CHAPTER 9
Capital Budgeting Decision Criteria
ANSWERS TO
END-OF-CHAPTER QUESTIONS
9-1. Capital budgeting decisions involve investments requiring rather large cash outlays
at the beginning of the life of the project and commit the firm to a particular course
of action over a relatively long time horizon. As such, they are costly and difficult
to reverse, both because of: (1) their large cost and (2) the fact that they involve
fixed assets, which cannot be liquidated easily.
9-2. The criticisms of using the payback period as a capital budgeting technique are:
(1) It ignores the timing of the free cash flows that occur during the payback
period.
(2) It ignores all free cash flows occurring after the payback period.
(3) The selection of the maximum acceptable payback period is arbitrary.
The advantages associated with the payback period are:
(1) It deals with cash flows rather than accounting profits, and therefore focuses
on the true timing of the project's benefits and costs.
(2) It is easy to calculate and understand.
(3) It can be used as a rough screening device, eliminating projects whose returns
do not materialize until later years.
These final two advantages are the major reasons why it is used frequently.
9-3. Yes. The payback period eliminates projects whose returns do not materialize until
later years and thus emphasizes the earliest returns, which in a country experiencing
frequent expropriations would certainly have the most amount of uncertainty
surrounding the later returns. In this case, the payback period could be used as a
rough screening device to filter out those riskier projects, which have long lives.
9-4. The three, discounted cash flow capital budgeting criteria are the net present value,
the profitability index, and the internal rate of return. The net present value method
gives an absolute dollar value for a project by taking the present value of the benefits
and subtracting out the present value of the costs. The profitability index compares
these benefits and costs through division and comes up with a measure of the
project's relative value—a benefit/cost ratio. On the other hand, the internal rate of
return tells us the rate of return that the project earns. In the capital budgeting area,
these methods generally give us the same accept-reject decision on projects but many
times rank them differently. As such, they have the same general advantages and
disadvantages, although the calculations associated with the internal rate of return
method can become quite tedious and it assumes cash flows over the life of the life
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