Norine Benson is studying for the Level I CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is most accurate? A) For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV). B) If the change in current liabilities is greater than the change in current assets, it means that additional financing was needed and there is a cash outflow. C) An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC). D) Replacement decisions involve mutually exclusive projects. T/G
A…
wow, i’m somewhat liking A, B and C. all have problems with them to my mind though … this is an area i remember CFAI having alot more than schweser’s definitely inflation is in WACC… but you do need to perhaps use it for estimating salvage value… current liabs increasing wouldn’t lower cash flow till the end. so not what i think they mean. i think i’ll go with NPV A, but i don’t necessarily agree with their rules. i think a large $$$$$ investment will have a higher NPV all else being equal than a smaller investment, even though you are subtracting the initial investment… i think it then needs to be divided by initial investment. not sure if CFAI has that. pretty sure schweser doesn’t.
This question has come up before. The answer hasn’t been picked yet.
D?
I have encountered this question and thought about it quite alot. By the end it makes sense. and hopefully i get it right this time. I believ that A is correct however D is much better reasoning being that in the case of a replacement you have to make a decision between the old machine and new machine. These are two mutually exclusive projects. Here we are going with the most accurate.
mwvt9 got it. Your answer: A was incorrect. The correct answer was D) Replacement decisions involve mutually exclusive projects. Because replacement decisions involve either keeping the old asset or replacing the old asset, the projects are mutually exclusive. The decision rule for NPV is to pick the project with the highest positive NPV. Only projects with positive NPV add to the company’s value. If neither project has a positive NPV, neither project should be chosen. The statement about net working capital (NWC) is stated in the reverse of how we usually think of it: D in NWC = DCurrent Assets − DCurrent Liabilities. Here, the change in current liabilities exceeds the change in current assets and the result is negative, meaning the project frees up cash, creating a cash inflow. Because the WACC is adjusted for inflation, the analyst must adjust project cash flows upward to reflect inflation. If the cash flows are not adjusted for inflation, the NPV will be biased downward. (Reverse the preceding logic for deflation.) T/G
i always love the “most accurate” wording… i think you’d lose your tenure at harvard for that wording.
D is the answer. i should have listed that when i said it is the most correct. I am glad i got it right.