Capital budgeting

Question 1

Internal rate of return (IRR)

Answer 1

The rate at which NPV is zero.

Question 2

When should you accept a project?

Answer 2

NPV is greater than zero
IRR is greater than the discount rate

Question 3

Incremental cash flows

Answer 3

Cash flows that change as a direct consequence of undertaking a project.

Question 4

Sunk costs

Answer 4

Money already spent. Do not include in capital budgeting.

Question 5

Opportunity cost

Answer 5

Potential revenues that have been lost from taking on the project

Question 6

Synergy

Answer 6

Occurs when the new product increases the cash flows of existing products.
Not incremental

Question 7

Erosion

Answer 7

Occurs when the new product decreases the cash flows of existing products.
Not incremental

Question 8

Allocated costs

Answer 8

Cost allocated by accountants.
Not incremental

Question 9

Nominal cash flow

Answer 9

A cash flow without adjustments for inflation.

Question 10

Real cash flow

Answer 10

A cash flow that has been adjusted for inflation.

Question 11

Real options

Answer 11

To expand
To abandon
Timing option

Question 12

Real option to expand

Answer 12

If initial project goes well expand.
If unsuccessful do not expand

Question 13

Real option to abandon

Answer 13

If initial project goes poorly there is the option to abandon which will save the company a lot of money.

Question 14

Real timing option

Answer 14

Holding off on buying or selling because the market isn’t right for it

Question 15

Sensitivity analysis

Answer 15

Used to understand how changes in key assumptions effect the outcome of the model.