10 - Capital Budgeting

Question 1

why do we take TVM into account for investing decisions?

Answer 1

as the initial inv may only recovered after a long time

Question 2

do we include interest expenses in NPV calc?

Answer 2

no, already included in WACC

Question 3

what do we do with the assessed loss if the project is making a profit?

Answer 3

deduct it directly from project’s taxable income

Question 4

what do we do with the assessed loss if the loss canNOT be utilized elsewhere in the company?

Answer 4

carry it over to the next year

Question 5

what do we do with the assessed loss if the loss CAN be utilized elsewhere in the company?

Answer 5

don’t carry over, will just have + tax for that year

Question 6

what is the IRR?

Answer 6

internal rate of return – takes into account TVM

Question 7

how do we manually calculate IRR?

Answer 7

discounted earnings from project / inv amount

Question 8

what do we do with IRR?

Answer 8

compare to WACC
must be bigger than WACC to accept

Question 9

how do we calculate ARR?

Answer 9

average annual acc profit / inv amount

Question 10

what do we do with ARR?

Answer 10

compare to WACC
must be bigger than WACC to accept

Question 11

how do we calculate payback period?

Answer 11

• take initial inv and reduce by profit in each year
  decimals and months etc
• can discount or not

Question 12

how to calculate profitability index?

Answer 12

PV / investment

Question 13

why do we base our decision on profitability index and not just NPV?

Answer 13

NPV bases our decision only on cash flows, whereas using profitability index allows us to see how profitable the project is in relation to its cost

Question 14

when do we use capital rationing?

Answer 14

when we have limited funds to spend on investments and we are deciding between multiple projects

Question 15

how do we perform capital rationing?

Answer 15

calculate all the PVs and profitability indexes and then rank them to decide which. Add up the projects which add up to the budget from the cost column

Question 16

which columns do we include in a capital rationing table?

Answer 16

projects, investment, PV, NPV, profitability index, rank 1, rank 2

Question 17

what is the outcome of capital rationing?

Answer 17

we get our most profitable mix of projects

Question 18

how can we compare repeating projects with unequal lives (and no budget limit)?

Answer 18

1) rank them based on NPV using lowest common multiple of years
2) equivalent annual amount

Question 19

how do we calculate the equivalent annual amount?

Answer 19

find the PMT through the calculator
PV = NPV
I/Y = WACC
FV = 0
N = number of years of project

Question 20

what is the impact of inflation on our capital budgeting?

Answer 20

• cash flows will increase each year by the interest rate
• incorporated into the discount rate

Question 21

when do we use a project-specific WACC for evaluating?

Answer 21

when we a project which is much riskier, as d/e holders and investors will require a higher return to compensate for the higher risk and we use this for the NPV calculation