Capital Budgeting, Risk Considerations, and Other Special Issues

Chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues

Multiple Choice Questions

1. Section: 13.1 Capital Expenditures

Learning Objective: 13.1

Difficulty: Intermediate

Solution: C. If a firm fails to invest effectively, its short-term performance and long-term survival will both be affected. Market value of its debt and equity will decline and the cost of capital will increase. The firm will find itself in a competitive disadvantage.

2. Section: 13.1 Capital Expenditures

Learning Objective: 13.1

Difficulty: Basic

Solution: D. The five factors are entry barriers, threat of substitutes, bargaining power of buyers, bargaining power of suppliers, and rivalry among existing competitors.

3. Section: 13.2 Evaluating Investment Alternatives

Learning Objective: 13.2

Difficulty: Intermediate

Solution: B

Using a financial calculator (TI BA II Plus):

[CF][2nd][CLR WORK]

–22,000 [Enter][↓]

0 [Enter][↓]

2 [Enter][↓]

10,200 [Enter][↓]

5 [Enter][↓]

[NPV][16][Enter] [↓]

[CPT] gives $2,820.00

4. Section: 13.2 Evaluating Investment Alternatives

Learning Objective: 13.2

Difficulty: Challenging

Solution: A. Refer to Figure 13-2. When k < crossover rate, Project A is preferred because it has a higher NPV despite the fact that its IRR is smaller.

5. Section: 13.2 Evaluating Investment Alternatives

Learning Objective: 13.2

Difficulty: Challenging

Solution: A.

Using a financial calculator (TI BA II Plus):

Project A:        Project B:

[CF][2nd][CLR WORK]                        [CF][2nd][CLR WORK]

–5,000 [Enter][↓]                                –5,000 [Enter][↓]

1,500 [Enter][↓] [↓]                                1,500 [Enter][↓] [↓]

4,000 [Enter][↓] [↓]                                1,500 [Enter][↓] [↓]

2,000 [Enter][↓] [↓]                                4,500 [Enter][↓] [↓]

[NPV][12][Enter] [↓]                                [NPV][12][Enter] [↓]        

[CPT] gives $951.62                        [CPT] gives $738.09

Since the NPVs of both projects are positive, we should accept both when they are independent and are within the capital budget. However, when they are mutually exclusive, we should accept the project with the higher NPV, which, in this case, is Project A.

6. Section: 13.2 Evaluating Investment Alternatives

Learning Objective: 13.2

Difficulty: Intermediate

Solution: C

Using a financial calculator (TI BA II Plus):

[CF][2nd][CLR WORK]

–8,000 [Enter][↓]

2,000[Enter][↓] [↓]

3,000[Enter][↓] [↓]

4,000[Enter][↓] [↓]

5,000[Enter][↓] [↓]

[IRR][CPT] gives 22.66%

Since 22.66% > 18%, we should accept the project.

7. Section: 13.2 Evaluating Investment Alternatives

Learning Objective: 13.2

Difficulty: Intermediate

Solution: D. We reject a project if NPV < 0, or IRR < required rate of return, or discounted payback period > required period, or PI < 1. Otherwise, we accept the project.

8. Section: 13.2 Independent and Interdependent Projects

Learning Objective: 13.3

Difficulty: Intermediate

Solution: A.

NPV and IRR yield the same ranking when evaluating independent projects. They may have different rankings when evaluating mutually exclusive projects.

9. Section: 13.4 Capital Rationing

Learning Objective: 13.4

Difficulty: Challenging

Solution: D. When a firm uses WACC for a high-risk project, which has a positive NPV using the proper discount rate (k > WACC), then the project would have an even higher NPV. Therefore, it is not possible the firm will reject the project.

10. Section: 13.4 Capital Rationing

Learning Objective: 13.4

Difficulty: Intermediate

Solution: B.

11. Section 13.5 International Considerations

Learning Objective: 13.5

Difficulty: Intermediate

Solution: C. We use the same rules to evaluate FDI and domestic projects while considering unique risks in FDI.

12. Section 13.5 International Considerations

Learning Objective: 13.5

Difficulty: Intermediate

Solution: A. Interest rate risk affects the discount rate and is therefore a risk for both FDI and domestic projects.

13. Section 13A The Modified Internal Rate of Return

Learning Objective: 13.6

Difficulty: Intermediate

Solution: B. IRR assumes cash flows are invested at IRR. MIRR relaxes this assumption.

14. Section 13A The Modified Internal Rate of Return

Learning Objective: 13.6

Difficulty: Intermediate

Solution: C. MIRR is greater than IRR only when cash flows are reinvested at a higher rate than IRR.

Practice Problems

Basic

15. Section: 13.2 Evaluating Investment Alternatives

Learning Objective: 13.2

Difficulty: Basic

Solution:

a. Payback period:

• Determines how long it takes for the project cash flows to add up to the investment
• Useful to gauge the possible liquidity impact of the project (how long is the firm’s capital tied up in the project)
• Easy to calculate, quick “back-of-the-envelope” type of calculation
• Does not take into account the time value of money
• Does not account for the cash flows beyond the cut-off date
• The choice of the cut-off date is arbitrary

IRR (internal rate of return)

• Determines the rate of return at which the NPV = 0. Intuitively, it is the rate of return promised by the project
• Easy to interpret and compare to other projects

Technically, can be very misleading (i.e., project scale, reinvestment rates, multiple solutions)

b. The most popular approaches (according to Figure 13-1) are NPV, IRR, and payback period.

c. Possible reasons can include:

Comfort: CFOs have been using these approaches for many years and have developed “rules of thumb” based on their experience and that, they believe, help them reach good decisions.

Intuitive nature: both the IRR and the payback methods are easy to understand on an intuitive basis. If you have to explain the decision to a large group (i.e., shareholders) with differing levels of financial education, IRR and payback can be an easily understandable measure.