Foundations of Finance, 8e, Global Edition, (Keown/Martin/Petty) Chapter 10 Capital Investment Decision Analysis-I

Foundations of Finance, 8e, Global Edition, (Keown/Martin/Petty) Chapter 10 Capital Investment Decision Analysis-I Learning Objective 1 1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal. Learning Objective 2 1) The most critical aspect in determining the acceptability of a capital budgeting project is the impact the project will have on the company's net income over the projects entire useful life. 2) Advantages of the payback period include that it is easy to calculate, easy to understand, and that it is based on cash flows rather than on accounting profits. 3) If project A generates $10 million of free cash flow over its five year useful life and project B generates $8 million of free cash flow over its useful life, then Project A will have a shorter payback period than Project B, assuming both projects require the same initial investment. 4) A project with a payback period of four years is acceptable as long as the company's target payback period is greater than or equal to four years. 5) Two projects that have the same cost and the same expected cash flows will have the same net present value. 6) The profitability index is the ratio of the company's net income (or profits) to the initial outlay or cost of a capital budgeting project. 7) If a project is acceptable using the net present value criteria, then it will also be acceptable under the less stringent criteria of the payback period. 8) An acceptable project should have a net present value greater than or equal to zero and a profitability index greater than or equal to one. 9) If a project's internal rate of return is greater than the project's required return, then the project's profitability index will be greater than one. 10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases. 11) The modified internal rate of return represents the project's internal rate of return assuming that intermediate cash flows from the project can be reinvested at the project's required return. 12) One drawback of the payback method is that some cash flows may be ignored. 13) The required rate of return reflects the costs of funds needed to finance a project. 14) The profitability index provides an advantage over the net present value method by reporting the present value of benefits per dollar invested. 15) The net present value of a project will increase as the required rate of return is decreased (assume only one sign reversal). 16) Whenever the internal rate of return on a project equals that project's required rate of return, the net present value equals zero. 17) One of the disadvantages of the payback method is that it ignores time value of money. 18) The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost. 19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR. 20) Many firms today continue to use the payback method but also employ the NPV or IRR methods especially when large projects are being analyzed. 21) NPV is the most theoretically correct capital budgeting decision tool examined in the text. 22) If the net present value of a project is zero, then the profitability index will equal one. 23) The internal rate of return will equal the discount rate when the net present value equals zero. 24) Mutually exclusive projects have more than one IRR. 25) For a project with multiple sign reversals in its cash flows, the net present value can be the same for two entirely different discount rates. 26) The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay. 27) If a project's profitability index is less than one then the project should be rejected. 28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the profitability index and IRR criteria. 29) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion is to select the set of projects that has the highest positive net present value subject to the capital constraint. 30) For any individual project, if the project is acceptable based on its internal rate of return, then the project will also be acceptable based on its modified internal rate of return. 31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows, which are less uncertain than later cash flows and provide for the liquidity needs of the firm. 32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash flows generated by prospective projects. 33) The profitability index is the ratio of the present value of the future free cash flows to the initial investment. 34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project is to maximize the company's sales. ..........................................continued.......................................................