1.

For two conventional projects whose cumulative cash flows are identical, the higher the
discount rate, the more valuable will be the proposal with the early cash flows.

True
2. A firm short of cash might well give greater emphasis to the payback period in evaluating a
project.
True
3. An investment with a short payback period is almost certain to have a positive net present
value.
False
4. The net present value of a project generally decreases as the required rate of return increases.
True
5. A mutually exclusive project is one whose acceptance does not preclude the acceptance of
alternative projects.
False
6. Use of the IRR method implicitly assumes that the project's intermediate cash inflows are
reinvested at the required rate of return used under the NPV method.
False
7. If a project's cash flows are discounted at the internal rate of return, the NPV will be zero.
True
8. All three major discounted cash flow methods of evaluation will consistently give the same
desirability ranking to a series of projects.
False
9. Capital rationing occurs when funds are unlimited.
False
10. For graduation you've been offered your choice of receiving either a Maserati or a Porsche.
This is an example of INDEPENDENT projects.
False
11. Sensitivity analysis provides useful knowledge about the sensitivity of a project's NPV to a
change in one (or more) input variables.
True
12. Sensitivity analysis indicates whether a project should be accepted or rejected.
False
Net present value profile The point where its net present value profile crosses
the horizontal axis indicates a project's internal rate of return. Where iRR is the
discount rate at which a project's NPV equals zero.
True
NPV 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.
3. Some competitive advantages last longer than other, with their durability
depending on competitors' ability to replicate them.
Managers should strive to develop nonreplicable sources of competitive

advantage, and if such an advantage cannot be demonstrated, then you should

question projects with high NPV, especially if they have long lives.
False
Evaluating Independent Projects Are those whose cash flows are independent
of one another.
False
Optimal Capital Budget The set of projects that maximizes the value of the
firm.
True
Economic LIfe The life that maximizes the NPV and thus maximizes
shareholder wealth. This analysis is based on the expected cash flows and the
expected salvage values, and it should always be conducted as a part of the
capital budgeting evaluation if salvage values are relatively high.
True

True/False Quiz
1.

Investment decisions involve costs and revenues that extend over a number of years.
a. True

b. False

2.

One of the reasons that capital budgeting is so important is that major capital investment
projects are generally irreversible.
a. True

b. False

3.

A firm should continue to increase its level of capital investment so long as the rate of return
on the least profitable investment project that the firm undertakes is less than the marginal
cost of capital.
a. True

b. False

4.

In calculating net cash flows, depreciation is treated as a cost.

a. True

b. False

5.

In general, a firm should undertake a project only if its net present value is positive.
a. True

b. False

6.

In general, a firm should undertake any project that has an internal rate of return that is
positive.
a. True

b. False

7.

If the internal rate of return is used to discount all cash flows associated with a project, the
net present value of the project will be equal to zero.
a. True

b. False

8.

Calculation of the internal rate of return incorporates the implicit assumption that net cash
flows from a project can be reinvested at the internal rate of return.

a. True

b. False

9.

If the net present value method and the internal rate of return method yield contradictory
results, the latter should be followed rather than the former.
a. True

b. False

10. A house that is owned by an individual is referred to as human capital, whereas a house that
is owned by a corporation is referred to as non-human capital.
a. True

b. False

11. The profitability per dollar invested is referred to as the profitability index.
a. True

b. False

12. One problem with the profitability index is that it ignores the time value of money.
a. True

b. False

13. In the absence of capital rationing, a firm should undertake all projects with a profitability
index greater than zero.
a. True

b. False

14. One advantage of using internal funding to support investment projects is that the firm
experiences no economic cost of capital for internal funding.
a. True

b. False

15. The cost of debt should generally be figured on an after-tax basis.

a. True

b. False

16. The difference between the external and internal cost of raising equity capital is due to
flotation costs.
a. True

b. False

17. The cost of raising equity capital should generally be figured on an after-tax basis.

a. True

b. False

18. The rate of return that stockholders require to invest in a firm is the cost of equity capital.
a. True

b. False

19. The cost of debt is generally greater than the cost of equity capital.
a. True

b. False

20. The difference between the rate of return on debt issued by the government and the rate of
return on equity capital is referred to as a risk premium.
a. True

b. False

21. According to the dividend valuation model, the price of a share of stock will increase if the rate
of return required by investors increases.
a. True

b. False

22. The capital asset pricing model determines the beta coefficient for a firm by regressing the
variability in the firm's common stock against the variability in an index of all common stocks.
a. True

b. False

23. A firm with a beta coefficient that is equal to zero has the same degree of risk as a broadbased portfolio of stocks.
a. True

b. False

24. A firm with a beta coefficient that is equal to two is twice as risky as a broad-based portfolio of
stocks.
a. True

b. False

25. Firms generally use only one of the three equity capital valuation methods.
a. True

b. False

26. The risk encountered by a firm when raising funds by issuing debt is greater than the risk from
issuing common stock.

