Question

Problem 3

You are asked to evaluate the following statements about capital budget criteria. Please state whether each statement below is true or false and briefly explain your answer. A statement is considered true when it is unambiguously correct; otherwise, the statement is false. For all statements, assume that the company is profitable, that the tax rate is greater than zero, and that the discount rate is greater than zero. You can also assume that all the discount rates and cash flows have been accurately estimated for each project. A typical investment project is a project that requires a cash outflow at time zero and provides positive cash inflows for the rest of its life. If it is indicated that a company is not capital-constrained (part e), it means that the firm has enough money to implement any combination of its projects (all of them, some, or none at all). Please do not round the number of periods to an integer; retain two digits after the decimal point.

a) For all investment projects, increasing the discount rate will reduce the NPV.
b) For typical investment projects, increasing the discount rate will shorten the discounted payback period.

c) If a company has to select one project from three mutually exclusive typical investment projects that are all profitable, it will create the most value for the shareholders by choosing the project with the highest profitability index.

d) One advantage of the IRR is that it can be used to rank typical investment projects according to their investment attractiveness without knowing their discount rates.

e) If a company is not capital-constrained and has several typical independent projects with known discount rates and known IRRs but with a different scale (different size of the initial investment), the IRR criterion will yield the same accept/reject decision for each project as the NPV.

f) Since depreciation is a non-cash expense, the choice of depreciation method (straight-line vs. MACRS) for both accounting and tax purposes does not affect the value of the profitability index for a typical investment project.

Answer 1

a) For all investment projects, increasing the discount rate will reduce the NPV

ANSWER:TRUE

NPV=Sum of Present Value of cash flows

Present Value of Cash Flow=(Cash Flow)/((1+r)^N)

r=discount rate, N=Year of cash flow

If r increases, Present Value of Cash Flow decreases . Hence, NPV decreases

b) For typical investment projects, increasing the discount rate will shorten the discounted payback period.

ANSWER: FALSE

Increasing the discount rate reduces the present value . Hence the payback period will increase

c) If a company has to select one project from three mutually exclusive typical investment projects that are all profitable, it will create the most value for the shareholders by choosing the project with the highest profitability index.

ANSWER : False

Profitability Index=Present Value of positive cash flows/Initial investment

Profitability Index=(Net Present Value(NPV)+Initial Investment) /Initial Investment

High Profitability Index does not indicate high NPV

d) One advantage of the IRR is that it can be used to rank typical investment projects according to their investment attractiveness without knowing their discount rates.

ANSWER : False

IRR by itself without required discount rate is not indication of attractiveness of the project

e) If a company is not capital-constrained and has several typical independent projects with known discount rates and known IRRs but with a different scale (different size of the initial investment), the IRR criterion will yield the same accept/reject decision for each project as the NPV.

ANSWER: True

If IRR is greater than discount rate , the project is accepted.

If IRR is greater than required discount rate, NPV will be positive , because at IRR, NPV=0

f) Since depreciation is a non-cash expense, the choice of depreciation method (straight-line vs. MACRS) for both accounting and tax purposes does not affect the value of the profitability index for a typical investment project.

ANSWER: False

Though depreciation is a non-cash expense, it affects cash flow because of tax savings (Depreciation Tax Shield).

Depreciation method will affect the amount of depreciation in different years. This will affect the depreciation tax shield. Hence NPV and Profitability index will be affected