Chapter 14 The Basics of Capital Budgeting

Question 1

What are Capital Budgeting decisions?

What is another term for this?

Answer 1

Decisions involving the listing of all capital investments (projects) to be undertaken in the future.

The process of selecting a business’s capital (long-term asset) investments.
Long-term (fixed) asset acquisition decisions involving expenditure of capital funds.

Question 2

Issue if too little is invested in fixed assets?

Answer 2

technological obsolescence and inadequate capacity

Question 3

What are the 5 Project Classifications

Answer 3

Category 1 Mandatory replacement
Category 2 Discretionary replacement
Category 3 Expansion of existing services or markets
Category 4 Expansion into new services or markets
Category 5 Environmental projects

Question 4

What are the four steps of capital budgeting financial analysis?

Answer 4

1. estimate the expected cash flows (most critical and difficult step)
   - initial cash outlay (cost)
   - operating flows
   - terminal (ending) flow
2. assess the riskiness of those flows (project’s riskiness)
3. estimate the appropriate cost-of-capital discount rate (opportunity cost of capital or discount rate)
4. determine the project’s profitability and breakeven characteristics. (measure the financial impact).

Question 5

What is the most critical and most difficult step in analyzing a project?

Answer 5

Estimating the incremental can flows that the project will generate

Question 6

What is capital budgeting?

Answer 6

the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments. (Forecasting costs is best for lowest possible financing costs and availability of funds as they are needed).

Question 7

What should be considered in incremental cash flows?

Answer 7

Opportunity costs (the cashflows forgone by using an asset)
and 
Other projects (impacted by "the project")

-sunk costs (cash outlays that cannot be recouped) are not included

Question 8

What are tax laws?

How do tax laws affect investor owned firms (3 ways).

Answer 8

Tax laws are Tax laws are the legal rules and procedures governing how federal, state and local governments calculate the tax you owe.

Taxes 1) Reduce a project’s operating cash flows

2) tax laws prescribe depreciation expense that can be taken in any year
3) Taxes affect a project’s salvage value cash flow

Question 9

What might a project have that is not accounted for in the estimated cash flows?

Answer 9

Strategic value ( at a minimum, strategic value should be noted and considered qualitatively in the analysis)

Question 10

What changes are required in Capital Projects when there are additional investments added in fixed assets ?

What do the changes represent and where is it included?

Answer 10

Changes in current accounts in addition to the investment in fixed assets.

The changes represent a cash flow that must be included in the analysis .

Question 11

What should be considered in project analyses and what is the best procedure?

Answer 11

The effects of inflation should be considered. The best procedure is to build inflation effects directly into the component cash flow estimates.

Question 12

What is time breakeven and what is it measured by? What insights does time breakeven provide to managers?

Answer 12

Time breakeven is measured by payback period and provides managers with insights concerning a project’s liquidity and risk.

Question 13

What is project profitability assessed by?

Answer 13

ROI Return on Investment measures. (most common) Net Present Value and Internal Rate of Return

Question 14

What is Net Present Value and what does it do?

Answer 14

NPV - the sum of the present values of all the project’s net cash flows when discounted at the project’s cost pf capital.

It measures a project’s expected dollar profitability.

Question 15

What does a NPV greater than 0 indicate?

Answer 15

the project is expected to be profitable after all costs including the opportunity cost of capital. The higher the NPA the more profitable the project

Question 16

Internal Rate of Return (IRR)

what does it measure?

Answer 16

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

It measures a project’s expected rate of return. (If a project’s IRR is greater than its cost of capital, the project is expected to be profitable. the higher the IRR the more profitable the project.

Question 17

What do the NPV and IRR profitability measures provide?

Answer 17

Measures provide identical indications of profitability, a project that is judged to be profitable by its NPV will also be judged profitable by its IRR.

Question 18

When mutually exclusive projects are being evaluated, how might a NPV rank differently (higher) than IRR?

