Answers to Financial Mangement

Chapter 10

The Basics of Capital Budgeting:

Evaluating Cash Flows

ANSWERS TO END-OF-CHAPTER QUESTIONS

10-1

a. Capital budgeting is the whole process of analyzing projects and deciding whether

they should be included in the capital budget. This process is of fundamental

importance to the success or failure of the firm as the fixed asset investment decisions

chart the course of a company for many years into the future. The payback, or

payback period, is the number of years it takes a firm to recover its project

investment. Payback may be calculated with either raw cash flows (regular payback)

or discounted cash flows (discounted payback). In either case, payback does not

capture a project's entire cash flow stream and is thus not the preferred evaluation

method. Note, however, that the payback does measure a project's liquidity, and

hence many firms use it as a risk measure.

b. Mutually exclusive projects cannot be performed at the same time. We can choose

either Project 1 or Project 2, or we can reject both, but we cannot accept both

projects. Independent projects can be accepted or rejected individually.

c. The net present value (NPV) and internal rate of return (IRR) techniques are

discounted cash flow (DCF) evaluation techniques. These are called DCF methods

because they explicitly recognize the time value of money. NPV is the present value

of the project's expected future cash flows (both inflows and outflows), discounted at

the appropriate cost of capital. NPV is a direct measure of the value of the project to

shareholders. The internal rate of return (IRR) is the discount rate that equates the

present value of the expected future cash inflows and outflows. IRR measures the

rate of return on a project, but it assumes that all cash flows can be reinvested at the

IRR rate.

d. The modified internal rate of return (MIRR) assumes that cash flows from all projects

are reinvested at the cost of capital as opposed to the project's own...