End-of-chapter questions. 10-1. We focus on cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest

10-1. We focus on cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder. In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project.

10-2. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. Thus, accounting profits become lower and, in turn, so do taxes, which are a cash flow item.

10-3. If a project requires an increased investment in working capital, the amount of this investment should be considered as part of the initial outlay associated with the project's acceptance. Since this investment in working capital is never "consumed," an offsetting inflow of the same size as the working capital's initial outlay will occur at the termination of the project corresponding to the recapture of this working capital. In effect, only the time value of money associated with the working capital investment is lost.

10-4. When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are irrelevant.

10-5. Mutually exclusive projects involve two or more projects where the acceptance of one project will necessarily mean the rejection of the other project. This usually occurs when the set of projects perform essentially the same task. Relating this to our discounted cash flow criteria, it means that not all projects with positive NPV's, profitability indexes greater than 1.0 and IRRs greater than the required rate of return will be accepted. Moreover, since our discounted cash flow criteria do not always yield the same ranking of projects, one criterion may indicate that the mutually exclusive project A should be accepted, while another criterion may indicate that the mutually exclusive project B should be accepted.

10-6. There are three principal reasons for imposing a capital rationing constraint. First, the management may feel that market conditions are temporarily adverse. In the early- and mid-seventies, this reason was fairly common, because interest rates were at an all-time high and stock prices were at a depressed level. The second reason is a manpower shortage, that is, a shortage of qualified managers to direct new projects. The final reason involves intangible considerations. For example, the management may simply fear debt, and so avoid interest payments at any cost. Or the common stock issuance may be limited in order to allow the current owners to maintain strict voting control over the company or to maintain a stable dividend policy.

Whether or not this is a rational move depends upon the extent of the rationing. If it is minor and noncontinuing, then the firm's share price will probably not suffer to any great extent. However, it should be emphasized that capital rationing and rejection of projects with positive net present values is contrary to the firm's goal of maximization of shareholders’ wealth.

10-7. When two mutually exclusive projects of unequal size are compared, the firm should select the project with the largest net present value, when there is no capital rationing. If there is capital rationing, then the firm should select the set of projects with the highest net present value. The firm needs to consider alternative uses of funds if the project with the lowest net present value is chosen.

10-8. The time disparity problem and the conflicting rankings that accompany it result from the differing reinvestment assumptions made by the net present value and internal rate of return decision criteria. The net present value criterion assumes that cash flows over the life of the project can be reinvested at the required rate of return; the internal rate of return implicitly assumes that the cash flows over the life of the project can be reinvested at the internal rate of return.

10-9. The problem of incomparability of projects with different lives is not directly a result of the projects having different lives but of the fact that future profitable investment proposals are being affected by the decision currently being made. Again the key is: "Does the investment decision being made today affect future profitable investment proposals?" If so, the projects are not comparable. While the most theoretically proper approach is to make assumptions as to investment opportunities in the future, this method is probably too difficult to be of any value in most cases. Thus, the most common method used to deal with this problem is the creation of a replacement chain to equalize life spans. In effect, the reinvestment opportunities in the future are assumed to be similar to the current ones. Another approach is to calculate the equivalent annual annuity of each project.

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