CHAPTER 6

PRJECT ANALYSIS UNDER CERTAINTY

ANSWERS TO REVIEW QUESTIONS

QUESTIONS

6.1 Explain and define the terms: net present value, internal rate of return, modified internal rate of return, accounting rate of return, and payback period.

6.2 Explain the role of ‘certainty’ in project evaluation decisions.

6.3 Assume that Anvil Inc. has estimated the following annual data for the introduction of a new product, Ranch Hand:

EOY 0 EOY 1 EOY 2 EOY 3 EOY 4 EOY 5

Cash Flows -14,250 3,700 2,980 6,540 7,810 6,320

Accounting

Income 2,870 2,540 5,890 6,720 5,780

Required rate of return:*…show more content…*

ANSWERS Answer to Q 6.1

Net present value: This is the net increase in the firm’s current wealth that will result from undertaking an investment. For a simplified case where there is only one capital outlay which occurs at the beginning of the first year of the project, the net present value (NPV) is calculated by subtracting this capital outlay from the present value of the annual net operating cash flows and the net terminal cash flow. See Chapter 1, ‘shareholder wealth maximization and net present value’ section for more details including a simple calculation example. The present value is calculated by discounting the future values. The discount rate represents the firm’s required rate of return, which, under certainty, will equal the risk free rate. If a calculated NPV is positive, the firm should accept the project. If the NPV is zero, the firm will be indifferent towards the project, and if the NPV is negative, the project should be rejected.

In many cases, the capital outlays can occur not only at the beginning of the first year of the project but at other times later during the project’s progress as well. For example, an upgrade to the plant and machinery may occur in a later year. In such cases the present value of those capital outlays need to be calculated by discounting the future capital outlays and then the present value of the total capital outlays need to be subtracted from

PRJECT ANALYSIS UNDER CERTAINTY

ANSWERS TO REVIEW QUESTIONS

QUESTIONS

6.1 Explain and define the terms: net present value, internal rate of return, modified internal rate of return, accounting rate of return, and payback period.

6.2 Explain the role of ‘certainty’ in project evaluation decisions.

6.3 Assume that Anvil Inc. has estimated the following annual data for the introduction of a new product, Ranch Hand:

EOY 0 EOY 1 EOY 2 EOY 3 EOY 4 EOY 5

Cash Flows -14,250 3,700 2,980 6,540 7,810 6,320

Accounting

Income 2,870 2,540 5,890 6,720 5,780

Required rate of return:

ANSWERS Answer to Q 6.1

Net present value: This is the net increase in the firm’s current wealth that will result from undertaking an investment. For a simplified case where there is only one capital outlay which occurs at the beginning of the first year of the project, the net present value (NPV) is calculated by subtracting this capital outlay from the present value of the annual net operating cash flows and the net terminal cash flow. See Chapter 1, ‘shareholder wealth maximization and net present value’ section for more details including a simple calculation example. The present value is calculated by discounting the future values. The discount rate represents the firm’s required rate of return, which, under certainty, will equal the risk free rate. If a calculated NPV is positive, the firm should accept the project. If the NPV is zero, the firm will be indifferent towards the project, and if the NPV is negative, the project should be rejected.

In many cases, the capital outlays can occur not only at the beginning of the first year of the project but at other times later during the project’s progress as well. For example, an upgrade to the plant and machinery may occur in a later year. In such cases the present value of those capital outlays need to be calculated by discounting the future capital outlays and then the present value of the total capital outlays need to be subtracted from

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