Capital Investment Appraisal

Question 1

What is capital budgeting?

Answer 1

The decision-making process for accepting or rejecting projects

Question 2

What is the NPV method of appraisal?

Answer 2

It uses discounted cash flows to evaluate capital investment projects

Question 3

What does the NPV method do?

Answer 3

It compares the present value of all cash flows with the present value of all cash outflows

Question 4

What are the key attributes of NPV?

Answer 4

It uses cash flows, it uses all the cash flows of the project, and it discounts the cash flows properly

Question 5

What happens if the NPV is greater than 0?

Answer 5

The project should be accepted

Question 6

What happens if the NPV is less than 0?

Answer 6

The project should be rejected

Question 7

What are weaknesses of NPV?

Answer 7

There is a single market rate of interest for both borrowing and lending, an individual can borrow or lend any amount of money at that rate, there are no transaction costs or taxes, and investors are rational

Question 8

What are disadvantages of NPV?

Answer 8

Project cash flows may be difficult to estimate, accepting all projects with positive NPV only possible in a perfect capital market, cost of capital may be difficult to find, and cost of capital may change over project life, rather than being constant

Question 9

What is the payback period method of project appraisal?

Answer 9

It calculates the length of time required for the stream of cash inflows from the project to equal the original outlay

Question 10

What happens if the payback period is less than the benchmark?

Answer 10

The project should be accepted

Question 11

What happens if the payback period is greater than the benchmark?

Answer 11

The project should be rejected

Question 12

What are the problems with the payback period?

Answer 12

The timing of cash flows within the payback period, payments after the payback period, and arbitrary standard for payback period

Question 13

What are the advantages of payback period?

Answer 13

Very small scale investments, firms with severe capital rationing, and exceptionally simple to understand

Question 14

What could be used instead of the payback period?

Answer 14

The discounted payback period

Question 15

Why was the discounted payback period established?

Answer 15

Due to some of the disadvantages of the payback period method

Question 16

What happens if the discounted payback period is less than the benchmark?

Answer 16

The project should be accepted

Question 17

What happens if the discounted payback period is greater than the benchmark/?

Answer 17

The project should be rejected

Question 18

What are the strengths of the discounted payback period?

Answer 18

Simple and uses time value of money

Question 19

What are the weaknesses of the discounted payback period?

Answer 19

It ignores cash flows beyond the benchmark, and the arbitrary benchmark

Question 20

What is the average accounting return method?

Answer 20

It is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life

Question 21

What happens if the average accounting return is greater than the target return?

Answer 21

The project should be accepted

Question 22

What happens if the average accounting return is less than the target return?

Answer 22

The project should be rejected

Question 23

What is net income?

Answer 23

Net cash flow minus depreciation and taxes

Question 24

What are the strengths of the average accounting return?

Answer 24

Simple return-based measure

Question 25

What are the weaknesses of the average accounting return?

Answer 25

Does not use cash flows or time value of money, arbitrary target rate, and it does not work with the right raw materials

Question 26

What is the internal rate of return?

Answer 26

it is the discount rate, which, when applied to the future cash flows of a project will produce an NPV of 0

Question 27

What does the internal rate of return represent?

Answer 27

It represents the yield from an investment opportunity, and it represents the average percentage return on the investment, taking account of the fact that cash may be flowing in and out of the project at various points in time

Question 28

What happens if the internal rate of return is greater than discount rate?

Answer 28

The project should be accepted

Question 29

What happens if the internal rate of return is less than the discount rate?

Answer 29

The project should be rejected

Question 30

What is an independent project?

Answer 30

One whose acceptance or rejection is independent of the acceptance or rejection of other projects

Question 31

What is a mutually exclusive project?

Answer 31

You can accept a or you can accept B or you can reject both of them, but you cannot accept both of them

Question 32

What are the problems with the IRR approach?

Answer 32

Investing or financing? and, multiple rates of return

Question 33

What is the IRR problem specific to mutually exclusive projects?

Answer 33

The scale problem and timing problem

Question 34

Where does IRR go wrong?

Answer 34

It ignores the issue of scale and ignores the timing of cash flows

Question 35

What is the general rule with mutually exclusive investments?

Answer 35

To avoid issues such as timing and scale, use incremental NPV or incremental IRR

Question 36

What is the probability index?

Answer 36

It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment

Question 37

What is capital rationing?

Answer 37

It occurs when there is not enough cash to invest in all positive NPV projects