Chapter 7-

Question 1

What is Capital Budgeting

Answer 1

Evaluating investment projects, and deciding which project to select with the goal of maximizing shareholder’s wealth.

Capital budgeting is really important because a lot of money is tied up in the projects.

examples of capital budgeting projects:
-New product line
-Pfizer investing in development of new drug

Question 2

Classification of Capital Budgeting Projects

Answer 2

I-Mutually exclusive projects
II-Substitute Projects (Taking project A decreases cash flows of Project B)
III-Complimentary Projects (Taking project A enhances CF of Project B)
IV-Independent Projects (Taking Project A does nothing to Project B)
V- Contingent Projects /Dependant Projects (P. A depends on P. B)

Question 3

Classification of Capital Budgeting Projects by type of cash flow

Answer 3

I-Conventional cash flows
II-Non-conventional cash flows

Question 4

The Payback Period (PbP)

Answer 4

-Ignores TVM/Risk
-Ignores all CFs after the cut-off date
-The choice of the cut-off period is arbitrary

Decision Rule: A project should be accepted if its PBP < Cut-off Period.

Question 5

The Discounted Payback Period (DPbP)

Answer 5

-Ignores all CFs after the cut-off date
-The choice of the cut-off period is arbitrary

Question 6

The internal rate of return (IRR)

Answer 6

The interest rate that makes npv = 0.
Decision Rule: If IRR > k(required rate of return on the investment), then accept the project.

If the project has non-conventional cash flows, then this can cause for there to be multiple IRR or none. IRR makes assumption funds are reinvested with the IRR which is not a realistic assumption. [NPV assumes funds are reinvested at the market rate]

Question 7

The Average Accounting Rate of Return (AAR)

Answer 7

AAR = Avg Net Income / Avg book value of the investment
Can be misleading because we are taking accounting values, which take into consideration depreciation. And what is the rate that we want to get (misleading)

Question 8

Can you use the wacc for NPV projects?

Answer 8

If the risk of a project is the same as that of the company, then you can use the comapnies WACC.

Question 9

NPV issues

Answer 9

figuring out the relevant k is the hardest part, and for NPV you need to forecast future cash flows.

Question 10

what causes difference between different NPV’s and IRR’s

Answer 10

The size of initial investment or difference in cash flows.

Question 11

Cash flow

Answer 11

Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure.

Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital.

Question 12

Capital Structure

Answer 12

Mix of debt and equity to maximize shareholder’s equity.