Capital Budgeting

Question 1

What are the capital budgeting techniques that we can use?

Answer 1

1. Net Present Value
2. Internal rate of return
3. Modified internal rate of Return
4. Payback method
5. Discounted Payback method
6. Accounting rate of Return
7. Profitability Index

Question 2

How does the Net Present Value capital budgeting method work?

Question 3

How does the Internal Rate of return capital budgeting method work?

Answer 3

It calculates the rate at which the NPV will be zero

It order to calculate it, you must simply set the NPV to zero and comp the rate using the calculator

Question 4

How does the Net Present Value capital budgeting method work?

Question 5

How does the Modified Internal Rate of return capital budgeting method work?

Question 6

How does the payback and discounted payback method of capital budgeting method work?

Question 7

How does the accounting rate of return capital budgeting method work?

Question 8

How does the profitability Index capital budgeting method work?

Question 9

What the rules for determining the cash flows to be used in the Capital budgeting process?

Answer 9

WORD:

• Only use incremental cash flows and not existing Cash flows
• Use after Tax cash flows
• Sunk costs are to be ignored
• All opportunity costs must be included
• the effects of new product lines on existing product lines are to be included
• Evaluate all alternatives
• ignore all ALLOCATED costs
• Financing charges must be ignored (accounted for WACC discount)
• only include the NET incremental investment in Working Capital EACH YEAR
• The working capital invested at the end of the year is all received as an income
• do not include accounting, just cash flows

Question 10

How should one compare projects with unequal lives that are mutually exclusive?

Answer 10

method 1, make use of replacement chains, this is when we assume that the projects will continue to be reinvested in and so we extend the useful lives until they match

method 2, to compare them based on their Equivalent annual annuities
- Project NPV / PV factor of an annuity for the period of the project

Question 11

what is the formula needed to convert a real interest rate into a nominal interest rate and vis versa?

Answer 11

Nominal = (1 + Real) (1 + Inflation) – 1
Real = ((1 + Nominal)/(1+ inflation)) – 1

Question 12

What is a nominal interest rate and what is a real interest rate?

Answer 12

nominal interest rate - includes the effect of inflation

real interest rates - exclude the effect of inflation

Question 13

What is the concept of capital rationing?

Answer 13

The idea of deciding how much capital to invest in a project BECAUSE the company only has a limited amount of finance

Question 14

How can capital rationing logically be performed?

Answer 14

indivisible projects
- calculate what group of projects has the highest group NPV

divisible projects of less than 1 year
- use the profitability index and choose the projects with the highest index first

Question 15

Assessed Loss
- If the company has an assessed loss and is able to utilise the assessed loss from
existing operations within the same time frame, what is the effect on the capital budget?

Answer 15

The assessed loss shouldn’t be considered, it doesn’t make a difference

Question 16

Assessed Loss
- If the company has an assessed loss and the new project enables the faster utilisation
of the assessed loss, what is the effect on the capital budget?

Question 17

Assessed Loss
- If the company has an assessed loss but has no other income, what is the effect on the capital budget?

Answer 17

The assessed loss shouldn’t be considered, it doesn’t make a difference

Question 18

Assessed Loss
- If the project creates a tax loss due to tax allowances and losses in the initial years and
the firm is able to set this off against other profits, what is the effect on the capital budget?

Question 19

Assessed Loss
- If the project creates a tax loss but the company is unable to set off such losses against
other income of the firm, what is the effect on the capital budget?