Question

Required: Suppose you paid your old college finance professor to evaluate a project for you. If you would pay him regardless of your decision concerning whether to proceed with the project, should his fee for evaluating the project be included in the project's incremental cash flows?

Required: Under what circumstances could payback and discounted payback be equal? And what are the drawbacks of these two methods?

Required: How are normal and non-normal cash flows different?

Required: Which capital budgeting method has the fewest drawbacks making it superior to other capital budgeting methods?

Finance (4th Edition)

Answer 1

1. The fees should not be included in the incremental cash flows because this is sunk cost. It will be incurred irrespective of the decision to proceed with the project. Hence it cannot be counted as incremental cash flows and it will not affect any additional cash flows.

2. The discounted payback and payback will only be equal if the interest rate is zero.

3. Normal cash flows begin with negative cash flow followed by a series of positive cash flows. Non normal cash flows are those in which there are two or more sign changes with respect to cash flows.

4. The net present value method has the fewest drawbacks and it is considered the best capital budgeting method. This method takes into account the time value of money and it is also possible to compare mutually exclusive projects on the basis of their dollar returns to the business.