divisions send _____, until the project's results are up to expectations.
a monthly report for the first six months after a project goes into operation, and a quarterly report thereafter
Payback Period: Project S We see that by the end of Year 3 the cumulative inflows have _____
more than recovered the initial outflow
NPV Rankings Depend on the Cost of Capital: Similarly, if a project has _____, its NPV will not decline very much if the cost of capital increases
most of its cash flows coming in the early years
Net Present Value (NPV): _____ is its life
n
Internal Rate of Return (IRR): The calculator has been programmed to solve for the IRR, and you activate this program by pressing the button labeled _____
"IRR."
Conclusions on Capital Budgeting Methods: The PI measures profitability relative to the cost of a project—it shows the _____
"bang per buck."
Rationale for the IRR Method: It is the _____ characteristic that makes the IRR useful in evaluating capital projects.
"break-even"
An Increasing Marginal Cost of Capital: As a result, a project might have a positive NPV if it is part of a _____ capital budget, but the same project might have a negative NPV if it is part of an unusually large capital budget
"normal size"
Conclusions on Capital Budgeting Methods: The NPV provides no information about either of these factors—the ____ or ____
"safety margin" inherent in the cash flow forecasts or the amount of capital at risk.
Conclusions on Capital Budgeting Methods: Further, IRR contains information concerning a project's _____
"safety margin."
Conclusions on Capital Budgeting Methods: In the process, we probably created the impression that ______ should use only one method in the decision process, NPV.
"sophisticated" firms
Modified Internal Rate of Return (MIRR): Our conclusion is that the MIRR is superior to the regular IRR as an indicator of a project's ____ or ____
"true" rate of return, or "expected long-term rate of return,"
Profitability Index: Project L, with a PI of 1.049, should produce _____ for each dollar invested.
$1.049
Profitability Index: Thus, on a present value basis, Project S is expected to produce _____ for each $1 of investment
$1.079
Proper Classification: Thus, a plant manager may be authorized to approve maintenance expenditures up to ____ on the basis of a relatively unsophisticated analysis, but the full board of directors may have to approve decisions that involve either amounts over $1 million or expansions into new products or markets.
$10,000
Discounted Payback Period: To construct Figure 12-3, each cash inflow is divided by _____
(1 + r)^t = (1.10)^t
Comparing Projects with Unequal Lives: We should note several potentially serious weaknesses inherent in this type of analysis: --->
(1) If inflation is expected, then replacement equipment will have a higher price. (2) Replacements that occur down the road would probably employ new technology, which in turn might change the cash flows. (3) It is difficult enough to estimate the lives of most projects, and even more so to estimate the lives of a series of projects.
Conclusions on Capital Budgeting Methods: This discussion suggests three things: ______
(1) If you can't identify the reason a project has a positive projected NPV, then its actual NPV will probably not be positive. (2) Positive NPV projects don't just happen—they result from hard work to develop some competitive advantage. At the risk of oversimplification, the primary job of a manager is to find and develop areas of competitive advantage. (3) Some competitive advantages last longer than others, with their durability depending on competitors' ability to replicate them.
Evaluating Mutually Exclusive Projects: Notice in Figure 12-4 that as long as the cost of capital is greater than the crossover rate of 7.2 percent, then ____
(1) NPVS is larger than NPVL and (2) IRRS exceeds IRRL.
Rationale for the IRR Method: Why is the particular discount rate that equates a project's cost with the present value of its receipts (the IRR) so special? What is the first reason?
(1) The IRR on a project is its expected rate of return.
The Optimal Capital Budget: However, two complications arise in practice: --->
(1) an increasing marginal cost of capital and (2) capital rationing.
Conclusions on Capital Budgeting Methods: The modified IRR has all the virtues of the IRR, but _____
(1) it incorporates a better reinvestment rate assumption, and (2) it avoids the multiple rate of return problem.
Capital Budgeting Decision Rules: Six key methods are used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget: --->:
(1) payback, (2) discounted payback, (3) net present value (NPV), (4) internal rate of return (IRR), (5) modified internal rate of return (MIRR), (6) profitability index (PI).
Comparing Projects with Unequal Lives: Here we assume _____
(1) that Project F's cost and annual cash inflows will not change if the project is repeated in three years and (2) that the cost of capital will remain at 11.5 percent:
Evaluating Independent Project: To see why this is so, assume that Projects L and S are independent, look at Figure 12-4, and notice ______
(1) that the IRR criterion for acceptance for either project is that the project's cost of capital is less than (or to the left of) the IRR and (2) that whenever a project's cost of capital is less than its IRR, its NPV is positive.
Conclusions on Capital Budgeting Methods: A long payback means _____
(1) that the investment dollars will be locked up for many years—hence the project is relatively illiquid—and (2) that the project's cash flows must be forecasted far out into the future—hence the project is probably quite risky.
The Post Audit: What is the first thing the post audit concludes?
(1) the actual NPVs of most cost reduction projects exceed their expected NPVs by a slight amount
The Post Audit: The results of post-audits often conclude that ______
(1) the actual NPVs of most cost reduction projects exceed their expected NPVs by a slight amount, (2) expansion projects generally fall short of their expected NPVs by a slight amount, (3) new product and new market projects often fall short by relatively large amounts.
Evaluating Mutually Exclusive Projects: Two basic conditions can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR: ---->
(1) when project size (or scale) differences exist, meaning that the cost of one project is larger than that of the other, or (2) when timing differences exist
Rationale for the IRR Method: Why is the particular discount rate that equates a project's cost with the present value of its receipts (the IRR) so special? What is the second reason?
(2) If the internal rate of return exceeds the cost of the funds used to finance the project, a surplus will remain after paying for the capital, and this surplus will accrue to the firm's stockholders.
The Post Audit: What is the second thing the post audit concludes?
(2) expansion projects generally fall short of their expected NPVs by a slight amount
Rationale for the IRR Method: Why is the particular discount rate that equates a project's cost with the present value of its receipts (the IRR) so special? What is the third reason?
(3) Therefore, taking on a project whose IRR exceeds its cost of capital increases shareholders' wealth
The Post Audit: What is the third thing the post audit concludes?
(3) new product and new market projects often fall short by relatively large amounts
Capital Rationing: Reluctance to issue new stock ---> This reluctance to issue new stock could be based on some sound reasons: --->
(a) flotation costs can be very expensive; (b) investors might perceive new stock offerings as a signal that the company's equity is overvalued; (c) the company might have to reveal sensitive strategic information to investors, thereby reducing some of its competitive advantages.
