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APICollege

SBM2103 Financial Management


Chapter 10
Week 5 Advanced topic 5: Capital budgeting decision methods (Tutorial
questions)

Review questions
1. How do we calculate the payback period for a proposed capital budgeting
project? What are the main criticisms of the payback method?

2. What is the decision rule for accepting or rejecting proposed projects when
using net present value?

3. What is the decision rule for accepting or rejecting proposed projects when
using internal rate of return?

4. Why is the coefficient of variation a better risk measure to use than the
standard deviation when evaluating the risk of capital budgeting projects?

5. Explain how using a risk-adjusted discount rate improves capital budgeting


decision making compared with using a single discount rate for all projects.

Problem questions

10-1
You are investing in a new business known informally as Zombiebook. The initial
investment is $5 million. Future cash flows are projected to be $2 million at the end
of years one, two, three, and four. A different business in which you are considering
investing is called Angry Rabbits. It too would cost $5 million. Future cash flows for
Angry Rabbits are projected to be $1 million at the end of years one, two, and three,
followed by a positive cash flow of $20 million at the end of year 4. Compute the
payback period for Zombiebook and for Angry Rabbits. On the basis of the two
payback computations, which of the two companies would you choose? Does this
choice cause you any concern?

10-4
You have just paid $20 million in the secondary market for the winning Powerball
lottery ticket. The prize is $2 million at the end of each year for the next 25 years. If
your required rate of return is 8 percent, what is the net present value (NPV) of the
deal?

Week 8 Capital budgeting decision methods


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APICollege

10-9
The Bedford Falls Bridge Building Company is considering the purchase of a new crane. George Bailey,
the new manager, has had some past management experience while he was the chief financial officer
of the local savings and loan. The cost of the crane is $17,291.42, and the expected incremental cash
flows are $5,000 at the end of year 1, $8,000 at the end of year 2, and $10,000 at the end of year 3.
a. Calculate the net present value if the required rate of return is 9 percent.
b. Calculate the internal rate of return.
c. Should Mr. Bailey purchase this crane?

Week 8 Capital budgeting decision methods


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