DECISION TREES

D. SIMULATION

This risk analysis method is frequently called Monte Carlo simulation. It requires that a probability distribution be constructed for each of the important variables affecting the project's cash flows. Since a computer is used to generate many results using random numbers, project simulation is expensive.

E. SENSITIVITY ANALYSIS

Forecasts of many calculated NPVs under various alternative functions are compared to see how sensitive NPV is to changing conditions. It may be found that a certain variable or group of variables, once their assumptions are changed or relaxed, drastically alters the NPV. This results in a much riskier asset than was originally forecast.

F. DECISION TREES

Some firms use decision trees (probability trees) to evaluate the risk of capital budgeting proposals. A decision tree is a graphical method of showing the sequence of possible outcomes. A capital budgeting tree would show the cash flows and NPV of the project under different possible circumstances. The decision tree method has the following advantages: (1) It visually lays out all the possible outcomes of the proposed project and makes management aware of the adverse possibilities, and (2) the conditional nature of successive years' cash flows can be expressly depicted. The disadvantages are: (1) most problems are too complex to permit year-by-year depiction and (2) it does not recognize risk.

EXAMPLE 3.13

Assume XYZ Corporation wishes to introduce one of two products to the market this year.

The probabilities and present values (PV) of projected cash inflows are given below:

How to Assess Capital Expenditure 3-14 Proposals for Strategic Decision Making

A decision tree analyzing the two products is given in Figure 3.1.

FIGURE 3.1

Expected net present value:

Product A $270,000 - $225,000 = $45,000 Product B $ 94,000 - $ 80,000 = $14,000 Based on the expected NPV, choose product A over product B.

VII. Conclusion

Net present value, internal rate of return, and profitability index are equally effective in selecting economically sound, independent investment proposals. But the payback method is inadequate since it does not consider the time value of money. For mutually exclusive projects, net present value, internal rate of return, and profitability index methods are not always able to rank projects in the same order; it is possible to come up with different rankings under each method. Risk should be taken into account in the capital budgeting process, such as by using probabilities, simulation, and decision trees.

How to Assess Capital Expenditure 3-15 Proposals for Strategic Decision Making

CHAPTER 3 – REVIEW QUESTIONS

The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience.

We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter.

1. Capital budgeting is a(n):

a) plan to insure that there are sufficient funds available for the operating needs of the company

b) exercise that sets the long-range goals of the company including the consideration of external influences

c) plan that coordinates and communicates a company’s plan for the coming year to all departments and divisions

d) plan that assesses the long-term needs of the company for plant and equipment purchases

2. The use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of:

a) raising the discount (hurdle) rate necessary to justify the project b) lowering the net present value of the project

c) increasing the present value of the depreciation tax shield d) increasing the cash outflows at the initial point of the project 3. A characteristic of the payback method (before taxes) is that it:

a) neglects total project profitability

b) uses accrual accounting inflows in the numerator of the calculation

c) uses the estimated expected life of the asset in the denominator of the calculator d) uses the hurdle rate in the calculation

4. The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its life to time period zero using the company’s minimum desired rate of return is the:

a) net present value method b) capital rationing method c) payback method

d) accounting rate of return method

How to Assess Capital Expenditure 3-16 Proposals for Strategic Decision Making

5. The technique that reflects the time value of money and is calculated by dividing the present value of the future net after-tax cash inflows that have been discounted at the desired cost of capital by the initial cash outlay for the investment is the:

a) net present value method b) capital rationing method

c) accounting rate of return method d) profitability index method

6. The net present value (NPV) method of capital budgeting assumes that cash flows are reinvested at:

a) the risk-free rate b) the cost of debt

c) the internal rate of return

d) the discount rate (cost of capital) used in the analysis

7. Net present value (NPV) and internal rate of return (IRR) differ in that:

a) NPV assumes reinvestment of project cash flows at the cost of capital, whereas IRR assumes reinvestment of project cash flows at the internal rate of return b) NPV and IRR make different accept or reject decisions for independent projects c) IRR can be used to rank mutually exclusive investment projects, but NPV cannot d) NPV is expressed as percentage, while IRR is expressed as a dollar amount 8. The proper discount rate to use in calculating certainty equivalent net present value

