Capital Budgetting

Question 1

Capital Budgetting

Answer 1

Evaluate project on CF implications because firm exists to make money for the shareholder

Question 2

Conventional project

Answer 2

cash outflow followed by inflow

Question 3

Loan project

Answer 3

cash inflow followed by outflow

Question 4

Payback

Answer 4

How long it takes for the cash inflows to equal cash outflows

Question 5

Discounted Payback

Answer 5

where PV of inflows = outflows

Question 6

NPV

Answer 6

sum of PV of all investment cash flows

Question 7

NPV > 0

Answer 7

accept

PV inflow > PV outflow

suggests that we cash inflows can offset the cash outflow but still have $ remaining for shareholders

Project earns more than discount rate

Question 8

NPV and stock price

Answer 8

stock price change: NPV / shares outstanding

Question 9

Discount rate

Answer 9

opportunity cost for shareholder, what external projects earn

Question 10

Hurdle rate

Answer 10

synonymous with discount rate

Question 11

IRR - conventional

Answer 11

return per period if you get projected CFs

discount rate where NPV is 0

IRR > d - accept because NPV is positive
IRR < d - reject, NPV is negative

Question 12

IRR in bond terms

Answer 12

yield to maturity

Question 13

Discount rate and risk

Answer 13

high risk high discount rate

risk is the uncertainty of the cash flow

Question 14

Profitability Index

Answer 14

PV of cash inflow / PV cash outflow

if it is greater than 1, accept the project as it implies high value of cash inflow

Question 15

Loan Projects (NPV, IRR, etc)

Answer 15

NPV slopes up

y-intercept: sum of project cash flows

Question 16

Loan - IRR

Answer 16

Cost per period

IRR > d - reject
IRR < d - accept

Question 17

Loan Discount Rate

Answer 17

return for a given risk

Question 18

Payback advantage

Answer 18

1. Easy to understand
2. Provides a control
3. Biased towards liquidity

Question 19

Payback Disadvantage

Answer 19

1. Ignores TVM
2. Ignores CF beyond payback period
3. Biased against long-term projects

Question 20

Discounted payback period advantage

Answer 20

1. Includes TVM
2. Easy to understand
3. No negative NPV investments / biased to liquidity

Question 21

Discounted payback period disadvantage

Answer 21

1. Reject some good positive NPV projects
2. Ignores CF beyond the cutoff date
3. Biased against long term projects

Question 22

AAR Advantages

Answer 22

1. Easy calculation

2. Have requisite info

Question 23

AAR Disadvantages

Answer 23

1. No TVM
2. Doesn’t use CFs
   3, Arbitrary cutoff date

Question 24

Profitability Index Advantages

Answer 24

1. Related to NPV
2. Intuitive aspect
3. Good in times of low funds

Question 25

Profitability Index Disadvantage

Answer 25

Similar to IRR can be misleading and make you pick wrong investment

Question 26

IRR Disadvantage

Answer 26

1. Same project can have multiple IRRs
2. Need to choose a hurdle / discount rate
3. Can’t be used for mutually exclusive projects
4. Adds nothing to NPV

Question 27

IRR Advantage

Answer 27

Intuitive aspect and uses TVM