a. True

b. False

27. The risk encountered by an investor when holding debt is greater than the risk from holding
common stock.
a. True

b. False

28. The composite cost of capital reflects the debt to equity ratio preferred by the firm.
a. True

b. False

29. During most of the 1980s, the cost of capital in the United States was below the cost of capital
in Japan.
a. True

b. False

30. According to the 1977 study by Gitman and Forrester, the single most commonly used capital
budgeting technique among the firms surveyed was the internal rate of return method.
a. True

b. False

Capital Budgeting
1. Defines its strategic direction because moves into new
products, services, or markets must be preceded by capital
expenditures.
2. The results of capital budgeting decisions continue for
many years, reducing flexibility.
3. Poor capital budgeting can have serious financial
consequences.
Net Present Value method
Is based upon discounted cash flow (DCF) technique

Mutually exclusive
If one project is take on, the other must be rejected.

Independent projects
Are those whose cash flows are independent of one
another.

Rationale for the NPV

If NPV is 0 it 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 capital.
If NPV is positive 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.

Internal Rate of Return (IRR) method

If you invest in a bond, hold it to maturity, and receive all
of the promised cash flows, you will earn the YTM on the
money you invested. The IRR is defined as the discount
rate that forces NPV to equal zero.
The NPV and IRR methods will always lead to the same
accept/reject decisions for independent projects. This
occurs because if NPV iv positive, IRR must exceed r.

Rationale for the IRR method

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.
Contains information concerning a project's "safety margin"

Net present value profile

The point where its net present value profile crosses the
horizontal axis indicates a project's internal rate of return.
Where iRR is the discount rate at which a project's NPV
equals zero.

NPV
If a project has most of its cash flows coming in the early
years, its NPV will not decline very much if the cost of
capital increases, but a project whose cash flows come
later will be severely penalized by high capital costs.
(A long-term bond has greater sensitivity to interest rates
than a short-term bond.

Evaluating Independent Projects

(1) 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)Whenever a project's cost of capital is less than its IRR,
its NPV is positive.

Evaluating Mutually Exclusive Projects

Logic suggests that the NPV method is better, because it
selects the project that adds the most to shareholder
wealth.

Conflicts to arise between NPV and IRR

1. When project size (or scale) differences exit, meaning
that the cost of one project is larger than that of the other
or
2. When timing differences exist, meaning 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 other project come in the
later years.

Resolving conflicts
The value of early cash flows depends on the return we can
ear on those cash flows, that is, the rate at which we can
reinvest them. The NPV method implicitly assumes that the
rate at which cash flows can be reinvested is the cost of
capital, whereas the IRR method assumes that the firm can
reinvest at the IRR. These assumptions are inherent in the
mathematics of the discounting process.
The vest assumption is that projects cash flows can be

reinvested at the cost of capital, which means that the NPV

method is more reliable

Normal cash flows

If a project has one or more cash outflows (costs) followed
by a series of cash inflows. They only have one change in
sign, they begin as negative cash flows, change to positive
cash flows, and then remain positive.

Nonnormal cash flows

Occur when there is more than one change in sign. For
example, a project may begin with negative cash flows,
switch to positive cash flows, and then switch back to
negative cash flows. This cash flow stream has two sign
changes. These projects can have two or more IRRs, or
multiple IRRS.

Modified IRR, or MIRR

The numerator is the compounded future value of the
inflows, assuming that the cash inflows are reinvested at
the cost of capital.
The compounded future value of the cash inflows is also
called the terminal value, or TV. The discount rate that
forces the present value of the TV to equal the present
value of the costs is defined as the MIRR.

MIRR
Assumes that cash flows from all projects are reinvested at
the cost of capital, while the regular IRR assumes that the
cash flows from each project are reinvested at the project's
own IRR.
If the projects are of equal size, but differ in lives, the MIRR
will always lead to the same decisions as the NPV if the
MIRRS are both calculated using as the terminal year the
life of the longer project.

Profitability index
Shows the relative profitability for any project, or the
present value per dollar of initial cost. A project is
acceptable if its PI is greater then 1.0, and the the higher
the PI the higher the project's ranking. If a project's NPV is
positive, its IRR and MIRR will always exceed r, and its PI
will always be greater than 1.0.

