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Financial Management > Chapter 11 Capital Budgeting > Flashcards

Chapter 11 Capital Budgeting Flashcards

1
Q

It is a process a company takes whether to accept or reject a project.

A

Capital Budgeting

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2
Q

Capital Budgeting is a process of planning expenditures on assets with :

A

cash flows that are expected to extend beyond 1 year.

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3
Q

Capital budgeting uses same concept with security valuations except :

A

securities exists in the securities market while capital projects are created by the firm.

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4
Q

In securities, investors has no influence on the cash flow produced while in capital projects :

A

the firm has major influence on the results.

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5
Q

In similarities, securities and capital project both :

A

forecast set of cashflows and find the present value.

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6
Q

It is a long-run plan that outlines in broad terms the firm’s basic strategy for the next 5 to 10 years.

A

Strategic Business Plan

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7
Q

2 phases of Typical Capital Budgeting Process

A

Phase 1: The firm’s management identifies promising investment opportunities.
Phase 2: Once an investment opportunity has been identified, its value-creating potential—what some refer to as its value proposition—is thoroughly evaluated.

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8
Q

3 Types of Capital Investment Projects

A
  1. Revenue-enhancing investments
  2. Cost-reducing investments
  3. Mandatory investments that are a result of government mandates
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9
Q

7 Categories of Capital Projects

A

1.Replacement: needed to continue current operations
2.Replacement: cost reduction
3.Expansion of existing products or markets
4.Expansion into new products or markets
5.Safety and/or environmental projects
6.Other projects
7.Mergers

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10
Q

This category consists of expenditures to replace worn-out or damaged equipment required in the production of profitable products.

A

Replacement: needed to continue current operations

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11
Q

This category includes expenditures to replace serviceable but obsolete equipment and thereby to lower costs. These decisions are discretionary, and a fairly detailed analysis is generally required.

A

Replacement: cost reduction

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12
Q

These are expenditures to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served.

A

Expansion of existing products or markets

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13
Q

The expansion of existing products or markets is more complex because :

A

they require an explicit forecast of growth in demand, so a more detailed analysis is required.

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14
Q

These investments relate to new products or geographic areas, and they involve strategic decisions that could change the fundamental nature of the business. Invariably, a detailed analysis is required, and the final decision is generally made at the top level of management.

A

Expansion into new products or markets

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15
Q

Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms fall into this

A

Safety and/or environmental projects

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16
Q

This catch-all includes items such as office buildings, parking lots, and executive aircraft. How they are handled varies among companies.

A

Other projects

17
Q

Buying a whole firm is different from buying an asset such as a machine or investing in a new airplane, but the same principles are involved.

A

Mergers

18
Q

7 Criteria for Deciding to Accept or Reject a Project

A
  1. Net present value (NPV)
  2. Equivalent Annual Expense
  3. Internal rate of return (IRR)
  4. Modified internal rate of return (MIRR)
  5. Regular payback
  6. Discounted payback
  7. Profitability Index
19
Q

It is a method of ranking investment proposals , which is equal to the present value of the project’s free cash flows discounted at the cost of capital.

A

Net Present Value (NPV)

20
Q

This represents the net amount of cash that is available for all investors after taking into account the necessary investments in fixed assets (capital expenditures) and net operating working capital.

A

Free cash flow

21
Q

Project with cash flows that are not affected by the acceptance or non acceptance of other projects.

A

Independent Projects

22
Q

A set of projects where only one can be accepted.

A

Mutually Exclusive Projects

23
Q

If they have the same useful life, we simply calculate the NPV and choose the one with the higher NPV.

A

Choosing Between Mutually Exclusive Investment

24
Q

For investment with different useful life, and we consider the replacement cost of each equipment, we must calculate the :

A

Equivalent Annual Cost (EAC)

25
Q

This is a budgeting technique that provides an estimate of the annual cost of owning and operating the investment over its lifetime.

A

Equivalent Annual Cost (EAC) Capital

26
Q

The discount rate that forces a project’s NPV to equal zero.

A

Internal Rate of Return (IRR)

27
Q

A project’s IRR is the discount rate that :

A

forces the PV of its inflows to equal its cost.

28
Q

The IRR is an estimate of the :

A

project’s rate of return, and it is comparable to the YTM on a bond.

29
Q

3 Method in Finding IRR for a Project

A
  1. Trial and Error
  2. Calculator Solution
  3. Excel Solution
30
Q

The discount rate at which the present value of a project’s cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm’s cost of capital.

A

Modified IRR (MIRR)

31
Q

The length of time required for an investment’s cash flows to cover its cost.

A

Payback Period

32
Q

3 Disadvantages of Payback Period

A

1.All dollars received in different years are given the same weight
2.Cash flows beyond the payback year are given no consideration regardless of how large they might be.
3.The payback merely tells us when we will recover our investment.

33
Q

The length of time required for an investment’s cash flows, discounted at the investment’s cost of capital, to cover its cost.

A

Discounted Payback

34
Q

The discounted payback period approach is similar to that of the traditional payback period except that :

A

it uses discounted cash flows to calculate the payback period.

35
Q

The discounted payback period is defined as the :

A

number of years needed to recover the initial cash outlay from the discounted cash flows.

36
Q

It is a cost-benefit ratio equal to the present value of an investment’s future cash flows divided by its initial cost.

A

The profitability index (PI)

37
Q

A PI greater than 1 indicates that the present value of the investment’s future cash flows exceeds the :

A

cost of making the investment, so the investment should be accepted.

Financial Management (2 decks)

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