Chapter 24: Q3DQ (page 1083)
Identify four reasons that capital budgeting decisions are risky.
The four reasons are the outcome is uncertain, a large of money is involved, long-term commitment, impossible to reverse the decision.
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What is the average amount invested in a machine during its predicted five-year life if it costs \(200,000 and has a \)20,000 salvage value? Assume that net income is received evenly throughout each year and straight-line depreciation is used.
A company is investing in a solar panel system to reduce its electricity costs. The system requires a cash payment of \(125,374.60 today. The system is expected to generate net cash flows of \)13,000 per year for the next 35 years. The investment has zero salvage value. Compute the internal rate of return on this investment.
A consultant commented that “too often the numbers look good but feel bad.” This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, personal biases and expectations can influence present value computations.
Required
1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate.
2. Why is understanding the three reasons mentioned for estimation error important when evaluating investment projects? Link this response to your answer for part 1.
Why is the present value of \(100 that you expect to receive one year from today worth less than \)100 received today? What is the present value of $100 that you expect to receive one year from today, discounted at 12%?
If a potential investment’s internal rate of return is above the company’s hurdle rate, should the investment be made?
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