Capital Budgeting

Question 1

Steps of cost-benefit analysis

Answer 1

1. Specify alternative projects
2. decide whos beneftis and costs count
3. Identify all relevant costs and benefits of the alternative projects
4. predict quantitatively (in $) costs and benefits over the life of the project
5. Discount benefits and costs to obtain present values
6. Compute the net present value (NPV) of each alternative
7. Perform sensitiviy analysis
8. Make recommendations.

Question 2

Discount rate/rate of interest/minimum acceptable rate of return (MAR) allows us to…

Answer 2

bridge time in comparing values.

Question 3

Simple discount rate formula

Answer 3

PV=FV/(1+n)

Question 4

Real vs Nominal dollars

Answer 4

Nominal dollars are actual price of a good or service.

Real dollars are net of inflation price.

Question 5

Consumer Price Index CPI

Answer 5

• measures inflation

- calculated by price levels increase or decrease for households

Question 6

Real price formula

Answer 6

RP= (Nominal price/price index)* Base of price index

Question 7

Real price calculation e.g
Base CPI (of 2011)=100
1980: $35, CPI=26.8
2014: $100, CPI=105.2

Answer 7

1980: 35/26.8*100 =

2014 100/105.2*100=

Question 8

Real discount rate formula

Answer 8

r=n-p (n= nominal interest rate, p= inflation rate)

Question 9

PV of a single sum formula

Answer 9

V0=Vn/(1+r)^n

Question 10

PV of perpetual annuity

Answer 10

V0=a/r

Question 11

PV of perpetual periodic series

Answer 11

V0=Vt/((1+r)^t -1)

Question 12

PV e.g:
Revenue per t years (Vt)=$100,000/ha
Planting Costs(Cp)=$1000/ha
Annual management costs (m)=$100/ha/y
r=8%
t= 40y

Answer 12

Vo=(Vt-Cp/((q+r)^t-1))-(m/r)-Cp

Question 13

What is a discount rate

Answer 13

opportunity cost of capital (i.e where else could you be putting your money)

Question 14

NPV

Answer 14

PV of revenues minus PV of costs

Question 15

NPV decision rule

Answer 15

• result >= 0, project is desirable (NPV of 0 = no return)

- if comparing projects, highest NPV is most desirable

Question 16

Internal rate of return (IRR)

Answer 16

the discount rate at which the present value of the revenues equals the present value of the costs
- discount rate where NPV = 0

Question 17

B/C ratio

Answer 17

present value of the benefits divided by present value of the costs
- project is acceptable if B/C = 1 (same as NPV=0)

Question 18

Payback period

Answer 18

• time it takes to recover invested capital
• shorter period desirable
• disadvanage: doesn’t consider NPV or IRR

Question 19

Challenges to ranking projects:

Answer 19

• assumption of reinvestment of income earned before end of project at the IRR of the project
• NPV criterion can hide amount of capital required in a project (e.g $1M investment @IRR=6.5 vs $10k inv. @IRR=20% and MAR is ^% then NPV of inv. 1 is higher)
• Unequal investment durations: to compare, put on same time period (i.e 10y project x3 to match 30y project)