9.7: Chapter Summary
- Page ID
- 150488
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)Chapter 9 Discussion Questions
- Why is capital budgeting considered one of the most important responsibilities of financial managers? Explain how poor investment decisions can affect firm value over time.
- Explain why Net Present Value (NPV) is considered the primary capital budgeting decision rule. What information does NPV provide that other methods do not?
- Internal Rate of Return (IRR) is often described as an intuitive measure. Why can IRR lead to incorrect decisions when projects are mutually exclusive or differ in scale?
- Discuss the strengths and weaknesses of the payback period. Why do many firms still use payback despite its limitations?
- Explain how the Profitability Index (PI) helps managers allocate capital when funds are limited. Under what conditions should PI not be used as the primary decision rule?
- Why is it important to evaluate project risk using sensitivity or scenario analysis rather than relying on a single NPV estimate?
- Describe the difference between hard and soft capital rationing. Provide an example of each.
- What causes ranking conflicts between NPV and IRR? How should managers resolve these conflicts?
- Why can projects with unequal lives not be compared directly using NPV? How does the Equivalent Annual Annuity (EAA) method solve this problem?
- In your own words, explain how real options change the way managers should think about capital budgeting decisions under uncertainty.
Chapter 9 Problems
Note: Unless stated otherwise, assume annual cash flows and discount rates expressed in decimal form.
Part A: Foundations (Problems 1–5)
- A project requires an initial investment of $120,000 and is expected to generate cash inflows of $35,000 per year for 5 years. The required rate of return is 9%.
a) Compute the project’s NPV.
b) Based on NPV, should the project be accepted? - Using the information from Problem 1, compute the project’s IRR.
a) Interpret the IRR.
b) Does the IRR decision agree with the NPV decision? - A project has the following cash flows: CF₀ = −80,000; CF₁–CF₄ = 30,000.
a) Compute the payback period.
b) If the firm’s payback cutoff is 3 years, should the project be accepted? - Explain why depreciation affects project cash flows even though it is not a cash expense.
- Why should financing cash flows (interest and principal payments) be excluded when estimating free cash flow for capital budgeting?
Part B: Applied Analysis (Problems 6–10)
- A firm is evaluating two independent projects, A and B.
Project A: Cost = $200,000; PV of inflows = $260,000
Project B: Cost = $150,000; PV of inflows = $195,000
a) Compute NPV and PI for each project.
b) If the firm has a capital budget of $300,000, which project(s) should it accept? - A project requires $100,000 today and produces cash flows of $40,000, $40,000, and $40,000 over the next three years.
a) Compute the discounted payback period at 10%.
b) Explain why the discounted payback differs from the simple payback. - Two mutually exclusive projects have the following NPVs at a 10% discount rate:
Project X: NPV = $55,000
Project Y: NPV = $42,000
If Project Y has a higher IRR than Project X, which project should be selected and why? - A project’s base-case NPV is $75,000. A 10% decrease in sales volume reduces NPV to $10,000, while a 10% increase raises NPV to $140,000.
a) Interpret these results.
b) What do they imply about project risk? - A firm is considering two machines with different lives.
Machine A: NPV = $90,000, life = 3 years
Machine B: NPV = $135,000, life = 5 years
The discount rate is 8%.
a) Compute the EAA for each machine.
b) Which machine should the firm choose?
Part C: Strategic Thinking (Problems 11–15)
- Explain how sensitivity analysis can help managers prioritize which assumptions require the most attention during project planning.
- Why might a project with a positive expected NPV still be rejected after scenario analysis?
- Describe a real-world example where the option to delay or abandon a project would add value beyond traditional NPV analysis.
- How does capital rationing change the interpretation of “accept all positive-NPV projects”?
- Explain why capital budgeting decisions are both financial and strategic in nature.