Comparing Projects with Unequal Lives: When we encounter such problems in practice, we use a ____and build ____ and/or _____ directly into the cash flow estimates, and then use the _____ approach.
- a computer spreadsheet -expected inflation and/or possible efficiency gains -replacement chain
Payback Period: Project S The cumulative net cash flow at t = 0 is just the initial cost of ____
-$1,000
Multiple IRRs: When solved, we find that NPV = ____ when IRR = ___ and also when IRR = _____
-0 -25% -400%
Payback Period: Project S Note: _____ represents the cash flow experienced at the project's inception.
CF0
Profitability Index: _____ represents the initial cost
CF0
Net Present Value (NPV): Here _____ is the expected net cash flow at Period t,
CFt
Profitability Index: Here ____ represents the expected future cash flows
CFt
Modified Internal Rate of Return (MIRR): ____ refers to cash inflows (positive numbers), and r is the cost of capital
CIF
Modified Internal Rate of Return (MIRR): Here _____ refers to cash outflows (negative numbers), or the cost of the project
COF
Intro: _____ is the process of evaluating a company's potential investments and deciding which ones to accept
Capital budgeting
Overview of Capital Budgeting: ____ is the decision process that managers use to identify those projects that add to the firm's value, and as such it is perhaps the most important task faced by financial managers and their staffs.
Capital budgeting
Conclusions on Capital Budgeting Methods: _____ also measures profitability, but here it is expressed as a percentage rate of return, which many decision makers prefer
IRR
Internal Rate of Return (IRR): Thus, we have an equation with one unknown,____, and we need to solve for IRR.
IRR
Profitability Index: If a project's NPV is positive, its ____ will always exceed r, and its PI will always be greater than 1.0.
IRR and MIRR
Multiple IRRs: All except one of the roots are imaginary numbers when investments have normal cash flows (one or more cash outflows followed by cash inflows), so in the normal case, only one value of ____
IRR appears
Evaluating Mutually Exclusive Projects: whereas the _____ assumes that the firm can reinvest at the IRR.
IRR method
Internal Rate of Return (IRR): Then the calculator solves for IRR and displays it on the screen. Here are the IRRs for Projects S and L as found with a financial calculator: --->
IRRs = 14.5% IRRl = 11.8%
Evaluating Independent Project: If independent projects are being evaluated, then the NPV and IRR criteria always lead to the same accept/reject decision: _____
If NPV says accept, IRR also says accept
Conclusions on Capital Budgeting Methods: One cannot know at Time 0 the ____ or ____
exact cost of future capital, or the exact future cash flows
Overview of Capital Budgeting: If the firm invests too much, it will waste investors' capital on _____
excess capacity.
Comparing Projects with Unequal Lives: When choosing between two mutually exclusive alternatives with significantly different lives, _____ is necessary.
an adjustment
Evaluating Payback and Discounted Payback: Also, since cash flows expected in the distant future are generally riskier than near-term cash flows, the payback is often used as _____
an indicator of a project's riskiness.
Comparing Projects with Unequal Lives: The key to the replacement chain approach is to ______
analyze both projects using a common life
Internal Rate of Return (IRR): If the cash flows are constant from year to year, then we have a ____, and we can use its formulas to find the IRR
annuity
Conclusions on Capital Budgeting Methods: In summary, quantitative methods such as NPV and IRR should be considered as an aid to informed decisions but not ____
as a substitute for sound managerial judgment
Comparing Projects with Unequal Lives: Given all the uncertainties in the estimation process, such projects would, for all practical purposes, be _____
assumed to have the same life
Capital Rationing: Reluctance to issue new stock ---> However, rather than placing a somewhat artificial limit on capital expenditures, a company might _____
be better off explicitly incorporating the costs of raising external capital into its cost of capital
Comparing Projects with Unequal Lives: Why is the replacement chain approach more widely used method when compairing projects with unequal lives?
because it is very easy to apply using spreadsheets and because it enables analysts to incorporate a variety of assumptions regarding future inflation and efficiency gains.
Conclusions on Capital Budgeting Methods: Companies can also create positive NPV by ______. The Post-it® notes invented by 3M are an example
being the first entrant into a new market or by creating new products that meet some previously unidentified consumer needs
Conclusions on Capital Budgeting Methods: A good analogy for this is the _____.
bond valuation process
The Post Audit: Thus, biases seem to exist, and companies that understand them can ____
build in corrections and thus design better capital budgeting programs
Overview of Capital Budgeting: If a firm has ______, many ideas for capital investment will be advanced.
capable and imaginative executives and employees, and if its incentive system is working properly
Capital Rationing: ____ is defined as a situation in which a firm limits its capital expenditures to less than the amount required to fund the optimal capital budget
capital rationing
Comparing Projects with Unequal Lives: The _____ is a bit more complicated, but the concepts involved are exactly the same as in our example.
cash flow estimation
Internal Rate of Return (IRR): Fortunately, it is easy to find IRRs with a financial calculator. You follow procedures almost identical to those used to find the NPV. First, you enter the cash flows as shown on the preceding time line into the calculator's _____
cash flow register
Multiple IRRs: In contrast, the NPV criterion can easily be applied, and this method leads to _____
conceptually correct capital budgeting decisions
NPV Profiles: Since we calculated IRRs and IRRl in an earlier section, we can _____
confirm the validity of the graph.
Discounted Payback Period: Often, however, the regular and the discounted paybacks produce _____
conflicting rankings.
Proper Classification: Replacement of worn-out or damaged equipment is necessary if the firm is to _____
continue in business.
Comparison of the NPV and IRR Methods: In many respects the NPV method is better than IRR, so it is tempting to _____
explain NPV only, to state that it should be used to select projects, and to go on to the next topic.
Conclusions on Capital Budgeting Methods: In making the accept/reject decision, most large, sophisticated firms calculate and consider all of the measures, because _____
each one provides decision makers with a somewhat different piece of relevant information
Comparing Projects with Unequal Lives: However, even for mutually exclusive projects, it is not always appropriate to ____
extend the analysis to a common life.
An Increasing Marginal Cost of Capital: In addition, investors often perceive _____ to be riskier, which may also drive up the cost of capital as the size of the capital budget increases.
extremely large capital investments
Overview of Capital Budgeting: Third, poor capital budgeting can have serious ______
financial consequences.
