reinvested at the cost of capital while the IRR method assumes reinvestment at the
IRR.
Since project cash flows can be replaced by new external capital which costs r,
the proper reinvestment rate assumption is the cost of capital, and thus the best capital
budget decision rule is NPV.
The post-audit is the final aspect of the capital
budgeting process. The post-audit is a feedback process in which the actual results are
compared with those predicted in the original capital budgeting analysis.
The post-
audit has several purposes, the most important being to improve forecasts and
improve operations.
h.
A replacement chain is a method of comparing mutually exclusive projects that have
unequal lives.
Each project is replicated such that they will both terminate in a
common year.
If projects with lives of 3 years and 5 years are being evaluated, the 3-
year project would be replicated 5 times and the 5-year project replicated 3 times;
thus, both projects would terminate in 15 years.
Not all projects maximize their NPV
if operated over their engineering lives and therefore it may be best to terminate a
project prior to its potential life.
The economic life is the number of years a project
should be operated to maximize its NPV, and is often less than the maximum
potential life.
Capital rationing occurs when management places a constraint on the
size of the firm’s capital budget during a particular period.
10-2
Project classification schemes can be used to indicate how much analysis is required to
evaluate a given project, the level of the executive who must approve the project, and the
cost of capital that should be used to calculate the project's NPV.
Thus, classification
schemes can increase the efficiency of the capital budgeting process.
10-3
The NPV is obtained by discounting future cash flows, and the discounting process
actually compounds the interest rate over time.
Thus, an increase in the discount rate has
a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1.
10-4
This question is related to Question 10-3 and the same rationale applies.
With regard to
the second part of the question, the answer is no; the IRR rankings are constant and
independent of the firm's cost of capital.
Answers and Solutions:
10 - 2

10-5
The NPV and IRR methods both involve compound interest, and the mathematics of
discounting requires an assumption about reinvestment rates.
The NPV method assumes
reinvestment at the cost of capital, while the IRR method assumes reinvestment at the
IRR.
MIRR is a modified version of IRR which assumes reinvestment at the cost of
capital.
10-6
Generally, the failure to employ common life analysis in such situations will bias the
NPV against the shorter project because it "gets no credit" for profits beyond its initial
life, even though it could possibly be "renewed" and thus provide additional NPV.
Answers and Solutions:
10 - 3

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
10-1
a.
$52,125/$12,000 = 4.3438, so the payback is about 4 years.
b.
Project K's discounted payback period is calculated as follows:
Annual