(32) Capital Budgeting Flashcards
LOS 35. a: Describe the capital budgeting process and distinguish among the various categories of capital projects. Define capital budgeting.
Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than one year.
LOS 35. a: Describe the capital budgeting process and distinguish among the various categories of capital projects. What are the four steps of the capital budgeting process?
The four steps of the capital budgeting process are:
(1) Generate investment ideas;
(2) Analyze project ideas;
(3) Create firm-wide capital budget;
(4) Monitor decisions and conduct a post-audit.
LOS 35. a: Describe the capital budgeting process and distinguish among the various categories of capital projects. What are the categories of capital projects?
Categories of capital projects include:
(1) Replacement projects for maintaining the business or for cost reduction;
(2) Expansion projects;
(3) New project or market development;
(4) Mandatory projects to meet environmental or regulatory requirements;
(5) Other projects, such as research and development or pet projects of senior management.
LOS 35. b: Describe the basic principles of capital budgeting.
Capital budgeting decisions should be based on incremental after-tax cash flows, the expected differences in after-tax cash flows if a project is undertaken. Sunk (already incurred) costs are not considered, but externalities and cash opportunity costs must be included in project cash flows.
LOS 35. c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing. What is the difference between independent vs. mutually exclusive projects?
Acceptable independent projects can all be undertaken, while a firm must choose between or among mutually exclusive projects.
LOS 35. c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing.
Project sequencing concerns the opportunities for future capital projects that may be created by undertaking a current project.
LOS 35. c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing.
If a firm cannot undertake all profitable projects because of limited ability to raise capital, the firm should choose that group of fundable positive NPV projects with the highest total NPV.
LOS 35. d: Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project.
NPV is the sum of the present values of a project’s expected cash flows and represents the increase in firms value from undertaking a project. Positive NPV projects should be undertaken, but negative NPV projects are expected to decrease the value of the firm.
LOS 35. d: Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project.
The IRR is the discount rate that equates the present values of the project’s expected cash inflows and outflows and, thus, is the discount rate for which the NPV of a project is zero. A project for which the IRR is greater (less) than the discount rate will have an NPV that is positive (negative) and should be accepted (not be accepted).
LOS 35. d: Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project.
The payback (discounted payback) period is the number of years required to recover the original cost of the project (original cost of the project in present value terms).
LOS 35. d: Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project.
The profitability index is the ratio of the present value of a project’s future cash flows to its initial cash outlay and is greater than one when a project’s NPV is positive.
LOS 35. e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problem associated with each of the evaluation methods.
The NPV profile plots a project’s NPV as a function of the discount rate, and it intersects the horizontal axis (NPV = 0) at its IRR. If two NPV profiles intersect at some discount rate, that is the crossover rate, and different projects are preferred at discount rates higher and lower than the crossover rate.
LOS 35. e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problem associated with each of the evaluation methods.
For projects with conventional cash flow patterns, the NPV and IRR methods produce the same accept/reject decision, but projects with unconventional cash flow patterns can produce multiple IRRs or no IRR.
LOS 35. e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problem associated with each of the evaluation methods.
Mutual exclusive projects can be ranked based on their NPVs, but ranking based on other methods will not necessarily maximize the value of the firm.
LOS 35. e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problem associated with each of the evaluation methods. What is the purpose of a post-audit?
A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations.
LOS 35. f: Describe expected relations among an investment’s NPV, company value, and share price.
The NPV method is a measure of the expected change in company value from undertaking a project. A firm’s stock price may be affected to the extent that engaging in a project with that NPV was previously unanticipated by investors.
