Chapter 13

Question 1

capital budgeting

Answer 1

The process of planning expediters on assets whose cash flows are expected to extend beyond one year.

Question 2

replacement decisions

Answer 2

Decisions about whether to purchase capital assets to take the place of existing assets so as to maintain existing operations.

Question 3

expansion decisions

Answer 3

Decisions about whether to purchase capital projects and add them to existing assets so as to increase existing operations.

Question 4

independent projects

Answer 4

Projects whose cash flows are not affected by the acceptance or nonacceptance of other projects.

Question 5

mutually exclusive projects

Answer 5

A set of projects where the acceptance of one project means that other projects cannot be accepted.

Question 6

cash flows

Answer 6

The actual cash, as opposed to accounting profits, that a firm receives or pays during some specified period.

Question 7

incremental cash flow

Answer 7

The change in a firm’s net cash flow attributable to an investment project.

Question 8

sunk cost

Answer 8

A cash outlay that already has been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.

Question 9

opportunity cost

Answer 9

The return on the best alternative use of an asset; the highest return that the firm will forgo if funds are invested in a particular project.

Question 10

externalities

Answer 10

The way in which accepting a project affects the cash flows in other parts (areas) of the firm.

Question 11

initial investment outlay

Answer 11

The incremental cash flows associated with a project that occur only at the start of a project’s life, CF0-.

Question 12

supplemental operating cash flows

Answer 12

The changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset.

Question 13

terminal cash flow

Answer 13

The net cash flow that occurs at the end of the life of a project, including the cash flows associated with 1) the final disposal of the project and 2) the return of the firm’s operations to their state prior to the project’s acceptance.

Question 14

net present value (NPV)

Answer 14

A method of evaluating the capital investment proposals by finding the present value of the net cash flows, discounted at the rate of return required by the firm.

Question 15

internal rate of return (IRR)

Answer 15

The discount rate that forces the present value of a project’s expected cash flows to equal its cost. It is similar to the yield to maturity on a bond.

Question 16

required rate of return (hurdle rate)

Answer 16

The discount rate (cost of funds) that the IRR must exceed for a project to be considered acceptable.

Question 17

traditional payback period (PB)

Answer 17

The length of time it takes to recover the original cost of an investment from the project’s expected cash flows.

Question 18

discounted payback period (DPB)

Answer 18

The length of time it takes for a project’s discounted cash flows to repay the initial cost of the investment.

Question 19

reinvestment rate assumption

Answer 19

The assumption that cash flows from a project can be reinvested 1) at the cost of capital, if using the NPV method, or 2) at the internal rate of return, if using the IRR method.

Question 20

multiple IRRs

Answer 20

The situation where a project has two or more IRRs.

Question 21

modified IRR (MIRR)

Answer 21

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 required rat of return (cost of capital).

Question 22

stand-alone risk

Answer 22

The risk that an asset would have if it were a firm’s only asset. It is measured by the variability of the asset’s expected returns.

Question 23

corporate (within-firm) risk

Answer 23

The effect a project has on the total risk of the firm. It captures the risk relationships among the assets that the firm owns.

Question 24

beta (market) risk

Answer 24

That part of a project’s risk that cannot be eliminated by diversification. It is measured by the project’s beta coefficient.

Question 25

scenario analysis

Answer 25

A risk analysis technique in which “bad” and “good” sets of financial circumstances are compared with a most likely, or a base case, situation.

Question 26

worst case scenario

Answer 26

An analysis in which all of the input variables are set at their worst reasonably forecasted values.

Question 27

best case scenario

Answer 27

An analysis in which all of the input variables are set at their best reasonably forecasted values.

Question 28

base case

Answer 28

An analysis in which all of the input variables are set at their most likely values.

Question 29

projected required rate of return (rproj)

Answer 29

The risk-adjusted required rate of return for an individual project.

Question 30

pure play method

Answer 30

An approach used for estimating the beta of a project in which a firm identifies companies whose only business is the product in question, determines the beta for each company, and then averages the betas to find an approximation of its own project’s beta.

Question 31

risk-adjusted discount rate

Answer 31

The discount rate (required rate of return) that applies to a particular risky stream of cash flows. It is equal to the risk-free rate of interest plus a risk premium appropriate to the level of risk attached to a particular project’s income stream.

Question 32

earnings repatriation

Answer 32

The process of sending cash flows from a foreign subsidiary back to the parent company.

Question 33

exchange rate risk

Answer 33

The uncertainty associated with the price at which the currency from one country can be converted into the currency of another country.

Question 34

political risk

Answer 34

The risk of expropriation of a foreign subsidiary’s assets by the host of country of of unanticipated restrictions on cash flows to the parent company.

Question 35

expropriation

Answer 35

The assets of a foreign subsidiary are seized, generally by the host government, without compensation to the company.