Self-Test Problem 287
A project’s true value may be greater than the NPV based on its physical life if it can
be terminatedat the end of its economic life.
Flotation costs and increased riskiness associated with unusually large expansion
programs can cause the marginal cost of capital to rise as the size of the capital
budget increases.
Capital rationing occurs when management places a constraint on the size of the
firm’s capital budget during a particular period.
Questions
Define each of the following terms:
a.Capital budgeting; regular payback period; discounted payback period
b.Independent projects; mutually exclusive projects
c.DCF techniques; net present value (NPV) method; internal rate of return (IRR) method
d.Modified internal rate of return (MIRR) method; profitability index
e.NPV profile; crossover rate
f.Nonnormal cash flow projects; normal cash flow projects; multiple IRRs
g.Hurdle rate; reinvestment rate assumption; post-audit
h.Replacement chain; economic life; capital rationing
How is a project classification scheme (for example, replacement, expansion into new markets,
and so forth) used in the capital budgeting process?
Explain why the NPV of a relatively long-term project, defined as one for which a high per-
centage of its cash flows are expected in the distant future, is more sensitive to changes in the
cost of capital than is the NPV of a short-term project.
Explain why, if two mutually exclusive projects are being compared, the short-term project might
have the higher ranking under the NPV criterion if the cost of capital is high, but the long-term
project might be deemed better if the cost of capital is low. Would changes in the cost of capital
ever cause a change in the IRR ranking of two such projects?
In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and MIRR meth-
ods? What is the assumed reinvestment rate of each method?
Suppose a firm is considering two mutually exclusive projects. One has a life of 6 years and the
other a life of 10 years. Would the failure to employ some type of replacement chain analysis
bias an NPV analysis against one of the projects? Explain.
Self-Test Problem (Solution Appears in Appendix A)
You are a financial analyst for the Hittle Company. The director of capital budgeting has asked
you to analyze two proposed capital investments, Projects X and Y. Each project has a cost of
$10,000, and the cost of capital for each project is 12 percent. The projects’ expected net cash
flows are as follows:
Expected Net Cash Flows
Year Project X Project Y
0 ($10,000) ($10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
ST–1
PROJECT ANALYSIS
7–6
7–5
7–4
7–3
7–2
7–1
The Basics of Capital Budgeting: Evaluating Cash Flows 285
