Chp 9: Capital Budgeting Intro & Techniques

Question 1

what decision has the greatest impact on a business’s future than any other decision it makes?

Answer 1

investment decisions

Question 2

what does capital refer to

Answer 2

long term securities and investments

Question 3

define capital budgeting - 2 points

Answer 3

1) method for evaluating long term investment opportunities in which all cash flows are discounted to the present
2) process of deciding which long term investments or projects a firm will acquire

Question 4

goal of financial manager and what do they need to do

Answer 4

increase shareholder wealth so they need to invest funds in projects that increase shareholder wealth

Question 5

explain NPV analysis

Answer 5

continuous process when applied to big projects where sunk costs have to be ignored and the focus moves to completing the project

Question 6

steps in capital budgeting process

Answer 6

1) identification of opportunities
2) evaluation of opportunities
3) selection
4) implementation
5) post audit

Question 7

explain step 1 in capital budgeting process: identification of opportunities - 2 points

Answer 7

1) Firm’s need some method of identifying opportunities to the attention of managers
2) Employees on front lines must have both incentives and means to communicate ideas to those who implement them

Question 8

explain step 2 in capital budgeting process: evaluation of opportunities

Answer 8

All costs and benefits need to be identified and analyzed

Question 9

explain step 3 in capital budgeting process: selection

Answer 9

Projects must be ranked and selection because of limited funds or because of human/physical constraints the firm faces - they can’t accept everything

Question 10

explain step 4 in capital budgeting process: implementation

Answer 10

Costs must be monitored and project risk must be evaluated

Question 11

explain step 5 in capital budgeting process: post audit - 2 points

Answer 11

1) Once the project is completed, compare costs and revenues with original projections.
2) Employees must be responsible for errors in projections to give them an incentive to do be more accurate next time

Question 12

Which of the following is NOT necessarily a step in the capital budgeting​ process?
A.Post audit.
B.Project rejection.
C.Evaluation of opportunities.
D.Identification of opportunities.

Answer 12

project rejection

Question 13

The steps of capital budgeting include all of the following​ except:
A.Pre Audit.
B.Post Audit.
C.Selection.
D.Evaluation of Opportunities.

Answer 13

pre audit

Question 14

An investment may change the whole face of a firm. True or false?

Answer 14

true

Question 15

5 things a good capital budgeting decision tool should do

Answer 15

1) Use all the cash flow
2) Account for time value of money
3) Account for risk
4) Able to rank mutually exclusive projects
5) Have a link to increased firm value

Question 16

5 capital budgeting decision tools

Answer 16

1) payback period (PB)
2) NPV
3) profitability index (PI)
4) IRR
5) modified IRR

Question 17

3 points to payback period

Answer 17

1) Number of years required to recapture initial investment
2) = initial investment / annual cash flow
3) No decision criteria

Question 18

3 points to NPV

Answer 18

1) The present value of all cash flows
2) = PV(cash inflows) - PV(cash outflows)
3) Accept if greater than or equal to 0

Question 19

3 points to profitability index

Answer 19

1) Ratio of the PV of cash inflows to outflows
2) = PV (inflows) / PV (outflows)
3) Accept if greater than or equal to 1

Question 20

2 points to IRR

Answer 20

1) Interest rate that sets the PV of cash inflows equal to PV of outflows
2) Accept if greater than or equal to cost of capital

Question 21

2 points to modified IRR

Answer 21

1) Interest rate that sets PV of outflows equal to FV of inflows, computed at firm’s cost of capital
2) Accept if greater than or equal to cost of capital

Question 22

True or​ False? Based on the Explain​ it! video and on the​ table, the decision criteria is used to evaluate the results of a capital budgeting analytic method so as to make the​ accept/reject decision.