Overview of Capital Budgeting: Second, the results of capital budgeting decisions continue for many years, reducing _____
flexibility
An Increasing Marginal Cost of Capital: As we discussed in Chapter 10, the ____ associated with issuing new equity or public debt can be quite high.
flotation costs
Net Present Value (NPV): Most projects last for more than ____ years, and, as we see in Chapter 13, we must go through a number of steps to develop the estimated cash flows
four
Economic Life versus Physical Life: This type of analysis can be used to determine a project's _____, which is the life that maximizes the NPV and thus maximizes shareholder wealth
economic life
Evaluating Mutually Exclusive Projects: That is, we can choose _____
either Project S or Project L, or we can reject both, but we cannot accept both projects.
Net Present Value (NPV): A solution process for Equation 12-1 is literally programmed into financial calculators, and all you have to do is _____
enter the cash flows (being sure to observe the signs), along with the value of r = I.
Overview of Capital Budgeting: On the other hand, if it does not invest enough, its _____may not be sufficiently modern to enable it to produce competitively
equipment and computer software
Intro: Chapter 13 then explains how to _____
estimate a project's cash flows and analyze its risk.
Conclusions on Capital Budgeting Methods: These inputs are simply _____, and if they turn out to be incorrect, then so will be the calculated NPVs and IRRs.
estimates
The Post Audit: Improve forecasts ---> When decision makers are forced to compare their projections to actual outcomes, there is a tendency for _____
estimates to improve
Modified Internal Rate of Return (MIRR): Apparently, managers find it intuitively more appealing to _____ than dollars of NPV.
evaluate investments in terms of percentage rates of return
Evaluating Payback and Discounted Payback: Note that the payback is a type of _____ calculation in the sense that if cash flows come in at the expected rate until the payback year
"breakeven"
Net Present Value (NPV): Different calculators are set up somewhat differently, but they all have a section of memory called the ______ that is used for uneven cash flows such as those in Projects S and L (as opposed to equal annuity cash flows).
"cash flow register"
NPV Rankings Depend on the Cost of Capital: Notice also that Project L's NPV is _____ to changes in the cost of capital than is NPVs
"more sensitive"
Capital Rationing: Reluctance to issue new stock ---> Many firms are extremely reluctant to issue new stock, so all of their capital expenditures must be ____
funded out of debt and internally generated cash.
Capital Rationing: Reluctance to issue new stock ---> If there still are positive NPV projects even using this higher cost of capital, then the company should ____
go ahead and raise external equity and accept the projects.
The Post Audit: Improve operations ---> Businesses are run by people, and people can perform at _____
higher or lower levels of efficiency
Capital Rationing: Constraints on nonmonetary resources ---> Sometimes a firm simply does not have the necessary _____ to immediately accept all positive NPV projects
managerial, marketing, or engineering talent
Capital Rationing: Controlling estimation bias ---> Neither solution is generally effective since _____ which might have been biased upward to begin with.
managers quickly learn the rules of the game and then increase their own estimates of project cash flows,
Modified Internal Rate of Return (MIRR): The ______ has a significant advantage over the regular IRR.
modified IRR
Modified Internal Rate of Return (MIRR): The new measure is called the _____, and it is defined as follows:
modified IRR, or MIRR
Overview of Capital Budgeting: First, a firm's capital budgeting decisions define its strategic direction, because _____
moves into new products, services, or markets must be preceded by capital expenditures
Evaluating Mutually Exclusive Projects: Now assume that Projects S and L are _____ rather than independent.
mutually exclusive
Internal Rate of Return (IRR): If they are _____, S ranks higher and should be accepted, so L should be rejected
mutually exclusive
Payback Period: If the projects were ______, S would be ranked over L because S has the shorter payback
mutually exclusive
Profitability Index: However, these methods can give conflicting rankings for_____. This point is discussed in more detail in the next section.
mutually exclusive projects
Comparing Projects with Unequal Lives: Still, it is important to recognize that a problem exists if _____
mutually exclusive projects have substantially different lives
Internal Rate of Return (IRR): However, NPV and IRR can give conflicting rankings for _____
mutually exclusive projects.
Capital Rationing: Reluctance to issue new stock ---> Also, most firms try to stay near their target capital structure, and, combined with the limit on equity, this limits ____
the amount of debt that can be added during any one year
Capital Rationing: Reluctance to issue new stock ---> The result can be a serious constraint on ____
the amount of funds available for investment in new projects
Intro: This chapter provides an overview of the capital budgeting process and explains _____ given that their expected cash flows have already been estimated.
the basic techniques used to evaluate potential
Internal Rate of Return (IRR): However, if ______, as is generally the case in capital budgeting, then it is difficult to find the IRR without a financial calculator
the cash flows are not constant
Conclusions on Capital Budgeting Methods: Qualitative factors, such as _____ should also be considered
the chances of a tax increase, or a war, or a major product liability suit,
Discounted Payback Period: After three years, Project S will have generated $1,011 in discounted cash inflows. Because _____
the cost is $1,000, the discounted payback is just under three years, or, to be precise, 2 + ($214/$225) = 2.95 years
Evaluating Payback and Discounted Payback: However, the regular payback does not consider ______—no cost for the debt or equity used to undertake the project is reflected in the cash flows or the calculation.
the cost of capital
Evaluating Independent Project: while both methods reject Project L if _____
the cost of capital is greater than 11.8 percent
NPV Rankings Depend on the Cost of Capital: While Project S has the higher NPV if _____
the cost of capital is greater than the 7.2 percent crossover rate
Evaluating Payback and Discounted Payback: An important drawback of both the payback and discounted payback methods is _____
that they ignore cash flows that are paid or received after the payback period.
Modified Internal Rate of Return (MIRR): Also, if the projects are of equal size, but differ in lives, the MIRR will always lead to the same decision as the NPV if _____
the MIRRs are both calculated using as the terminal year the life of the longer project.
NPV Rankings Depend on the Cost of Capital: But notice in the figure that Project L has the higher NPV when ____
the cost of capital is low
Capital Budgeting Decision Rules: Our present focus is on _____, so we provide the cash flows used in this chapter, starting with the expected cash flows of Project S and L in Figure 12-1
the different decision rules
NPV Profiles: Next, we calculate the projects' NPVs at _____, and plot these values.
three costs of capital, 5, 10, and 15 percent
NPV Profiles: To construct NPV profiles, first note that at a zero cost of capital, the NPV is simply the _____
total of the projects' undiscounted cash flows
Internal Rate of Return (IRR): Without a calculator, you must solve Equation 12-2 by _____—try some discount rate and see if the equation solves to zero, and if it does not, try a different discount rate, and continue until you find the rate that forces the equation to equal zero
trial and error
Economic Life versus Physical Life: To complete the analysis, note that if the project were terminated after one year, its NPV would be $254.55. Thus, the optimal life for this project is _____ years.
two
Special Applications of Cash Flow Evaluation: Misapplication of the NPV method can lead to errors when _____
two mutually exclusive projects have unequal lives
Multiple IRRs: Projects with nonnormal cash flows can actually have _____
two or more IRRs, or multiple IRRs!
