Capital Budgeting

Question 1

Relevant Cash Flows

Answer 1

cost of new equipment, after-tax cash savings/inflows, proceeds from disposal of old equipment (salvage value), depreciation on new equipment

Question 2

Accounting Rate of Return

Answer 2

annual increase in net income / required investment

annual cash inflow - depreciation / initial investment

Question 3

Payback Period

Answer 3

initial investment / annual after-tax savings (cash inflow)

Question 4

Net Present Value

Answer 4

the difference between the present value of the net cash savings or inflows expected over the life of the project and the required investment

Question 5

NPV Calculation

Answer 5

(-1 * initial investment) + [cash flow year 1/(1 + r)^1 + cash flow year 2/(1+r)^2 + cash flow year 3/(1+r)^3 … ]

Question 6

Internal Rate of Return

Answer 6

hurdle rate or break-even point; the discount rate at which the investment’s NPV equals zero; equates the present value of the expected cash inflows with the present value of the expected cash outflows

Question 7

Profitability Index

Answer 7

present value of future cash flows / initial investment

NPV / initial investment

Question 8

Comparing NPV and IRR

Answer 8

NPV and IRR give the same accept/reject decision if projects are independent, but differ when projects are mutually exclusive

Question 9

Lease

Answer 9

a long-term contract in which the owner of property (the lessor) allows another party (the lessee) the right to use the property for a stated period in exchange for a stated payment

Question 10

Service/Operating Lease

Answer 10

usually include both financing and maintenance services

Question 11

Financial Leases

Answer 11

do not provide for maintenance services, are noncancelable, and fully amortize the cost of the leased asset over the term

Question 12

Sale-Leaseback

Answer 12

allows a firm to acquire capital from the sale of an asset while retaining the use of the asset

Question 13

Capital Lease

Answer 13

the purchase of an asset and should be treated as a purchase

Question 14

Capital Lease Criteria

Answer 14

title passes to the lessee and the end of the lease
lease contains a bargain purchase option
the PV of the lease paymets equals 90% or more of the fair value of the leased property
the lease term is 75% or more of the usual economic life of the property

Question 15

Operating Lease

Answer 15

accounted for as a rental contract; no accounting entry is made to record the lease, payments are expensed as incurred