Payback period

The expected number of years required to recover the

original investment. Start with the project's cost, determine
the number of years prior to full recovery of the cost, and
then determine the fraction of the next year that is
required for full recover, assuming cash flows occur evenly
during the year.

Flaws in the payback method

1. Dollars received in different years are all given the same
weight
2. Cash flows beyond the payback year are given no
consideration whatsoever, regardless of how large they
might be.
3. Unlike the NPV, which tells us by how much the project
should increase shareholder wealth, and the IRR, which
tells us how much a project yield over the cost of capital,
the payback merely tells us when we get our investment
back.

Discounted payback period

The expected cash flows are discounted by the project's
cost of capital. The discounted payback period is defined as
the number of years required to recover the investment
from discounted net cash flows. The shorter the payback
period the greater the project's liquidity.

Longer payback
1. The investment dollars will be locked up for many years hence the project is relatively illiquid
2. The project's cash flows must be forecasted far out into
the future hence the project is probably quite risky.

Qualitative factors
Such as the chances of a tax increase or a war, or a major
product liability suit,, should also be considered.
Quantitative methods such as NPV and IRR should be
considered as an aid to informed decisions but not as a
substitute for sound managerial judgement.

...
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.
3. Some competitive advantages last longer than other,

with their durability depending on competitors' ability to

replicate them.
Managers should strive to develop nonreplicable sources of
competitive advantage, and if such an advantage cannot
be demonstrated, then you should question projects with
high NPV, especially if they have long lives.

Replacement chain (common life) approach

Analyze both projects using a common life. We assume
1. Project F's cost and annual cash inflows will not change if
the project is repeated in 3 years and
2. The cost of capital will remain the same.

Equivalent Annual Annuities

Convert the annual cash flows under the alternative
investments into a constant cash flow stream whose NPV
was equal to, or equivalent to, the NPV of the initial stream.

Conclusions about Unequal Lives

1. If inflation is expected, then replacement equipment will
have a higher price. Moreover, both sales prices and
operating costs will probably change. Thus the static
conditions built into the analysis would be invalid.
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 estimated the lives of most
projects, and even more so to estimate the lives of a series
of projects.

Economic LIfe
The life that maximizes the NPV and thus maximizes
shareholder wealth. This analysis is based on the expected
cash flows and the expected salvage values, and it should
always be conducted as a part of the capital budgeting
evaluation if salvage values are relatively high.

Optimal Capital Budget

The set of projects that maximizes the value of the firm.

Increasing Marginal Cost of Capital

The cost of capital jumps upward after a company invests
all of its internally generated cash and must sell new
common stock. A project might have a positive NPV if it is
part of a "normal size" capital budget, but the same project

might have a negative NPV if it is part of an unusually large

capital budget.

Capitol Rationing
The situation in which a firm limits its capital expenditures
to less than the amount requires to fund the optimal capital
budget.
1. Reluctance to issue new stock.
a. flotation costs
b. stock offerings are viewed negatively
c. might have to reveal strategic information
2. Constraints on nonmonetary resources
linear programming - each potential project as an expected
NPV, and each potential project requires a certain level of
support by different types of employees.
3. Controlling estimation bias.

Accounting Rate of Return (ARR)

An approach to evaluating capital budgeting decisions
based on the average annual project income (project
revenues less project expenses) divided by the average
investment.

Annuity
A stream of funds provided by a capital investment when
the amounts provided are the same and at equal intervals
(sach as the end of each year).

Capital Rationing
An approach to capital budgeting used to evaluate
combinations of projects according to their net present
value (NPV)

Discount Rate
The term used for k when finding a present value.

Hurdle Rate
The established minimum internal rate of return that must
be met or exceeded for a project to be accpeted under the
internal rate of return model of capital budgeting.

Incremental Cash Flow

The change in cash fow of an operation that results from an
investment.

Internal Rate of Return (IRR)

An approach to evaluating capital budgeting decisions
based on the rate of return generated by the investment.

Net Present Value (NPV)

An approach to evaluating capital budgeting decisions
based on discounting the cash flows relating to the project
to their present value; calculated by subtracting the project
cost from the present value of the discounted cash flow
stream.

Payback
An approach to evaluating capital budgeting decisions
based on the number of years of annual cash flow
generated by the fixed asset purchase required to recover
the investment.

Time Value of Money

The process of placing future years' income on an equal
basis with current year expenditures in order to facilitate
comparison.