Finance Study Guide

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9.1 How is a project classification scheme (for example, replacement, expansion into new markets, and so forth) used in the capital budgeting process? Project classification schemes can be used to indicate how much of an analysis is required to evaluate a given project, and the level of the executive who much approve the project, and the cost of capital that should be used to calculate the project’s NPV. By doing so, classification schemes can increase the efficiency of the capital budgeting process. 9.4 Explain the decision rules—that is, under what conditions a project is acceptable—for each of the following capital budgeting methods: a. Net present value (NPV) b. Internal rate of return (IRR) c. Modified internal rate of return (MIRR) d. Traditional payback (PB) e. Discounted payback (DPB) a. Should only be undertaken if NPV is greater than 0. b. Should only be undertaken if IRR is greater than the cost of capital. c. The MIRR will yield the same as the IRR method, so it would need to be greater than the cost of the capital. d. Should only be undertaken if PB is less than the arbitrary number of years. e. Should be undertaken if it has the shortest payback period, and can be used to identify the project that will generate more cash for investment quickly. 9.6 In what sense is a reinvestment rate assumption embodied in the NPV and IRR methods? What is the assumed reinvestment rate of each method? The NPV and IRR methods both involve compound interest, and the math of discounting requires an assumption about reinvestment rates. The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes reinvestment at the IRR. IRR assumes that all cash flows are reinvested at the project’s rate of return. Since NPV discounts future cash flows at the investor’s cost of capital, is more accurately represents the value of a project and assumes that cash flows are reinvested at the cost of capital. 9-1 A firm is evaluating the acceptability of an...
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