Capital Budgeting

Question 1

Define “capital budgeting”.

Answer 1

The process of measuring, evaluating, and selecting long-term investment opportunities, primarily in the form of projects or programs.

Question 2

Define “risk”.

Answer 2

The possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes.

Question 3

Give examples of risk associated with investments in capital projects.

Answer 3

1. Incomplete or incorrect analysis of a project;
2. Unanticipated actions of customers, suppliers and competitors;
3. Unanticipated changes in laws, regulations, etc.;
4. Unanticipated macroeconomic changes (e.g., interest rates, inflation/deflation, tax rates, currency exchange rates, etc.).

Question 4

Describe the risk/reward relationship.

Answer 4

The greater the perceived risk of an undertaking, the higher the expected reward from the undertaking.

Question 5

Define “risk-free rate of return”.

Answer 5

The rate of return expected solely for the deferred current consumption that results from making an investment; rate of return expected assuming virtually no risk. In the US it is measured by the rates paid on United States Treasury obligations.

Question 6

Define “risk premium”.

Answer 6

The rate of return expected above the risk-free rate based on the perceived level of risk inherent in an investment/undertaking.

Question 7

Describe the relationship between a firm’s capital projects and the firm’s capital that funds those projects.

Answer 7

The rate of return earned on a firm’s capital projects must be equal or greater than the rate of return required to attract and maintain investors’ capital.

Question 8

Identify five different techniques for evaluating capital budgeting projects.

Answer 8

1. Payback period approach;
2. Discounted payback period approach;
3. Accounting rate of return approach;
4. Net present value approach;
5. Internal rate of return approach.

Question 9

Describe the payback period approach to project evaluation.

Answer 9

Determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. Uses undiscounted expected future cash flows.

Question 10

Identify the advantages of the payback period approach to project evaluation.

Answer 10

1. Easy to use and understand;
2. Useful in evaluating liquidity of a project;
3. Use of a short payback period reduces uncertainty.

Question 11

Identify the disadvantages of the payback period approach to project evaluation.

Answer 11

1. Ignores the time value of money;
2. Ignores cash flows received after the payback period;
3. Does not measure total project profitability;
4. Maximum payback period may be arbitrary.

Question 12

Under what circumstances would the payback period approach to project evaluation be most appropriate?

Answer 12

1. When used as a preliminary screening technique;

2. When used in conjunction with other evaluation techniques.

Question 13

Identify a technique that is intended to rank capital budgeting projects in terms of desirability.

Answer 13

The profitability index (PI).

Question 14

Describe the discounted payback period approach to capital budgeting evaluation.

Answer 14

A variation of the payback period approach that takes the time value of money into account by discounting expected future cash flows.

Question 15

Identify the advantages of the discounted payback period approach to capital budgeting evaluation.

Answer 15

1. Easy to use and understand;
2. Uses time value of money approach;
3. Useful in evaluating liquidity of a project;
4. Use of a short payback period reduces uncertainty.

Question 16

Identify the disadvantages of the discounted payback period approach to capital budgeting evaluation.

Answer 16

1. Ignores cash flows received after the payback period;
2. Does not measure total project profitability;
3. Maximum payback period may be arbitrary.

Question 17

Will the payback period from using the discounted payback period approach be longer or shorter than using undiscounted payback period approach (to capital budgeting)?

Answer 17

The discounted payback period will be longer than the undiscounted payback period because the present value of cash flows will be less than the undiscounted values.

Question 18

Describe the accounting rate-of-return (also called the simple rate of return) approach to capital project evaluation.

Answer 18

Measures the expected average annual incremental accounting income from a project as a percent of the initial (or average) investment and compares that with established minimum rate required.

Question 19

What are the advantages of the accounting rate-of-return approach to project evaluation?

Answer 19

1. Easy to use and understand;
2. Consistent with financial statement values;
3. Considers entire life and results of project.

Question 20

What are the disadvantages of the accounting rate-of-return approach to project evaluation?

Answer 20

1. Ignores the time value of money;

2. Uses accrual accounting values, not cash flows.

Question 21

What alternative investment bases can be used in the accounting rate-of-return approach (to capital budgeting)?

Answer 21

Two alternative investment bases may be used:

1. Initial investment;
2. Average investment (i.e., the average book value of the asset over its life).

Question 22

In computing the accounting rate-of-return approach (to capital budgeting), will using the Initial Investment or the Average Investment give the higher rate of return?