NPV Profiles: These values are plotted as the _____ intercepts in Figure 12-4.
vertical axis
Economic Life versus Physical Life: Thus, Project A would not be accepted if ____
we assume that it will be operated over its full three-year life
Rationale for the NPV Method: Therefore, if a firm takes on a project with a positive NPV, the _____ increases.
wealth of the stockholders
Multiple IRRs: _____ occur when there is more than one change in sign.
Nonnormal cash flows
Comparing Projects with Unequal Lives: However, if we choose Project C, we cannot _____
make this second investment
NPV Profiles: When we _____ we have the net present value profiles
plot a curve through the data points,
Comparison of the NPV and IRR Methods: Therefore, it is important for you to understand the IRR method but also to be able to explain _____
why, at times, a project with a lower IRR may be preferable to a mutually exclusive alternative with a higher IRR.
Rationale for the NPV Method: The rationale for the NPV method is straightforward. An NPV of _____ signifies that the project's cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return on that capita
zero
Net Present Value (NPV): To implement this approach, we proceed as follows: --->
-1). Find the present value of each cash flow, including all inflows and outflows, discounted at the project's cost of capital. -2). Sum these discounted cash flows; this sum is defined as the project's NPV. -3). If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen
Comparing Projects with Unequal Lives: If we choose Project F, we will have an opportunity to make a similar investment in ____ years, and if cost and revenue conditions continue at the Figure 12-6 levels, this second investment will also be profitable
-3
Modified Internal Rate of Return (MIRR): Thus, for any set of projects like our Projects S and L, if _____, then _____, and the kinds of conflicts we encountered between NPV and the regular IRR will not occur
-NPVs > NPVl -MIRRs > MIRRl
Comparing Projects with Unequal Lives: For example, suppose a company is planning to modernize its production facilities, and it is considering either a conveyor system (______) or some forklift trucks (______) for moving materials.
-Project C -Project F
Evaluating Mutually Exclusive Projects: However, if the cost of capital is less than the crossover rate, the NPV method ranks _____ higher, but the IRR method indicates that _____ is better.
-Project L -Project S
Evaluating Independent Project: ______ could be analyzed similarly, and it will always turn out that if the IRR method says accept, then so will the ____ method
-Project S—and all other independent projects under consideration -NPV
Payback Period: Therefore, if the firm required a payback of three years or less, Project ____ would be accepted but Project ____ would be rejected.
-S -L
Net Present Value (NPV): On this basis, both projects should be accepted if they are ____, but S should be chosen over L if they are _____
-independent -mutually exclusive.
Profitability Index: Therefore, both S and L would be accepted by the PI criterion if they were _____, and S would be ranked ahead of L if they were _____
-independent -mutually exclusive.
NPV Rankings Depend on the Cost of Capital: Recall that a _____ has greater sensitivity to interest rates than a _____.
-long-term bond -short-term bond
Capital Budgeting Decision Rules: Incidentally, the S stands for ____ and the L for _____: Project S is a short-term project in the sense that its cash inflows come in sooner than L's.
-short - long
NPV Rankings Depend on the Cost of Capital: That is, Project L's net present value profile has _____, indicating that a given change in r has a greater effect on NPVL than on NPVS.
-the steeper slope
The Post Audit: The post-audit has three main purposes: --->
1. Improve forecasts. 2. Improve operations 3. Identify termination opportunities
Proper Classification: Accordingly, firms generally categorize projects and then analyze those in each category somewhat differently: --->
1. Replacement: maintenance of business. 2. Replacement: cost reduction. 3. Expansion of existing products or markets 4. Expansion into new products or markets 5. Safety and/or environmental projects 6. Research and development 7. Long-term contracts
Evaluating Independent Project: Thus, at any cost of capital less than _____ percent, Project L will be acceptable by both the NPV and the IRR criteria
11.8
Internal Rate of Return (IRR): If the cost of capital is above _____ percent, both projects should be rejected.
14.5
Multiple IRRs: Therefore, the IRR of the investment is both ___ and ____ percent
25 and 400
Discounted Payback Period: Project L's discounted payback is ____ years:
3.88
Comparing Projects with Unequal Lives: In view of these problems, no experienced financial analyst would be too concerned about comparing mutually exclusive projects with lives of _____ years.
8 and 10
Discounted Payback Period: Discounted payback S = _____
= 2.0 + $214/$225 = 2.95 years
Discounted Payback Period: Discounted payback L = _____
= 3.0 + $360/$410 = 3.88 years
NPV Profiles: Thus, at a zero cost of capital NPVs = ____, and NPVl = _____.
=$300 =$400
Rationale for the NPV Method: In our example, shareholders' wealth would increase by _____ if the firm takes on Project S, but by only _____ if it takes on Project L.
=$78.82 -$49.18
Net Present Value (NPV): ______ (expenditures such as the cost of buying equipment or building factories) are treated as negative cash flows
Cash outflows
Internal Rate of Return (IRR): It is also easy to find the IRR using the same spreadsheet we used for the NPV. With _____, we simply enter this formula in Cell B6: =IRR(B4:F4). For Project S, the result is 14.5 percent.4
Excel
Net Present Value (NPV): To implement this Net Present Value (NPV) approach, what is the first step?
Find the present value of each cash flow, including all inflows and outflows, discounted at the project's cost of capital.
Comparison of the NPV and IRR Methods: However, the ____ is familiar to many corporate executives, it is widely entrenched in industry, and it does have some virtues
IRR
Capital Rationing: Why would any company forego value-adding projects?
Here are some potential explanations, along with some suggestions for better ways to handle these situations: 1. Reluctance to issue new stock 2. Constraints on nonmonetary resources 3. Controlling estimation bias.
Net Present Value (NPV): To implement this Net Present Value (NPV) approach, what is the third step?
If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen
Proper Classification: The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes?
If the answers are yes, maintenance decisions are normally made without an elaborate decision process
Modified Internal Rate of Return (MIRR): Is MIRR as good as NPV for choosing between mutually exclusive projects?
If two projects are of equal size and have the same life, then NPV and MIRR will always lead to the same decision.
Economic Life versus Physical Life: However, what would its NPV be if the project were terminated after two years?
In this case, we would receive operating cash flows in Years 1 and 2, plus the salvage value at the end of Year 2, and the project's NPV would be $34.71:
Payback Period: _____ are projects whose cash flows don't affect one another.