Answer 18

This difference can occur because the two measures have different reinvestment rate assumptions. IRR assumes that cash flows can be reinvested at the project’s IRR. NPV assumes that cash flows can be reinvested at the projects’s cost of capital.

Question 19

What is modified internal rate of return (MIRR)

Answer 19

forces a projects cash flows to be reinvested at the projects cost of capital and is a better measure of a project’s percentage rate of return than the IRR

Question 20

What is the Net Present Social Value (NPSV) Model

Answer 20

formalizes the capital budgeting decision process for not-for -profit firms.

Question 21

What do firms use to subjectively incorporate a large number of factors including financial and nonfinancial, into the capital budgeting decisions process

Answer 21

project scoring

Question 22

what is a key element in capital budgeting? (comparing actual results with predicted results, managers can improve both operations and the cash flow estimation process)

Answer 22

post-audit

Question 23

capital budgeting techniques, what are they used for?

Answer 23

used for a wide variety of settings in addition to project evaluation.

Question 24

Capital budgeting decisions

Answer 24

the process of selecting a business’s capital (long-term assets) investments. The list of investments chosen constitutes a business’s capital budget.

Question 25

Incremental cash flow

Answer 25

the business’s cash flows in each period if the project is undertaken minus the cash flows if the project in not undertaken

CFt = CFt(business with project) - CFt(business without project)

A cash flow that arises solely from a project that is being evaluated and hence should be included in the project analysis

Question 26

terminal value

Answer 26

when a project’s cash flows are arbitrarily truncated, an estimate of the value of the cash flows beyond the truncation point.

Question 27

salvage value

Answer 27

the expected market value of an asset (project) at the end of its useful life.

Question 28

sunk cost

Answer 28

a cost that hs already occurred or is irrevocably committed. Sunk costs are nonincremental to project analyses and hence should not be included.

Question 29

non incremental cash flow

Answer 29

a cash flow that does not stem solely from a project that is being evaluated. Nonincremental cash flows are not included in a project analysis

Question 30

strategic value

Answer 30

the value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted.

Question 31

Return on Investment (ROI)

Answer 31

the estimated financial return on an investment. In capital budgeting analysis, ROI can be measured either in dollar or percentage (rate of ) return.

Question 32

payback period

Answer 32

the number of years it takes a business to recover its investment in a project ;without considering the time value of money.

Question 33

Modified internal rate of return

Answer 33

A project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital .

Question 34

project scoring

Answer 34

an approach to project assessment that considers both financial and non financial factors.

Question 35

what is the role of financial analysis for investor-owned businesses?

Answer 35

identifies those projects that are expected to contribute to shareholder wealth

Question 36

post audit

Answer 36

the feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations

Question 37

what is the role of financial analysis for not-for-profit businesses?

Answer 37

identifies a project’s expected effect on the business’s financial condition. (What is needed in the community?)

Question 38

How is cash flow timing analyzed?

Answer 38

• (daily)(costly to estimate) exactly as they are expected to occur
• often approximated by annual flow

Question 39

In Cash Flow Estimation, what is Project Life? (time wise)

Answer 39

• often unknown
• typically set for 5-10 years
• often truncated(shortened) if long

Question 40

What in Cash Flow Estimation is included and not included

Answer 40

Does not include - sunk costs
Includes - opportunity costs (the loss pf potential gain from other alternatives when one alternative is chosen) for capital
-opportunity costs for other resources

Question 41

What breakeven analysis is used in project analysis?

Answer 41

• time breakeven

- input variable breakeven

Question 42

In Input variable breakeven what does it consist of?

Answer 42

• volume (4142 scans versus 5000 expected)

- net revenue (73.13 per scan versus $80 expected).

Question 43

What are the benefits and disadvantages of time breakeven and how it is determined?

Answer 43

Benefits - shorter pay back period = more quickly funds will be amiable for other
-shorter payback period are less risky

Disadvantages

• ignores all cash flows that occur after the payback period
• ignores opportunity costs associated with the capital

Determined using Cumulative Cash Flows