Capital Investment Decisions

Question 1

capital budgeting

Answer 1

the process of identifying, analyzing, and selecting investments in long-term projects

Question 2

capital budgeting applications include

Answer 2

-buying equipment
-building facilities
-acquiring a business
-developing a product or product line
-expanding into new markets

Question 3

stages in capital budgeting

Answer 3

1. identification and definition (most difficult)
2. search
3. information-acquisition: financial and nonfinancial measures are analyzed
4. selection: using models such as NPV, IRR
5. financing
6. implementation and monitoring

Question 4

steps in ranking potential investments

Answer 4

1. determine the asset cost or net investment
2. calculate estimated cash flows
3. relate the cash-flow benefits to their cost
4. rank the investments

Question 5

what is a firm’s hurdle rate

Answer 5

the minimum rate of return on a project or investment that an investor is willing to accept

Question 6

what are the three categories of relevant cash flows

Answer 6

1. net initial investment
2. annual cash flows
3. project termination cash flows

Question 7

depreciation tax shield

Answer 7

depreciation expense x tax rate

Question 8

components of net initial investment

Answer 8

-cost of new equipment
-initial working capital requirements
-after-tax proceeds from disposal of old equipment

Question 9

components of annual net cash flows

Answer 9

-after-tax cash collections form operations (not including depreciation)
-tax savings from deprecation deductions (depreciation tax shield)

Question 10

components of project termination cash flows

Answer 10

-after tax proceeds from disposal of new equipment
-recovery of working capital (untaxed)

Question 11

if the NPV of a project is positive

Answer 11

the project is desirable because it has a higher rate of return than the company’s desired rate

Question 12

the internal rate of return

Answer 12

expresses a project’s return in percentage terms

the discount rate at which the investment’s NPV equals zero

Question 13

if the IRR is higher than the company’s rate of return

Answer 13

the project is desirable

Question 14

disadvantages of IRR

Answer 14

-direction of cash flows
-mutually exclusive projects
-varying rates of reutrn
-multiple investments

Question 15

payback period

Answer 15

the number of years required to return the original investment

no accounting is made for the time value of money

Question 16

if the cash flows are constant, the payback period formula is

Answer 16

initial net investment / annual expected cash flow

Question 17

discounted payback method

Answer 17

used to account for the time value of money

Question 18

profitability index

Answer 18

PV of future cash flows / net investment

Question 19

if the profitability index is greater than 1

Answer 19

the project should be accepted

the required rate of return must be less than the IRR

Question 20

when the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to

Answer 20

discount each cash flow using a discount rate that reflects the degree of risk

Question 21

A treasurer is in the process of determining whether she should invest a portion of her company’s pension plan assets in a publicly traded company. The treasurer has collected the following information on the company:
Current-year dividend = $1.50
Yearly dividend increase = 5%
Expected investor return = 10%
Current share price = $25.00
On the basis of the information provided above, the treasurer is justified in concluding that an investment in the company

Answer 21

Should be profitable if assumptions hold true.

The investment is projected to earn a good return, and the dividend is expected to grow from year to year. If these hold true, then the investment should be profitable.

Question 22

The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net present value method (NPV) may be different when

Answer 22

multiple projects have unequal lives and the size of the investment for each project is different

The two methods ordinarily yield the same results, but differences can occur when the duration of the projects and the initial investments differ. The reason is that the IRR method assumes cash inflows from the early years will be reinvested at the internal rate of return. The NPV method assumes that early cash inflows are reinvested at the NPV discount rate.

Question 23

A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is

Answer 23

sensitivity analysis

Question 24

what statement is correct regarding the net present value (NPV) and the internal rate of return (IRR) approaches to capital budgeting?

Answer 24

if the IRR of a project is equal to the company’s cost of capital, the NPV must be zero.

Question 25

What is the most satisfactory method of evaluating competing capital projects

Answer 25

NPV

Question 26

If a project costing $50,000 and returning 14,000 per year for 5 years, what statement is true

Answer 26

IRR is greater than 10%

The total cash inflows are only $70,000 (5 × $14,000). Thus, whatever the discount rate, the NPV will be less than $20,000 ($70,000 – $50,000). The return in the first year is $14,000, or 28% of the initial investment. Since the same $14,000 flows in each year, the IRR is going to be greater than 10% (actually, it is almost 14%).

Question 27

What is an advantage of using the payback method for capital budgeting?

Answer 27

more liquid projects are rated higher

Question 28

Assume that an investment project’s assumed cash flows are not changed, but the assumed weighted-average cost of capital is reduced. What impact would this have on the net present value (NPV) and the internal rate of return (IRR) of this project?

Answer 28

NPV would increase, and IRR would not change.