investing in Long-Term Assets: Capital
Budgeting
1 1-1 How are project classifications used in the capital budgeting process? What are three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain. 11-3 Why is the NPV, of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) more sensitive to changes in the WACC than that of a short-term project? What is a mutually exclusive project? How should managers rank mutually exclusive projects? 11-5 If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking, of mutually exclusive projects? Explain. 11-6 Discuss the following statement If a firm has only independent projects, a constant WACC, and projects with normal cash flows, the NPV and IRR methods will always lead to identical capital budgeting decisions. What does this imply about the choice between IRR and NPV? If each of the assumptions were changed (one by one), how would your answer change? 11-7 Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method?
Project X is very risky and has an NPV of $3 million. Project Y is very safe and has an NPV of $2.5 million They are mutually exclusive, and project risk has been properly considered in the NPV analyses. Which project should be chosen? Explain. at reinvestment rate assumptions are built into the NPV, IRR, and MIRR methods? Give an explanation for your answer. 1 1-10 A firm has a $100 million capital budget. It is considering two projects, each costing $100 million. Project A has an IRR of 20% and an NPV of $9 million; it will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30% and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts. Project B because no revenues will be generated for several years. Should the short-run effects on EPS influence the choice between the two projects? How might situations like this influence a firm’s decision to use payback?
NPV Project K costs $52,125, its expected cash inflows are $12,000 per year for 8 years, and its WACC is .12%. What is the project’s NPV? IRR Refer to Problem 114. What is the project’s IRR? MIRR Refer to Problem 114. What is the project’s MIRR? Refer to Problem 114. What is the project’s pa,yback? DISCOUNTED PAYBACK Refer to Problem 11-1. What is the project’s discounted payback? NPV Your division is considering ‘two projects with the folloWing cash flows (in millions): 0 1 2 3
. What are .the projects’ NPVs assuming the WACC is 5%? 10%? 15%? b. What are the projects’ IRRs at each of these VVACCs? If the WACC. was 5% and A and B were, mutually exclusive, which project would you choose? What if the. WACC was 10%? 15%? (Hint The crossover rate is 7.81%)
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