Principal of Finance Chapter 6 Solutions

1. What is the difference between independent projects and mutually exclusive projects?

REFERENCE: 6.1

Independent projects are projects which do not compete with each other for the firm’s resources. The acceptance or rejection of one project does not influence the acceptance or rejection of another. On the other hand, mutually exclusive projects do compete for the firm’s resources. The acceptance of one precludes the acceptance of the other.

2. List the five steps in the capital budgeting process.

REFERENCE: 6.2

• Identification

• Development

• Selection

• Implementation

• Follow-up

3. Calculate the payback for a project that costs $1,000 and is expected to provide cash inflows of $400 per year for the next three years. If the required payback is 3 years, should the firm accept the project?

REFERENCE: 6.3

Payback = $1,000/$400 = 2.5 years

YES.

4. Calculate the net present value for a project that costs $1,000 and is expected to provide cash inflows of $400 per year for the next three years if the cost of capital is 10%. Should the firm accept the project?

REFERENCE: 6.3

NPV = $400 (PVIFA10%,3) - $1,000

NPV = $995 - $1,000

NPV = $-5

NO.

5. Calculate the internal rate of return for a project that costs $1,000 and is expected to provide cash inflows of $400 per year for the next three years. The cost of capital is 10%. Should the firm accept the project?

REFERENCE: 6.3

NPV = $400 (PVIFA10%,3) - $1,000

0 = $400 (PVIFAIRR,3) - $1,000

IRR = 9.7%

NO.

6. What does cannibalization mean in an investment analysis context? Provide an example.

REFERENCE: 7.2

Cannibalization occurs when a project robs cash flows from the firm’s existing lines of business. One example would be when an automaker introduces a new car model that negatively impacts the sales of one or more of its existing models.

7. What is an...