reinvested at the cost of capital while the IRR method assumes reinvestment at | Course Hero
reinvested at the cost of capital while the IRR method assumes reinvestment at
Reinvested at the cost of capital while the irr
School Thai Nguyen University of Agriculture and Forestry
Course Title FINANCE FIN1
Uploaded By MagistrateComputerOwl2551
Villanova University • MSF 8610
reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR. Since project cash flows can be replaced by new external capital which costs r, the proper reinvestment rate assumption is the cost of capital, and thus the best capital budget decision rule is NPV. The post-audit is the final aspect of the capital budgeting process. The post-audit is a feedback process in which the actual results are compared with those predicted in the original capital budgeting analysis. The post- audit has several purposes, the most important being to improve forecasts and improve operations. h. A replacement chain is a method of comparing mutually exclusive projects that have unequal lives. Each project is replicated such that they will both terminate in a common year. If projects with lives of 3 years and 5 years are being evaluated, the 3- year project would be replicated 5 times and the 5-year project replicated 3 times; thus, both projects would terminate in 15 years. Not all projects maximize their NPV if operated over their engineering lives and therefore it may be best to terminate a project prior to its potential life. The economic life is the number of years a project should be operated to maximize its NPV, and is often less than the maximum potential life. Capital rationing occurs when management places a constraint on the size of the firm’s capital budget during a particular period. 10-2 Project classification schemes can be used to indicate how much analysis is required to evaluate a given project, the level of the executive who must approve the project, and the cost of capital that should be used to calculate the project's NPV. Thus, classification schemes can increase the efficiency of the capital budgeting process. 10-3 The NPV is obtained by discounting future cash flows, and the discounting process actually compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1. 10-4 This question is related to Question 10-3 and the same rationale applies. With regard to the second part of the question, the answer is no; the IRR rankings are constant and independent of the firm's cost of capital. Answers and Solutions: 10 - 2
10-5 The NPV and IRR methods both involve compound interest, and the mathematics 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. MIRR is a modified version of IRR which assumes reinvestment at the cost of capital. 10-6 Generally, the failure to employ common life analysis in such situations will bias the NPV against the shorter project because it "gets no credit" for profits beyond its initial life, even though it could possibly be "renewed" and thus provide additional NPV. Answers and Solutions: 10 - 3
SOLUTIONS TO END-OF-CHAPTER PROBLEMS 10-1 a. $52,125/$12,000 = 4.3438, so the payback is about 4 years. b. Project K's discounted payback period is calculated as follows: Annual
FM8e- EOC Sol Ch11
Bahria University • BBA FIN 660
Thai Nguyen University of Agriculture and Forestry • SFD 3432
DeVry University, Addison • FM Finance