Chapter 10, Problem 1Q

Define each of the following terms:

1. a. Capital budgeting; payback period; discounted payback period
2. b. Independent projects; mutually exclusive projects
3. c. Net present value (NPV) method; internal rate of return (IRR) method; profitability
4. 1. index (PI)
5. d. Modified internal rate of return (MIRR) method
6. e. NPV profile; crossover rate
7. f. Nonnormal cash flow projects; normal cash flow projects; multiple IRRs
8. g. Reinvestment rate assumption
9. h. Replacement chain; economic life; capital rationing; equivalent annual annuity (EAA)

Summary Introduction

To determine: The definition of capital budgeting, payback period and discounted payback period.

Explanation of Solution

Capital budgeting is the entire process of project planning and assessing whether it must be included in the capital budget. This method is of central importance to the company's success or failure because fixed investment decisions separate a company's path into the future for many years.

The payback period is the number of years that a company takes to recover its investment in the project. Rough cash flows (regular payback) or discounted cash flows (discounted payback) may be used to measure payback.

Payback does not control the entire cash flow stream of a company in either case and is thus not the preferred form of evaluation. However, remember that the payback tests the value of a project and that most businesses use it as a risk measure.

Summary Introduction

To determine: The definition of independent projects and mutually exclusive projects.

Explanation of Solution

It is not possible to carry out mutually incompatible ventures at the same time. We can either accept Project A or Project B, or we can refuse both, but we can't take both. Individual projects can be independently approved or denied.

Summary Introduction

To determine: The definition of net present value (NPV) method, internal rate of return (IRR) method and profitability index (PI).

Explanation of Solution

The Net Present Value (NPV) and Internal Return Rate (IRR) strategies are discounted cash flow measurement techniques as they consider money's time value directly. NPV is the present value of future cash flows (both inflows and outflows) generated by the company, discounted at the correct cost of capital. NPV is a direct indicator of the shareholders' interest of the project.

The internal rate of return (IRR) is the rate of discount that is equivalent to the present value of future cash inflows and outflows. IRR calculates the rate of return on a venture, but it assumes that it is possible to reinvest all cash flows at the IRR.

The profitability index is the ratio of expected cash flows ' present value to the original cost of the project. This indicates every project's relative profitability. Equivalent to a successful NPV plan is a profitability index greater than 1.

Summary Introduction

To determine: The definition of modified internal rate of return (MIRR) method.

Explanation of Solution

The modified internal rate of return (MIRR) assumes that, as opposed to the project's IRR, cash profits from all programs should be reinvested at capital cost. This makes the adjusted internal return rate a better predictor of the true profitability of a project.

Summary Introduction

To determine: The definition of NPV profile and cross over rate.

Explanation of Solution

The NPV profile is the NPV plot versus its capital cost. The crossover value is the capital price at which the NPV profiles converge for two projects implying that their NPVs are identical at that point.

Summary Introduction

To determine: The definition of abnormal cash flow projects and normal cash flow projects and multiple IRR’s.

Explanation of Solution

Capital projects with non-normal cash flow either sometime during or at the end of their lives have a large cash outflow. Several IRRs are a common problem experienced when reviewing non-normal cash flow ventures. A plan has natural cash flows when a sequence of cash inflows accompanies one or more capital outflows (costs).

Summary Introduction

To determine: The definition of reinvestment rate assumption.

Explanation of Solution

The NPV method's theory means reinvesting project cash flows at capital cost while the IRR method assumes reinvestment at the IRR. Because project cash flows can be replaced by new external capital which costs r, the proper assumption of reinvestment rate is the cost of capital, and thus NPV is the best rule of capital budget decision.

Summary Introduction

To determine: The definition of replacement chain, economic life, capital rationing, equivalent annual annuity (EAA).

Explanation of Solution

A substitution chain is a way of comparing mutually exclusive, unequal-life programs. Each plan will be repeated in such a way that both will finish in a similar year. When 3-year and 5-year life plans were compared, the 3-year project would be repeated 5 times and the 5-year project replicated 3 times; thus, all projects will finish in 15 years. Not all projects optimize their NPV if they are run during their lifespan in engineering, so it might be wise to terminate a project before their lifetime.

Economic life is the number of years that a plan will be managed to optimize its NPV, which is often less than the total life potential. Capital rationing happens when the management of business reduces capital spending to a smaller amount than would be necessary to finance the optimal capital budget.

The alternative method of comparing mutually incompatible ventures that have unequal lives is the analogous annuity method. This approach turns the annual cash flows under alternative investments into a constant cash flow stream whose NPV is equivalent to the initial stream's NPV.