Chapter 10: Capital Budgeting

Question 1

The reason for and the process of capital budgeting

Answer 1

• Capital budgeting decisions are the most important investment decisions made by management
• The objective of these decisions is to select investments in productive assets that will increase the value of the firm
• These investments create value when they are worth more than they cost
• Capital investments are important because they can involve substantial cash outlays and, once made, are not easily reversed
• They also define what the company is all about—the firm’s lines of business and its inherent business risk. For better or worse, capital investments produce most of a typical firm’s revenues for years to come

Question 2

capital budgeting defintion

Answer 2

• the process of choosing the productive assets in which the firm will invest

Question 3

cost of capital concept

Answer 3

the required rate of return for a capital investment

Question 4

capital rationing concept

Answer 4

• a situation where a firm does not have enough capital to invest in all attractive projects and must therefore ration capital

Question 5

independent projects

Answer 5

projects whose cash flows are unrelated

(accepting or rejecting one project does not eliminate other projects from consideration (assuming the firm has unlimited funds to invest))

Question 6

mutually exclusive projects

Answer 6

projects for which acceptance of one precludes acceptance of the other
- (pick which has the higher NPV)

(Typically, mutually exclusive projects perform the same function, and thus only one project needs to be accepted)

Question 7

Net Present Value (NPV) concept

Answer 7

• a method of evaluating a capital investment project that measures the difference between its cost and the present value of its expected cash flows
• taking the cost (subtract) rom the present value, you get your net present value
• essentially revenues (-) expenses

(and it is one of the most basic analytical methods underlying corporate finance.
The NPV method tells us the amount by which the benefits from a capital expenditure exceed its costs
It is the capital budgeting technique recommended in this book)

Question 8

NPV decision rule

Answer 8

NPV > 0 Accept the project
NPV < 0 Reject the project

Question 9

payback period concept

Answer 9

• the length of time required to recover a project’s initial cost aka breaking even

(The payback period is one of the most widely used tools for evaluating capital projects.
The payback period is defined as the number of years it takes for the cash flows from a project to recover the project’s initial investment.
With the payback method for evaluating projects, a project is accepted if its payback period is below some specified threshold.
Although it has serious weaknesses, this method does provide some insight into how quickly a firm will recover the cash that has been invested in a project)

Question 10

Internal Rate of Return (IRR) concept

Answer 10

• what the company requires for a project to make sense (what they deem they need to return on th investment to make the investment worth it)