9.7: Chapter Summary

Principles of Financial Management · LibreTexts

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    Chapter 9 Discussion Questions

    1. Why is capital budgeting considered one of the most important responsibilities of financial managers? Explain how poor investment decisions can affect firm value over time.
    2. Explain why Net Present Value (NPV) is considered the primary capital budgeting decision rule. What information does NPV provide that other methods do not?
    3. Internal Rate of Return (IRR) is often described as an intuitive measure. Why can IRR lead to incorrect decisions when projects are mutually exclusive or differ in scale?
    4. Discuss the strengths and weaknesses of the payback period. Why do many firms still use payback despite its limitations?
    5. Explain how the Profitability Index (PI) helps managers allocate capital when funds are limited. Under what conditions should PI not be used as the primary decision rule?
    6. Why is it important to evaluate project risk using sensitivity or scenario analysis rather than relying on a single NPV estimate?
    7. Describe the difference between hard and soft capital rationing. Provide an example of each.
    8. What causes ranking conflicts between NPV and IRR? How should managers resolve these conflicts?
    9. Why can projects with unequal lives not be compared directly using NPV? How does the Equivalent Annual Annuity (EAA) method solve this problem?
    10. In your own words, explain how real options change the way managers should think about capital budgeting decisions under uncertainty.

    Chapter 9 Problems

    Note: Unless stated otherwise, assume annual cash flows and discount rates expressed in decimal form.

    Part A: Foundations (Problems 1–5)

    1. A project requires an initial investment of $120,000 and is expected to generate cash inflows of $35,000 per year for 5 years. The required rate of return is 9%.
      a) Compute the project’s NPV.
      b) Based on NPV, should the project be accepted?
    2. Using the information from Problem 1, compute the project’s IRR.
      a) Interpret the IRR.
      b) Does the IRR decision agree with the NPV decision?
    3. A project has the following cash flows: CF₀ = −80,000; CF₁–CF₄ = 30,000.
      a) Compute the payback period.
      b) If the firm’s payback cutoff is 3 years, should the project be accepted?
    4. Explain why depreciation affects project cash flows even though it is not a cash expense.
    5. Why should financing cash flows (interest and principal payments) be excluded when estimating free cash flow for capital budgeting?

    Part B: Applied Analysis (Problems 6–10)

    1. A firm is evaluating two independent projects, A and B.
      Project A: Cost = $200,000; PV of inflows = $260,000
      Project B: Cost = $150,000; PV of inflows = $195,000
      a) Compute NPV and PI for each project.
      b) If the firm has a capital budget of $300,000, which project(s) should it accept?
    2. A project requires $100,000 today and produces cash flows of $40,000, $40,000, and $40,000 over the next three years.
      a) Compute the discounted payback period at 10%.
      b) Explain why the discounted payback differs from the simple payback.
    3. Two mutually exclusive projects have the following NPVs at a 10% discount rate:
      Project X: NPV = $55,000
      Project Y: NPV = $42,000
      If Project Y has a higher IRR than Project X, which project should be selected and why?
    4. A project’s base-case NPV is $75,000. A 10% decrease in sales volume reduces NPV to $10,000, while a 10% increase raises NPV to $140,000.
      a) Interpret these results.
      b) What do they imply about project risk?
    5. A firm is considering two machines with different lives.
      Machine A: NPV = $90,000, life = 3 years
      Machine B: NPV = $135,000, life = 5 years
      The discount rate is 8%.
      a) Compute the EAA for each machine.
      b) Which machine should the firm choose?

    Part C: Strategic Thinking (Problems 11–15)

    1. Explain how sensitivity analysis can help managers prioritize which assumptions require the most attention during project planning.
    2. Why might a project with a positive expected NPV still be rejected after scenario analysis?
    3. Describe a real-world example where the option to delay or abandon a project would add value beyond traditional NPV analysis.
    4. How does capital rationing change the interpretation of “accept all positive-NPV projects”?
    5. Explain why capital budgeting decisions are both financial and strategic in nature.

    This page titled 9.7: Chapter Summary was last modified on Mon, 15 Jun 2026 03:11:18 GMT and is shared under a CC BY 4.0 license and was authored, remixed, and/or curated by Andrew Carr.