Independent projects
NPV Rankings Depend on the Cost of Capital: Accordingly, Project _____, is hurt badly if the cost of capital is high
L, which has its largest cash flows in the later years
Proper Classification: Within each category, projects are classified by their dollar costs: --->
Larger investments require increasingly detailed analysis and approval at a higher level within the firm.
Evaluating Mutually Exclusive Projects: NPV says choose mutually exclusive L, while IRR says take S. Which is correct?
Logic suggests that the NPV method is better, because it selects the project that adds the most to shareholder wealth.
Modified Internal Rate of Return (MIRR): The discount rate that forces the present value of the TV to equal the present value of the costs is defined as the _____
MIRR
Payback Period: What does mutually exclusive mean?
Mutually exclusive means that if one project is taken on, the other must be rejected.
Conclusions on Capital Budgeting Methods: _____ is important because it gives a direct measure of the dollar benefit of the project to shareholders
NPV
Net Present Value (NPV): Note that the equation has one unknown, _____. Now all you need to do is to ask the calculator to solve the equation for you, which you do by pressing the NPV button (and, on some calculators, the "compute" button). The answer, 78.82, will appear on the screen.1
NPV
Internal Rate of Return (IRR): Thus, the same basic equation is used for both methods, but in the NPV method the discount rate, r, is specified and the NPV is found, whereas in the IRR method the _____
NPV is specified to equal zero, and the interest rate that forces this equality (the IRR) is calculated.
Evaluating Mutually Exclusive Projects: However, when evaluating mutually exclusive projects, especially those that differ in scale and/or timing, the _____ should be used.
NPV method
Evaluating Mutually Exclusive Projects: The _____ implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital
NPV method
Modified Internal Rate of Return (MIRR): For example, if we were choosing between a large project and a small mutually exclusive one, then we might find _____
NPVl > MPVs but MIRRs > MIRRl
Profitability Index: The PI for Project S, based on a 10 percent cost of capital, is 1.079: --->
PIs = $1,078.82 / $1,000 = 1.079
Conclusions on Capital Budgeting Methods: ______ can keep competitors at bay
Patents, the control of scarce resources, or large size in an industry where strong economies of scale exist
Conclusions on Capital Budgeting Methods: ____ and ____ provide an indication of both the risk and the liquidity of a project
Payback and discounted payback
Payback Period: Applying the same procedure to Project L, we find _____
PaybackL = 3.33 years
Comparing Projects with Unequal Lives: We see that _____, when discounted at the firm's 11.5 percent cost of capital, has the higher NPV and thus appears to be the better project.
Project C
Comparing Projects with Unequal Lives: In this example, we will find the NPV of Project F over a six-year period, and then compare this extended NPV with _____
Project C's NPV over the same six years.
Comparing Projects with Unequal Lives: Since the $9,281 extended NPV of Project F over the six-year common life is greater than the $7,165 NPV of Project C, _____ should be selected.
Project F
NPV Rankings Depend on the Cost of Capital: Therefore, ______ has the steeper slope.
Project L's NPV profile
NPV Rankings Depend on the Cost of Capital: While Project ______, is affected less by high capital costs
S, which has relatively rapid cash flows
Net Present Value (NPV): To implement this Net Present Value (NPV) approach, what is the second step?
Sum these discounted cash flows
Comparing Projects with Unequal Lives: The NPV of this extended Project F is $9,281, and its IRR is 25.2 percent. (_____.)
The IRR of two Project Fs is the same as the IRR for one Project F
Modified Internal Rate of Return (MIRR): Given this fact, can we devise a percentage evaluator that is better than the regular IRR?
The answer is yes—we can modify the IRR and make it a better indicator of relative profitability, hence better for use in capital budgeting
Evaluating Mutually Exclusive Projects: Which is the better assumption—that cash flows can be reinvested at the cost of capital, or that they can be reinvested at the project's IRR?
The best assumption is that projects' cash flows can be reinvested at the cost of capital, which means that the NPV method is more reliable.
Comparing Projects with Unequal Lives: Two different approaches can be used to correctly compare Projects C and F --->
The first is the equivalent annual annuity (EAA) approach, and the second is the replacement chain (common life) approach.
Evaluating Mutually Exclusive Projects: But what causes the conflicting recommendations?
Two basic conditions can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR: (1) when project size (or scale) differences exist, meaning that the cost of one project is larger than that of the other, or (2) when timing differences exist
Rationale for the IRR Method: Why is the particular discount rate that equates a project's cost with the present value of its receipts (the IRR) so special?
The reason is based on this logic: (1) The IRR on a project is its expected rate of return. (2) If the internal rate of return exceeds the cost of the funds used to finance the project, a surplus will remain after paying for the capital, and this surplus will accrue to the firm's stockholders. (3) Therefore, taking on a project whose IRR exceeds its cost of capital increases shareholders' wealth.
Comparing Projects with Unequal Lives: When should we worry about unequal life analysis?
The unequal life issue (1) does not arise for independent projects, but (2) it can arise if mutually exclusive projects with significantly different lives are being compared
Evaluating Mutually Exclusive Projects: The key to resolving conflicts between mutually exclusive projects is this: How useful is it to generate cash flows sooner rather than later?
The value of early cash flows depends on the return we can earn on those cash flows, that is, the rate at which we can reinvest them.
Internal Rate of Return (IRR): Why does this occur?
This occurs because if NPV is positive, IRR must exceed r.
Comparing Projects with Unequal Lives: When should you extend the analysis to a common life?
This should be done only if there is a high probability that the projects will actually be repeated at the end of their initial lives
Capital Rationing: T/F: Despite being at odds with finance theory, this practice is quite common.
True
Comparing Projects with Unequal Lives: T/F: Although the NPV shown in Figure 12-6 suggests that Project C should be selected, this analysis is incomplete, and the decision to choose Project C is actually incorrect.
True
Evaluating Payback and Discounted Payback: T/F: cash flows expected in the distant future are generally riskier than near-term cash flows
True
Modified Internal Rate of Return (MIRR): T/F: In spite of a strong academic preference for NPV, surveys indicate that many executives prefer IRR over NPV
True
Payback Period: T/F: The shorter the payback period, the better.
True
Internal Rate of Return (IRR): In Chapter 4 we presented procedures for finding the yield to maturity, or rate of return, on a bond—if you invest in a bond, hold it to maturity, and receive all of the promised cash flows, you will earn the _____ on the money you invested
YTM
The Post Audit: Improve operations ---> In a discussion related to this point, one executive made this statement: " _____".
