Capital budgeting

Question 1

What does it mean to have a benefit-cost ratio greater than 1?

Answer 1

It means that the present value of benefits is greater than the present value of costs

Question 2

You have to recommend one alternative from two or more alternatives. If your recommendation has to be based on the benefit-cost ratio, you would select the alternative with:

Answer 2

The highest benefit-cost ratio

Question 3

One principal reason to finance capital improvement by borrowing instead of paying from resources on hand is

Answer 3

Borrowing helps to distribute costs across generation and future residents
Debt is usually less expensive than giving up equity
Debt can be cheaper than your opportunity cost.
Paying interest on debt reduces tax burden

Question 4

Governments use debt financing to

Answer 4

Cover deficits of annual expenditures

Question 5

State and local governments use many different debt instruments because:

Answer 5

They sometimes seek to evade statutory or constitutional debt limits

Question 6

Revenue bonds are backed by the

Answer 6

The specific revenues generated by the project being financed

Question 7

What is capital budgeting?1

Answer 7

Capital budgeting is the process by which capital budgets become planning and policy instruments used by states and local governments in guiding investment in long-life fixed assets

Question 8

What is capital budgeting?

Answer 8

the process used to evaluate and determine potential expenses or investments in large projects such as:

1) building a new plant
2) investing in a long-term venture
3) buying another company

Question 9

What is the payback period approach?

Answer 9

length of time required to recover the cost of an investment

Question 10

What are two advantages of used the payback period?

Answer 10

1) useful in evaluating project liquidity

2) short payback period reduces uncertainty

Question 11

What are two disadvantages of using the payback period?

Answer 11

1) ignores TVM

2) does not measure total project profitability

Question 12

How do you calculate the payback period?

Answer 12

years = initial investment / ANNUAL after-tax net cash flow (or savings)

Question 13

How do you calculate the ANNUAL after-tax net cash flow?

Answer 13

CF - cash expenses + non-cash expenses

Question 14

How does depreciation affect ANNUAL after-tax net cash flow?

Answer 14

its ignored (i.e. added back) to the extent depreciation expense is tax deductible which is called a tax shield

Question 15

How do you calculate the tax shield for depreciation?

Answer 15

tax shield is ADDED back to ANNUAL after-tax net cash flow

= depreciation expense x tax rate %

Question 16

Does the residual value affect considered in the payback period approach?

Answer 16

no, its ignored

Question 17

What is the internal rate of return (IRR) approach and why is it used?

Answer 17

1) discount rate at which an investments NPV of all cash flows equals zero
2) to evaluate the attractiveness of a project or investment

Question 18

What is the advantages of using the IRR?

Answer 18

takes into account a projects total profitability by discounting all projected CF using the hurdle interest rate

Question 19

What are three disadvantages of using the IRR?

Answer 19

) requires estimation of CF over the entire life of project, which could be very long

2) requires all CF be either inflows or outflows
3) assumes CF from the project are immediately reinvested at the project’s IRR

Question 20

What is the IRR compared to in order to determine if a project should be accepted or not?

Answer 20

hurdle rate

Question 21

What is the hurdle rate?

Answer 21

the lowest acceptable rate of return on investment (aka the cost of capital)

Question 22

What is the accounting rate of return approach? (ARR)

Answer 22

measures expected annual accounting income from a project as a percentage of the initial (or average) investment

Question 23

What is the net present value approach? (NPV)

Answer 23

difference between PV of cash inflows and PV of cash outflows (typically the investment made today)

Question 24

What are two advantages of using the NPV?

Answer 24

1) relates project rate of return to cost of capital

2) considers the entire life and results of project

Question 25

What are two disadvantages of using the NPV?

Answer 25

1) requires estimation of CF over entire life of the project, which could be very long
2) assumes cash flows are immediately reinvested at the discount rate

Question 26

How do you calculate the NPV?

Answer 26

PV of future cash inflows - initial investment (or PV or future cash outflows)

Question 27

used to rank projects because it allows you to quantify the amount of value created per unit of investment

Answer 27

profitability index (PI)

Question 28

How do you calculate the PI when using the PV of future cash flows?

Answer 28

PV of cash inflows/project cost

Question 29

How do you calculate the PI when using the NPV?

Answer 29

NPV / project cost

Question 30

the discount rate refers to the

Answer 30

interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.

Question 31

What effect does a higher discount rate on the time value of money?

Answer 31

Future cash flows are discounted at the discount rate, and so the higher the discount rate the lower the present value of the future cash flows. Similarly, a lower discount rate leads to a higher present value.

Question 32

the discount rate is higher

Answer 32

money in the future will be “worth less”, or have lower purchasing power, than dollars do today.

Question 33

How do you choose the appropriate discount rate?

Answer 33

1. Use the opportunity cost
2. Use its weighted average cost of capital (WACC)
3. used the historical average returns of an asset or project similar to the one being analyzed

Question 34

Use the opportunity cost

Answer 34

Individuals should use the opportunity cost of putting their money to work elsewhere as an appropriate discount rate - simply put, it’s the rate of return the investor could earn in the marketplace on an investment of comparable size and risk

Question 35

Cost of capital

Answer 35

is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm’s cost of debt and cost of equity blended together.

Question 36

weighted average cost of capital (WACC).

Answer 36

Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the weighted average cost of capital (WACC).

Question 37

Earning Potential

Answer 37

Earning potential refers to the potential gains from dividend payments and capital appreciation shareholders might earn from holding a stock. In other words, it reflects the largest possible profit that a corporation can make. It is often passed on to investors in the form of dividends.
earnings per share (EPS), return on assets (ROA) or return on equity (ROE) basis.

Question 38

Discounted Cash Flow (DCF)

Answer 38

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

Question 39

Cash Flow

Answer 39

Cash flows are the net amount of cash and cash-equivalents being transferred into and out of a business. Cash received are inflows, and money spent are outflows.

Question 40

FCF

Answer 40

Free cash flow is the cash that a company generates from its normal business operations after subtracting any money spent on capital expenditures.