Answer 22

Because the average investment gives a smaller denominator, the accounting rate of return will be higher when the average investment is used, rather than when the initial investment is used.

Question 23

Describe the net-present-value approach to capital project evaluation.

Answer 23

Compares present value of expected cash flows of project with initial cash investment in project.

Derived by discounting future cash flows (or savings) and determining whether or not the resulting present value is more or less than the cost of the investment.

Question 24

Identify the advantages of the net-present-value approach to capital project evaluation.

Answer 24

1. Uses time value of money concept;
2. Relates project rate of return to cost of capital;
3. Considers entire life and results of project;
4. Easier to compute than internal rate of return approach

Question 25

Identify the disadvantages of the net-present-value approach to capital project evaluation.

Answer 25

Requires estimation of cash flows over entire life of the project, which could be very long.

Assumes cash flows are immediately reinvested at the discount rate.

Question 26

How is the Net Present Value determined?

Answer 26

How is the Net Present Value determined?

Question 27

Using the net-present-value approach (to capital budgeting), under what conditions would a project be considered economically feasible?

Answer 27

If the Net Present Value is zero or positive, the project is considered economically feasible; otherwise, the project is not considered economically feasible

Question 28

Describe the internal rate of return (also called time adjusted rate of return) approach to capital project evaluation.

Answer 28

Evaluates a project by determining the discount rate that equates the present value of a project’s cash inflows with the present value of the project’s cash outflows.

Question 29

Identify the advantages of the internal-rate-of-return approach to capital project evaluation.

Answer 29

1. Recognizes the time value of money;

2. Considers the entire life and results of the project

Question 30

Identify the disadvantages of the internal-rate-of-return approach to capital project evaluation

Answer 30

1. Difficult to compute;
2. Requires estimation of cash flows over entire life of project, which could be very long;
3. Requires all future cash flows be in the same direction, either inflows or outflows;
4. Assumes cash flows resulting from the project are immediately reinvested at the project’s internal rate of return.

Question 31

Compare the internal-rate-of-return (IRR) approach with the net-present-value (NPV) approach (to capital budgeting).

Answer 31

The IRR Approach computes the discount rate that would make the present value of a project’s cash inflows and outflows equal to zero;

The NPV Approach uses an assumed discount rate to determine whether or not the present value of a project’s cash inflows and outflows is positive or not.

Question 32

Under what conditions is the internal-rate-of-return approach (to capital budgeting) not appropriate?

Answer 32

When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.

Question 33

Describe the profitability index (also called cost/benefit ratio or present value index).

Answer 33

Ranks projects by taking into account both the net present value of each project and the cost of each project; computed as: PI = NPV/Project Cost.

Question 34

When using the profitability index, how are projects ranked relative to each other?

Answer 34

The projects are ranked according to the computed Profitability Index (i.e., NPV/Project Cost) for each for each project; the higher the PI, the higher the rank of the project.

Question 35

Will the profitability index and the net-present-value approach (to capital budgeting) result in the same ranking of multiple projects?

Answer 35

No. Since the Net Present Value Approach does not explicitly consider the differences in initial cost of one project compared to another project, it does not give the same ranking as the Profitability Index, which considers both the Net Present Value and the initial cost of the project by getting an NPV per dollar invested.

Question 36

Describe the concept of capital rationing.

Answer 36

Limiting the number of economically feasible projects that are undertaken and selecting those that will be undertaken.

Question 37

Give three reasons for capital rationing.

Answer 37

1. Insufficient funds to undertake all economically feasible projects;
2. Insufficient management capacity to take on all economically feasible projects;
3. Perceived instability in the market/economy.

Question 38

In what circumstance might the use of the payback period approach be useful in ranking capital projects?

Answer 38

When liquidity issues are a major concern in selecting from a set of projects.

Question 39

In ranking economically feasible projects, what is the primary shortcoming of the net-present-value approach?

Answer 39

It fails to take into account differences in the initial cost of economically feasible projects. Each project is evaluated independently of each other project, therefore differences in initial cost among projects is not considered.

Question 40

What is the preferred method of ranking economically feasible projects?

Answer 40

The Profitability Index, which takes into account both the Net Present Value and the initial cost of each project.