Chapter 5

Question 1

What is Capital Budgeting

Answer 1

• Long-term decisions; involves large expenditures
• Very important to firm’s future
• Analysis of potential additions to fixed assets

Question 2

Steps to capital budgeting

Answer 2

1) Estimate cash flows (inflow and outflow)
2) Assess riskiness of cashflows
3) Determine the appropriate cost of capital
4) Find NPV or IRR
5) Accept project if NPV >0 or IRR>WACC

Question 3

Independant Projects

Answer 3

Cash flows of one are unaffected by the acceptance of the other

Question 4

Mutually Exclusive Projects

Answer 4

Cash flows of one can be adversely impacted by the acceptance of the other

Question 5

Normal Cash Flows

Answer 5

Initial outlay (negative cash flow or cash outflow) followed by a series of positive cash inflows

Question 6

Non-Normal Cash Flows

Answer 6

Two or more changes of signs. Most common: Initial outlay (negative CF), then string of positive CFs, then cost to close project.

Question 7

Present Value

Answer 7

• What money at some point in the future is worth today

- The PV shows the value of cash flows in terms of today’s purchasing power

Question 8

Discounting

Answer 8

Finding the PV of a cash flow or series of cash flows when compound interest is applied

Question 9

Ordinary Annuity

Answer 9

Fixed payment at intervals end of period

Question 10

Annuity Due

Answer 10

Fixed payment at intervals beginning of period

Question 11

NPV method assumes CFs are reinvested at the

Answer 11

WACC

Question 12

IRR Method assumes CFs are reinvested at the

Answer 12

IRR

Question 13

Strengths of Payback

Answer 13

• Provides an indication of projects risk and liquidity

- Easy to calculate

Question 14

Weaknesses

Answer 14

• Ignores the time value of money

- Ignores cashflows occuring after payback period

Question 15

Subsidiary vs Parent differences in perspectives due to

Answer 15

• Tax differentials
• Regulations that restrict remittances
• Excessive remittances
• Exchange rate movements

Question 16

Factors to consider in Multinational Capital Budgeting *

Answer 16

1) Financing arrangement
-Financing costs are usually captured in the discount rate e.g WACC. However, when foreign projects are partially financed by foreign subsidiaries, a more accurate approach is to
• Separate the subsidiary investment
• Consider any foreign loan payments as cash
outflows
2) Exchange rate fluctuations
3) Interest rates in foreign markets
4) Blocked funds
-Some countries require that the earnings
generated by the subsidiary be reinvested locally for at least a certain period of time before they can be remitted to the parent
5) Host government incentives such as tax incentives etc

Question 17

Adjusting Project Assessment Risk

Answer 17

When an MNC is unsure of the estimated cash flows of a proposed project, it needs to incorporate an adjustment for this risk
• One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that should be applied to the cash flows.

Question 18

Country Risk

Answer 18

Potentially adverse impact of a country’s environment on an MNC’s cash flows

Question 19

Political Risk Factors

Answer 19

• Attitude of consumers in the host country
• Actions of host government
• War
• Corruption

Question 20

Financial Risk

Answer 20

• Indicator of economic growth