Chapter 14: Capital Budgeting Decisions

Question 1

What are the two broad categories of capital budgeting

Answer 1

Screening decisions
Preference decisions

Question 2

What are screening decisions

Answer 2

Does a proposed project meet some preset standard of acceptance

Question 3

What are preference decisions

Answer 3

Selecting from among several competing courses of action

Question 4

What do capital budgeting techniques that best recognize the time value of money involve

Answer 4

discounted cash flows

Question 5

What is the payback period

Answer 5

Length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates

Question 6

Downfalls of payback method analysis

Answer 6

1. does not consider time value of money
2. ignores cash flows after payback period
3. Shorter payback period does not always mean a more desirable investment

Question 7

Calculate payback period if the annual net cash inflow is the same each year

Answer 7

Payback period = Investment required / Annual net cash inflow

Question 8

Strengths of Payback Method

Answer 8

1. Serves as screening tool
2. Identifies investments that recoup cash investments quickly
   3, Identifies products that recoup initial investment quickly

Question 9

What is the net present value method

Answer 9

compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between the inflows and outflows is called the net present value

Question 10

When do cash flows occur

Answer 10

All cash flows other than the initial investment occur at the end of periods

Question 11

What do positive and negative net present values mean

Answer 11

positive - the return exceeds the discount rate (ACCEPTABLE)

negative - return is less than the discount rate (REJECT)

Zero - return equals required rate of return (ACCEPT)

Question 12

What is cost of capital

Answer 12

the average return the company must pay to its long-term creditors and stockholders and is usually regarded as the minimum required rate of return

Question 13

Does the net present value method automatically provide for return of original investment

Answer 13

True, Yes

Question 14

What is internal rate of return

Answer 14

the rate of return promised by an investment project over its useful life

Question 15

If the IRR is equal or grater than the minimum required rate of return then

Answer 15

the project is acceptable

Question 16

If the IRR is less than the minimum required rate of return then

Answer 16

the project is rejected

Question 17

When using IRR, the cost of capital acts as what

Answer 17

a HURDLE RATE that a project must clear for acceptance

Question 18

Is NPV or IRR simpler to use and why

Answer 18

NPV because IRR assumes cash inflows are reinvested at the IRR but if IRR is high then this assumption is realistic and its more likely to be reinvested at the discount rate

Question 19

What alternative should be chosen in decisions where revenues are not directly involved

Answer 19

the alternative with the least total cost from a present value perspective

Question 20

What are screening decisions

Answer 20

decisions that pertain to whether or not a proposed investment is acceptable; first-priority decisions

Question 21

What are preference decisions

Answer 21

decisions that attempt to rank acceptable alternatives from the most to least appealing

Question 22

When using the IRR method to rank, the preference rule is:

Answer 22

The higher the IRR, the more desirable a project

Question 23

When using NPV method to rank

Answer 23

The NPV cannot be directly compared unless the investments are equal

Question 24

Ranking investment projects using project profitability index

Answer 24

NPV of project / investment required

Question 25

What is the simple rate of return

Answer 25

does not focus on cash flows - focuses on accounting net operating income

Question 26

Calculate Simple rate of return (SRR)

Answer 26

Annual incremental net operating income / (initial investment - salvage value)

Question 27

Shortcomings of SRR

Answer 27

1. Ignores the time value of money
2. The same project may appear desirable in some years and undesirable in other years

Question 28

What is a post-audit

Answer 28

A follow up after the project has been completed to see whether or not expected results were realized