You academicians worry only about making good decisions. In business, we also worry about making decisions good
Conclusions on Capital Budgeting Methods: An investor should never compare the yields to maturity on two bonds without also considering their terms to maturity, because _____
a bond's riskiness is affected by its maturity.
Capital Rationing: Constraints on nonmonetary resources ---> Each potential project has an expected NPV, and each potential project requires _____
a certain level of support by different types of employees
Overview of Capital Budgeting: A firm's growth, and even its ability to remain competitive and to survive, depends on ______
a constant flow of ideas for new products, for ways to make existing products better, and for ways to operate at a lower cost
Proper Classification: Analyzing capital expenditure proposals is not _____—benefits can be gained, but analysis does have a cost.
a costless operation
Net Present Value (NPV): It is not hard to calculate the NPV as was done in the time line by using Equation 12-1 and a regular calculator. However, it is more efficient to use ____
a financial calculator
Conclusions on Capital Budgeting Methods: In _____, there would be no positive NPV projects—all companies would have the same opportunities, and competition would quickly eliminate any positive NPV
a perfectly competitive economy
Rationale for the NPV Method: Therefore, accepting positive NPV projects should result in _____
a positive EVA and a positive MVA (market value added, or the excess of the firm's market value over its book value).
Modified Internal Rate of Return (MIRR): Because reinvestment at the cost of capital is generally more correct, the modified IRR is a better indicator of _____
a project's true profitability.
Net Present Value (NPV): If the NPV is positive, the project should be _____
accepted
Payback Period: Mutually Exclusive Example ---> The installation of a conveyor belt system in a warehouse and the purchase of a fleet of forklifts for the same warehouse would be mutually exclusive projects because _____
accepting one implies rejection of the other.
Comparing Projects with Unequal Lives: The NPV for Project C as calculated in Figure 12-6 is already over the six-year common life. For Project F, however, we must _____
add in a second project to extend the overall life of the combined projects to six years.
Conclusions on Capital Budgeting Methods: The different measures provide different types of information to decision makers. Since it is easy to calculate all of them, ______. For any specific decision, more weight might be given to one measure than another, but it would be foolish to ignore the information provided by any of the methods.
all should be considered in the decision process
NPV Rankings Depend on the Cost of Capital: Figure 12-4 shows that the NPV profiles of both Project L and Project S decline as the _____ increases
cost of capital
Rationale for the NPV Method: This description of the process is somewhat oversimplified. Both analysts and investors anticipate that firms will identify and accept positive NPV projects, and _____ reflect these expectations
current stock prices
Evaluating Payback and Discounted Payback: Consequently, both payback methods have serious ______.
deficiencies
Conclusions on Capital Budgeting Methods: In all of these cases, the companies ______, and that advantage resulted in positive NPV projects.
developed some source of competitive advantage
Modified Internal Rate of Return (MIRR): However, if the projects _____ then conflicts can still occur.
differ in size
Rationale for the NPV Method: There is also a _____ between NPV and EVA (economic value added, as discussed in Chapter 7)—NPV is equal to the present value of the project's future EVAs
direct relationship
Internal Rate of Return (IRR): The _____ that causes the equation (and the NPV) to equal zero is defined as the IRR
discount rate
NPV Profiles: Recall that the IRR is defined as the _____
discount rate at which a project's NPV equals zero.
Internal Rate of Return (IRR): The IRR is defined as the _____
discount rate that forces the NPV to equal zero
Net Present Value (NPV): One such method is the net present value (NPV) method, which relies on _____ techniques.
discounted cash flow (DCF)
Evaluating Payback and Discounted Payback: The _____ does consider capital costs—it shows the breakeven year after covering debt and equity costs
discounted payback
Discounted Payback Period: Some firms use a variant of the regular payback, the ______, which is similar to the regular payback period except that the expected cash flows are discounted by the project's cost of capital
discounted payback period
Multiple IRRs: The example illustrates _____
how multiple IRRs can arise when a project has nonnormal cash flows.
Internal Rate of Return (IRR): If both projects have a cost of capital, or _____, of 10 percent, then the internal rate of return rule indicates that if the projects are independent, both should be accepted as they are both expected to earn more than the cost of the capital needed to finance them
hurdle rate
Conclusions on Capital Budgeting Methods: Therefore, managers should be able to ____ before accepting that a project will really have a positive NPV
identify the imperfection and explain why it will persist
Capital Rationing: Controlling estimation bias ---> A better solution is to ______ and to link the accuracy of forecasts to the compensation of the managers who initiated the projects.
implement a post-audit program
Rationale for the IRR Method: On the other hand, if the internal rate of return is less than the cost of capital, then taking on the project will _____
impose a cost on current stockholders.
Net Present Value (NPV): As the flaws in the payback were recognized, people began to search for ways to _____
improve the effectiveness of project evaluations
Proper Classification: Expenditures to _____ , or to expand retail outlets or distribution facilities in markets now being served, are included here
increase output of existing products
Profitability Index: Mathematically, the NPV, IRR, MIRR, and PI methods will always lead to the same accept/reject decisions for ____ projects
independent
Evaluating Payback and Discounted Payback: Although the payback methods have serious faults as ranking criteria, they do provide _____
information on how long funds will be tied up in a project.
Internal Rate of Return (IRR): Exactly the same concepts are employed in capital budgeting when the _____ is used.
internal rate of return (IRR) method
Modified Internal Rate of Return (MIRR): But the NPV method is still the best way to choose among competing projects because ____
it provides the best indication of how much each project will add to the value of the firm.
Evaluating Payback and Discounted Payback: For example, suppose Project L had an additional cash flow of $5,000 at Year 5. Common sense suggests that Project L would be more valuable than Project S, yet ______
its payback and discounted payback make it look worse than Project S.
An Increasing Marginal Cost of Capital: This means that the cost of capital _____after a company invests all of its internally generated cash and must sell new common stock.
jumps upward
Evaluating Mutually Exclusive Projects: We should reiterate that, when projects are independent, the NPV and IRR methods both ____
lead to exactly the same accept/reject decision.
Internal Rate of Return (IRR): Mathematically, the NPV and IRR methods will always _____
lead to the same accept/reject decisions for independent projects.
Rationale for the NPV Method: So, a reward system that compensates managers for producing positive EVA will ____
lead to the use of NPV for making capital budgeting decisions.
Modified Internal Rate of Return (MIRR): The _____ is simply the present value of the investment outlays when discounted at the cost of capital,
left term
Capital Rationing: Constraints on nonmonetary resources ---> To avoid potential problems due to spreading existing talent too thinly, many firms simply _____
limit the capital budget to a size that can be accommodated by their current personnel.
