- Answer the following Chapter 10 Review Questions:
RQ 10-1 Why capital budgeting such an important process and why capital-budgeting errors so costly
Capital budgeting is an essential process in investment because it involves a substantial amount of money. If a company does not research the investment thoroughly, it will end up with a failed investment, which may cost it a tremendous amount of money, that it could have invested in another profitable project. Capital budgeting errors are costly because of several reasons. One is when a firm accepts a project based on the capital budgeting process only for the project to turn out as a worthless investment due to errors made in capital budgeting. Such errors end up affecting the value of a firm.
RQ 10-2 What are the disadvantages of using the payback period as a capital-budgeting technique? What are its advantages? Why is it so frequently used?
There are several disadvantages associated with using the payback period as a technique of capital budgeting. One is that it ignores the time value of money. This is the most serious problem of this technique since the cash flows that the firm received during the early years of the project are highly weighted than those obtained in the later years. Its advantages are that it does not deal with the accounting profit, but the cash flows, which means that it focuses on the correct timing of the benefits and costs of the project. Second, it may be a useful decision rule for a company that is capital-constrained and needs capital projects whose repayments are quick. The other two advantages are also the reasons why it is frequently used. One is because it is easy for the accountant to calculate, and help the interested parties to understand. Two, it serves as a rough screening device that eliminates projects with returns that do not materialize until several years are over.
- Briefly compare the NPV and IRR criteria. What are the advantages and disadvantages of using each of these methods?
Several discounted cash flow capital budgeting methods exist. They include the net present value method, profitability index, and internal return on revenue. The NPV uses the present value of the benefits, which subtracts from the present value of the costs to give the absolute dollar value for a project. The IRR, on the other hand, helps us understand the rate of return that a project earns over a lifespan. The advantages of these criteria are that they recognize the time value of money, deal with cash flows instead of accounting profits, and are consistent with the goal of a firm, which is to maximize shareholder profit. Their disadvantages are that they require detailed and long term cash flow forecasts, which are associated with the project and are challenging to generate. Also, they estimate the discount rate, which is somehow tricky, especially for new and risky projects.
- Answer Chapter 10 Study Problem 10-7
SP 10-7 (NPV, PI, and IRR calculations) You are considering two independent projects, project A and project B. The initial cash outlay with project A is $50,000, and the initial cash outlay associated with project B is $70,000. The required rate of return on both projects is 12 percent. The expected annual free cash inflows from each project are as follows:
| PROJECT A | PROJECT B | |
| Initial outlay | -$50,000 | -$70,000 |
| Inflow year 1 | 12,000 | 13,000 |
| Inflow year 2 | 12,000 | 13,000 |
| Inflow year 3 | 12,000 | 13,000 |
| Inflow year 4 | 12,000 | 13,000 |
| Inflow year 5 | 12,000 | 13,000 |
| Inflow year 6 | 12,000 | 13,000 |
Here are the NPV and IRR values for the two alternatives.
NPVA = –$663 IRRA = 11.53 percent
NPVB = –$16,552 IRR B = 3.18 percent
Discuss the two projects, their NPV and IRR, and what you would recommend to management based on these values. Which project should be selected, and why?
None of the two projects should be accepted because both have a negative NPV. If either had a positive NPV, it would mean that the value of the cash inflow or revenue is bigger than the outflow or the cost. Revenue that is greater than the cost means that an investor is making a profit. The opposite is true. A negative NPV means that the project has no gain and is no good for an investor.
- Answer the following Chapter 12 Review Questions:
RQ 12-2 Distinguish between business risk and financial risk. How do these sources of risk contribute to the overall risk of a firm?
Business risk refers to risk as to whether the owners of a company can run the business or not. It is a risk that relates to the operations of a company and whether it can generate profits or not. A financial risk, on the other hand, is a risk associated with a company’s ability to pay off its debts. When a company uses debt to raise its financial leverage, it suffers a financial risk. These risks are both exposures of the company to factors that may affect its capital structure, lower its profits, and lead to failure.
RQ 12-5 A manager in your firm, decides to employ break-even analysis. Of what shortcomings should this manager be aware?
Several crucial shortcomings of a break-even analysis exist. One is that a firm assumes that all of its production can be sold at a fixed price. The second is that the cost-volume-profit relationship is believed to be linear over a whole range of output. The third is that the production mix, sales mix, variable cost to sales ratio, and the total fixed costs are held constant.