is the:

a) risk-adjustment discount rate b) risk-free rate

c) cost of equity capital d) cost of debt

How to Assess Capital Expenditure 3-17 Proposals for Strategic Decision Making

CHAPTER 3 – SOLUTIONS AND SUGGESTED RESPONSES

1. A: Incorrect. Capital budgeting involves long-term investment needs, not immediate operating needs

B: Incorrect. Strategic planning establishes long-term goals in the context of relevant factors in the firm’s environment.

C: Incorrect. An operating budget communicates a company’s plan for the coming year to all departments.

D: Correct. Capital budgeting relates to planning for the best selection and financing of long-term investment proposals. There are many investment decisions that the company may have to make in order to grow. Examples of capital budgeting applications are product line selection, keep or sell a business segment, lease or buy, and which asset to invest in.

(See page 3-1 of the course material.)

2. A: Incorrect. The hurdle rate must be set by the decision maker.

B: Incorrect. The greater depreciation tax shield increases the NPV.

C: Correct. Accelerated depreciation results in greater depreciation in the early years of an asset’s life compared with the straight-line method. Thus, accelerated depreciation results in lower income tax expense in the early years of a project and higher income tax expense in the later years. By effectively deferring taxes, the accelerated method increases the present value of the depreciation tax shield.

D: Incorrect. Greater initial depreciation reduces the cash outflows for taxes but has no effect on the initial cash outflows.

(See page 3-2 of the course material.)

3. A: Correct. The payback period measures the length of time required to recover the amount of initial investment. It is computed by dividing the initial investment by the cash inflows through increased revenues or cost savings. If the net cash inflows are not constant, a cumulative approach is used. The shortcomings of this method are that: 1) it does not recognize the time value of money, and 2) it ignores the impact of cash inflows received after the payback period; essentially, cash flows after the payback period determine profitability of an investment.

B: Incorrect. The net investment is the numerator.

C: Incorrect. The constant expected net cash inflow is the denominator.

D: Incorrect. No hurdle rate or other interest rate is used.

(See pages 3-3 to 3-4 of the course material.)

How to Assess Capital Expenditure 3-18 Proposals for Strategic Decision Making

4. A: Correct. Net present value (NPV) is the excess of the present value (PV) of cash inflows generated by the project over the amount of the initial investment (I): NPV = PV – I. If NPV > 0, the investment is considered to be acceptable.

B: Incorrect. Capital rationing is not a technique but rather a condition that characterizes capital budgeting when the limited amount of capital available is insufficient to fund all profitable investments.

C: Incorrect. The payback method does not consider the time value of money.

D: Incorrect. The accounting rate of return method fails to consider the time value of money. Further, it uses accounting income data rather than cash flows.

(See page 3-6 of the course material.)

5. A: Incorrect. The NPV method does not divide the future cash flows by the cost.

B: Incorrect. Capital rationing is not a technique but rather a condition that characterizes capital budgeting when insufficient capital is available to finance all profitable investment opportunities.

C: Incorrect. The accounting rate of return method does not discount cash flows.

D: Correct. The profitability index, also called present value index, is the ratio of the total PV of future cash inflows to the initial investment. This index is used as a means of ranking projects in descending order of attractiveness in a capital rationing situation.

(See page 3-8 of the course material.)

6. A: Incorrect. The NPV method assumes that cash inflows are reinvested at the discount rate used in the NPV calculation.

B: Incorrect. The NPV method assumes that cash inflows are reinvested at the discount rate used in the NPV calculation. The cost of debt is not the cost of capital in many cases.

C: Incorrect. The IRR method assumes a reinvestment rate equal to the IRR.

D: Correct. The NPV method discounts all cash flows at the cost of capital, thus