Capital Rationing: Reluctance to issue new stock ---> To avoid these costs, many companies simply _____
limit their capital expenditures.
Capital Rationing: Controlling estimation bias ---> Others try to control the bias by ____
limiting the size of the capital budget
Capital Rationing: Constraints on nonmonetary resources ---> A _____ can identify the set of projects that maximizes NPV, subject to the constraint that the total amount of support required for these projects does not exceed the available resources.
linear program
Capital Rationing: Constraints on nonmonetary resources ---> A better solution might be to employ a technique called _____
linear programming.
Overview of Capital Budgeting: Also, if it has inadequate capacity, it may _____ and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly.
lose market share to rival firms,
Conclusions on Capital Budgeting Methods: Just as it would be foolish to ignore these capital budgeting methods, it would also be foolish to _____
make decisions based solely on them
Multiple IRRs: This cash flow stream has two sign changes—_____—so it is a nonnormal cash flow
negative to positive and then positive to negative
An Increasing Marginal Cost of Capital: Fortunately, this problem occurs very rarely for most firms, and it is unusual for an established firm to require ____
new outside equity.
Multiple IRRs: Note that _____ would arise if the NPV method were used; we would simply use Equation 12-1, find the NPV, and use this to evaluate the project.
no dilemma
Multiple IRRs: However, the possibility of multiple real roots, hence multiple IRRs, arises when the project has _____
nonnormal cash flows (negative net cash flows occur during some year after the project has been placed in operation)
Multiple IRRs: A project has _____ if it has one or more cash outflows (costs) followed by a series of cash inflows
normal cash flows
Internal Rate of Return (IRR): Although it is easy to find the NPV without a financial calculator, this is ____
not true of the IRR
Modified Internal Rate of Return (MIRR): the ______ is the compounded future value of the inflows, assuming that the cash inflows are reinvested at the cost of capital.
numerator of the right term
Net Present Value (NPV): In evaluating Projects S and L, only CF0 is negative, but for many large projects such as the Alaska Pipeline, an electric generating plant, or a new Boeing jet aircraft, cash outflows _____
occur for several years before operations begin and cash flows turn positive
Multiple IRRs: Notice that normal cash flows have only ____—they begin as negative cash flows, change to positive cash flows, and then remain positive
one change in sign
The Post Audit: Accordingly, we regard the post-audit as being _____
one of the most important elements in a good capital budgeting system.
Net Present Value (NPV): If two projects with positive NPVs are mutually exclusive, the ______ should be chosen
one with the higher NPV
Evaluating Mutually Exclusive Projects: Similarly, for projects of equal size, the _____ —provides more funds for reinvestment in the early years.
one with the larger early cash inflows—in our example, Project S
Economic Life versus Physical Life: Thus, Project A would be profitable if we ____
operate it for two years and then dispose of it.
Economic Life versus Physical Life: Projects are normally analyzed under the assumption that the firm will ____
operate the asset over its full physical life
Special Applications of Cash Flow Evaluation: There are also situations in which an asset should not be ______. The following sections explain how to evaluate cash flows in these situations
operated for its full life
Conclusions on Capital Budgeting Methods: Valid explanations might include ____ or _____, which is how pharmaceutical and software firms create positive NPV projects. Aventis's Allegra® allergy medicine and Microsoft's Windows XP® operating system are examples.
patents or proprietary technology
Conclusions on Capital Budgeting Methods: However, virtually all capital budgeting decisions are analyzed by computer, so it is easy to calculate and list all the decision measures: _____
payback and discounted payback, NPV, IRR, modified IRR (MIRR), and profitability index (PI).
Economic Life versus Physical Life: For Project A, the economic life is two years versus the three-year ____ or ____ life.
physical, or engineering
NPV Profiles: Therefore, the _____ indicates a project's internal rate of return
point where its net present value profile crosses the horizontal axis
Multiple IRRs: Notice that Equation 12-2 is a ______, so it may have as many as n different roots, or solutions.
polynomial of degree n
Rationale for the NPV Method: If a project has a _____ NPV, then it is generating more cash than is needed to service the debt and to provide the required return to shareholders, and this excess cash accrues solely to the firm's stockholders.
positive
Conclusions on Capital Budgeting Methods: Therefore, _____ must be predicated on some imperfection in the marketplace, and the longer the life of the project, the longer that imperfection must last.
positive NPV projects
The Post Audit: An important aspect of the capital budgeting process is the _____, which involves (1) comparing actual results with those predicted by the project's sponsors and (2) explaining why any differences occurred.
post-audit
The Post Audit: Our observations of businesses and governmental units suggest that the best-run and most successful organizations put great emphasis on ______
post-audits
Capital Rationing: Controlling estimation bias ---> Many managers become overly optimistic when estimating the cash flows for a project. Some firms try to control this estimation bias by _____
requiring managers to use an unrealistically high cost of capital
The Post Audit: Improve forecasts ---> Conscious or unconscious biases are observed and eliminated; new forecasting methods are sought as the need for them becomes apparent; and people simply tend to do everything better, including forecasting, if they know _____
that their actions are being monitored.
Conclusions on Capital Budgeting Methods: Therefore, we regard NPV as the best single measure of ______
profitability.
NPV Profiles: NPV profiles can be very useful in _____, and we will use them often in the remainder of the chapter.
project analysis
Multiple IRRs: For example, a nonnormal cash flow ____
project may begin with negative cash flows, switch to positive cash flows, and then switch back to negative cash flows.
Evaluating Payback and Discounted Payback: Thus, the shorter the payback period, other things held constant, the greater the ______
project's liquidity.
Multiple IRRs: There is another reason the IRR approach may not be reliable—when _____
projects have nonnormal cash flows.
Capital Budgeting Decision Rules: These projects are equally risky, and the cash flows for each year, CFt, reflect ______
purchase cost, investments in working capital, taxes, depreciation, and salvage values
The Post Audit: Improve operations ---> When a divisional team has made a forecast about an investment, its members are, in a sense, ______ if they are evaluated with post-audits.
putting their reputations on the line and will strive to improve operations
Discounted Payback Period: _____ is the project's cost of capital.
r
Net Present Value (NPV): _____ is the project's cost of capital
r
Discounted Payback Period: For Projects S and L, the _____ are the same regardless of which payback method is used; that is, Project S is preferred to Project L, and Project S would still be selected if the firm were to require a discounted payback of three years or less
rankings
Evaluating Mutually Exclusive Projects: Given this situation, the _____ is a critical issue.
rate of return at which differential cash flows can be invested
Internal Rate of Return (IRR): For a _____, the trial-and-error approach is a tedious, time-consuming task.
realistic project with a fairly long life
Modified Internal Rate of Return (MIRR): MIRR assumes that cash flows from all projects are ____,
reinvested at the cost of capital
Modified Internal Rate of Return (MIRR): while the regular IRR assumes that the cash flows from each project are _____
reinvested at the project's own IRR.
