PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 11, Problem 5PS
Biased forecasts Look back to the cash flows for projects F and G in Section 5-3. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the
- a. What are the projects’ true NPVs?
- b. What are the NPVs at the 18% discount rate?
- c. Are there any circumstances in which the 18% discount rate would give the correct NPVs? (Hint: Could upward bias be more severe for more-distant cash flows?)
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Which of the following is FALSE regarding various methods of project analysis?
Both NPV and IRR consider the time value of money.
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Payback focuses on liquidity.
O Profitability Index is able to rank projects in the situation of capital rationing.
() Payback considers the time value of money.
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A company considering a project with extremely risky cash flows decides to apply a premium to the discount rate used to evaluate the project. The management of the company has set the following limits regarding the use of premia on discount rates:
If the CV of the project is less than 1, no premium is added.
If the CV of the project is 1 or more, but less than 1.5, the discount rate is multiplied by 1.5
If the CV of the project is 1.5 or more, the discount rate is multiplied by 2.
The project under consideration has a CV of 1.5 while the company’s WACC is 10%. What would the discount rate employed to evaluate the project be?
Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Check all that apply.
The discounted payback period does not take the project’s entire life into account.
The discounted payback period does not take the time value of money into account.
The discounted payback period is calculated using net income instead of cash flows.
Chapter 11 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 11 - Capital budgeting process True or false? a. The...Ch. 11 - Capital budgeting process Explain how each of the...Ch. 11 - Capital budgeting process Draw up an outline or...Ch. 11 - Prob. 4PSCh. 11 - Biased forecasts Look back to the cash flows for...Ch. 11 - Prob. 6PSCh. 11 - Prob. 7PSCh. 11 - Prob. 8PSCh. 11 - Market prices Suppose the current price of gold is...Ch. 11 - Prob. 10PS
Ch. 11 - Prob. 11PSCh. 11 - Prob. 12PSCh. 11 - Prob. 13PSCh. 11 - Economic rents True or false? a. A firm that earns...Ch. 11 - Prob. 16PSCh. 11 - Economic rents Thanks to acquisition of a key...Ch. 11 - Prob. 18PSCh. 11 - Prob. 19PSCh. 11 - Prob. 20PSCh. 11 - Prob. 21PSCh. 11 - Prob. 22PSCh. 11 - Economic rents Taxes are a cost, and, therefore,...Ch. 11 - Prob. 1MCCh. 11 - Libby Flannery, the regional manager of Ecsy-Cola,...
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Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- A consultant commentated that "too often the numbers look good but feel bad." This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, personal biases and expectations can influence present value computations. 1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate. 2. Why is understanding the three reasons mentioned for estimation error important when evaluating investments projects? Link your responses to your answer in part 1.arrow_forwardA consultant commented that “too often the numbers look good but feel bad.” This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, personal biases and expectations can influence present value computations. Required 1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate. 2. Why is understanding the three reasons mentioned for estimation error important when evaluating investment projects? Link this response to your answer for part 1.arrow_forwardA consultant commented that “too often the numbers look good but feel bad.” This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, personal biases and expectations can influence present value computations. 1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate. 2. Why is understanding the three reasons mentioned for estimation error important when evaluating investment projects? Link this response to your answer for part 1.arrow_forward
- Which one of the following statements is correct concerning the payback rule? a. The payback period is computed using the present value of each of the cash flows. b. The rule says that you should accept a project if the payback period is greater than 1.0. c. The rule is biased in favour of long-term projects. d. The rule is flawed because it ignores all cash flows after some arbitrary point in time.arrow_forwardLast month, Lloyd's Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected. Old WACC: 10.00% New WACC: 9.50% Year 0 1 2 3 Cash flows -$1,000 $410 $410 $410arrow_forwardWhich of the following statements is FALSE? A. When evaluating a capital budgeting decision, we generally include interest expense. B. Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project. C. Many projects use a resource that the company already owns. O D. As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings.arrow_forward
- Last month, Lloyd's Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected. Old WACC: Year Cash flows. a. $14.28 b. $7.58 c. $13.50 d. $20.10 e. $8.05 10.00% 0 -$1,000 1 $430 New WACC: 2 $430 9.25% 3 $430 Chank My Work (1 remaining)arrow_forwardHardchoice Corp. is a firm considering prospective capital budgeting projects. Selected data on the projects follow: Image attached 1b) Ignoring the information in question (1a), assume instead that projects A and C are independent, Hardchoice is subject to capital rationing (i.e., it may not be able to afford both projects), and the relevant discount rate is 10%. a) What is the IRR of Project A? Project C? b) How would you rank Project A compared to Project C? Pls show formula used. Final dollar answers should be rounded to two decimal places. Interest rate answers should be rounded to 6 decimal places if expressed as a decimal or 4 decimal places if expressed as a percent. Use timeline if necessary. No excel .Thanks!arrow_forwardThe payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions. Consider the case of Blue Hamster Manufacturing Inc.: Blue Hamster Manufacturing Inc. is a small firm, and several of its managers are worried about how soon the firm will be able to recover its initial investment from Project Sigma’s expected future cash flows. To answer this question, Blue Hamster’s CFO has asked that you compute the project’s payback period using the following expected net cash flows and assuming that the cash flows are received evenly throughout each year. Complete the following table and compute the project’s conventional payback period. For full credit, complete the entire table. (Note: Round the conventional payback period to two decimal places. If your answer is negative, be sure to use a minus sign in your answer.) Year 0 Year 1 Year 2 Year 3 Expected cash flow -$6,000,000 $2,400,000 $5,100,000…arrow_forward
- Most firms generate cash flows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the analysis? If we do not, will this bias our results? If it does, would the NPV be biased up of down? Explain.arrow_forwardWhat will happen to the internal rate of return (IRR) of a project if the discount rate is decreased from 8% to 6%? Select one: a. We cannot determine the direction of the effect on IRR from the information provided. b. The change in discount rate will not affect IRR. c. IRR will always increase. d. IRR will always decrease.arrow_forward3. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. Answer One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. The regular payback ignores cash flows beyond the payback pericod, but the discounted payback method overcomes this problem. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion.arrow_forward
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