Evaluating Mutually Exclusive Projects: These assumptions are inherent in the mathematics of the discounting process. The cash flows may actually be withdrawn as dividends by the stockholders and spent on beer and pizza, but the NPV method still assumes that cash flows can be reinvested at the cost of capital, while the IRR method assumes _____
reinvestment at the project's IRR.
Net Present Value (NPV): If the NPV is negative, the project should be _____
rejected
Proper Classification: For certain types of projects, a _____ may be warranted; for others, simpler procedures should be used.
relatively detailed analysis
Capital Budgeting Decision Rules: The first, and most difficult, step in project analysis is estimating the _____ a step that Chapter 13 explains in detail
relevant cash flows,
Comparing Projects with Unequal Lives: Both methods are theoretically correct, but the _____ is the most widely used method in practice
replacement chain approach
Proper Classification: These projects lower the costs of labor, materials, and other inputs such as electricity by ____
replacing serviceable but less efficient equipment.
Conclusions on Capital Budgeting Methods: However, it is relatively easy to _____
replicate nonpatentable features on products.
Comparing Projects with Unequal Lives: Note that a replacement decision involves comparing two mutually exclusive projects: ____ versus _____
retaining the old asset versus buying a new one.
The Post Audit: From then on, reports on the operation are _____ like those of other operations.
reviewed on a regular basis
Economic Life versus Physical Life: The _____ listed in the third column are after taxes, and they have been estimated for each year of Project A's life.
salvage values
Overview of Capital Budgeting: Some ideas will be good ones, but others will not. Therefore, companies must _____ for those that add value, the primary topic of this chapter.
screen projects
Conclusions on Capital Budgeting Methods: We have discussed _____ capital budgeting decision methods, compared the methods with one another, and highlighted their relative strengths and weaknesses.
six
Net Present Value (NPV): Therefore, financial analysts generally use _____ when dealing with capital budgeting projects.
spreadsheets
Conclusions on Capital Budgeting Methods: The bottom line is that managers should _____, and if such an advantage cannot be demonstrated, then you should question projects with high NPV, especially if they have long lives.
strive to develop nonreplicatible sources of competitive advantage
Discounted Payback Period: where ____ is the year in which the cash flow occurs
t
Modified Internal Rate of Return (MIRR): The compounded future value of the cash inflows is also called the ____
terminal value, or TV
Economic Life versus Physical Life: However, this may not be the best course of action—it may be best to _____, and this possibility can materially affect the project's estimated profitability
terminate a project before the end of its potential life
Evaluating Mutually Exclusive Projects: when project size (or scale) differences exist, meaning _____
that the cost of one project is larger than that of the other
Evaluating Mutually Exclusive Projects: when timing differences exist, meaning _____, as occurred with our Projects L and S.
that the timing of cash flows from the two projects differs such that most of the cash flows from one project come in the early years while most of the cash flows from the other project come in the later years
Payback Period: Project S Thus, the payback occurred during the ____ year.
third
Internal Rate of Return (IRR): In effect, you have entered the cash flows into the equation shown below the time line. Note that we have one unknown, IRR, which is _____
the discount rate that forces the equation to equal zero.
Capital Budgeting Decision Rules: Finally, we assume that all cash flows occur at _____
the end of the designated year
Economic Life versus Physical Life: Note that this analysis was based on ____ and ____, and it should always be conducted as a part of the capital budgeting evaluation if salvage values are relatively high.
the expected cash flows and the expected salvage values
Payback Period: The payback period, defined as _____, was the first formal method used to evaluate capital budgeting projects
the expected number of years required to recover the original investment
Rationale for the NPV Method: Thus, stock prices react to announcements of new capital projects only to _____
the extent that such projects were not already expected.
Capital Rationing: Constraints on nonmonetary resources ---> In other words, the potential projects are not really independent, because ____
the firm cannot accept them all
Conclusions on Capital Budgeting Methods: Rather, managers should use quantitative methods in the decision-making process but also consider _____
the likelihood that actual results will differ from the forecasts.
Rationale for the NPV Method: Viewed in this manner, it is easy to see why S is preferred to L, and it is also easy to see _____
the logic of the NPV approach
Modified Internal Rate of Return (MIRR): The MIRR also eliminates _____
the multiple IRR problem
Discounted Payback Period: Thus, the discounted payback period is defined as _____
the number of years required to recover the investment from discounted net cash flows.
Internal Rate of Return (IRR): Notice that the internal rate of return formula, Equation 12-2, is simply the NPV formula, Equation 12-1, solved for ____
the particular discount rate that forces the NPV to equal zero.
Payback Period: Project S At Year 1 the cumulative net cash flow is _____
the previous cumulative of -$1,000 plus the Year 1 cash flow of $500: -$1,000 + $500 = -$500
Payback Period: Project S Similarly, the cumulative for Year 2 is _____
the previous cumulative of -$500 plus the Year 2 inflow of $400, resulting in -$100.
Net Present Value (NPV): This sum is defined as ______
the project's NPV
NPV Profiles: A graph that plots a project's NPV against the cost of capital rates is defined as _____; profiles for Projects L and S are shown in Figure 12-4.
the project's net present value profile
Profitability Index: The PI shows ____
the relative profitability of any project, or the present value per dollar of initial cost
Evaluating Mutually Exclusive Projects: Therefore, if r is greater than the crossover rate of 7.2 percent, the two methods both lead to _____
the selection of Project S.
An Increasing Marginal Cost of Capital: The cost of capital may depend on ____
the size of the capital budget
The Post Audit: Identify Termination Opportunities ---> The post-audit can help identify projects that should be terminated because _____
they have lost their economic viability
Proper Classification: These decisions are more complex because _____, so a more detailed analysis is required.
they require an explicit forecast of growth in demand
Conclusions on Capital Budgeting Methods: Thus, quantitative methods provide valuable information, but _____
they should not be used as the sole criteria for accept/reject decisions in the capital budgeting process.
The Post Audit: Identify Termination Opportunities ---> Although the decision to undertake a project may be the correct one based on information at hand, but ______
things don't always turn out as expected
Evaluating Mutually Exclusive Projects: When either size or timing differences are present, the firm will have different amounts of funds to invest in the various years, depending on _____
which of the two mutually exclusive projects it chooses