Answer 22

true

Question 23

single sentence good and bad thing for payback period

Answer 23

The easiest to compute but theoretically the worst evaluation method

Question 24

payback period - what to do with unequal cash flow

Answer 24

make table to cash inflow and balance and when balance is last negative do balance/next cash inflow to get number of months in between. Multiply fraction by 12 to get months and round up. Note: balance for that year should be subtracted by cash inflow in that year.

Question 25

2 advantages of payback period

Answer 25

1) Simple | 2) Provides liquidity info (shorter the payback period, the greater the project’s liquidity)

Question 26

4 disadvantages of payback period

Answer 26

1) No clearly defined accept/reject criteria 2) No risk adjustment (risky CF treated same as low risk CF) 3) Ignores cash flows beyond payback period 4) Ignores time value of money (large and early CF are valued as much as small, early CF)

Question 27

when is payback period often used?

Answer 27

when some projects are too small to justify complexity of other methods

Question 28

define discounted payback method

Answer 28

amount of time it takes for a project to recoup the investment and cost of capital

Question 29

what does discounted payback method take into account?

Answer 29

This method takes into account time value of money, but not the other problems

Question 30

All of the following are weaknesses of the payback period technique​ except: A.Ignores time value of money. B.Difficulty of calculation. C.No clearly defined​ accept/reject criteria. D.Ignores cash flows beyond payback period.

Answer 30

B.Difficulty of calculation.

Question 31

Of the different techniques available for evaluating cash​ flows, which is technically the​ worst? A.The internal rate of return​ (IRR) B.The net present value​ (NPV) C.The modified internal rate of return​ (MIRR) D.The payback period E.The profitability index​ (PI)

Answer 31

payback period

Question 32

why is NPV widely used?

Answer 32

Most popular and theoretically sound evaluation tool

Question 33

what does positive NPV mean

Answer 33

Positive NPV means current value of income exceeds current value of expense for project

Question 34

what does negative NPV mean

Answer 34

Negative NPV means project costs more than it will bring in

Question 35

what time does annuity find PV?

Answer 35

an annuity finds PV to period before first cash flow

Question 36

3 advantages of NPV

Answer 36

1) Uses time value of money 2) Clear decision criteria 3) Discount rate adjusts for risk

Question 37

2 disadvantages of NPV

Answer 37

1) Can be difficult for people without background in financial theory 2) Of little help when company must select among group of positive NPV projects

Question 38

NPV relationship to firm value

Answer 38

NPV has a 1:1 relationship when increased firm value. If NPV of a project is $10, this means the value of the firm will increase by $10 by accepting the project.

Question 39

what discount rate is used to evaluate capital budgeting projects and what it reflects

Answer 39

firm’s cost of capital. It reflects the risk of the firm and the firm’s average required return on its investments.

Question 40

in excel what do you have to do for NPV?

Answer 40

manually subtract out the beginning cash outflow

Question 41

define NPV profile

Answer 41

graphs NPV at various discount rates (as discount rate rises, NPV decreases to account for risk)

Question 42

what does NPV profile show

Answer 42

Shows sensitivity of the project to the firm’s cost of capital

Question 43

x and y axis for NPV profile

Answer 43

Various discount rates are on the x axis and NPV is on the y axis

Question 44

NPV profile: graphing 2 projects at certain discount rate

Answer 44

At a certain discount rate, if we graph 2 projects, the one that is higher is the one to choose

Question 45

why do we do a sensitivity analysis?

Answer 45

cost of capital is hard to estimate

Question 46

how do we find NPV when discount rate is 0?

Answer 46

summing the cash flows

Question 47

define profitability index

Answer 47

Provides a measure of the bang for the buck provided by investing in the project

Question 48

what does profitability index tell you

Answer 48

Tells you how many dollars in PV terms you receive per dollar of investment

Question 49

2 formulas for profitability index

Answer 49

1 + NPV/PV(cash outflow) or = PV(inflow)/PV(outflow)

Question 50

PI when NPV =0

Answer 50

1

Question 51

PI when NPV > 0

Answer 51

>1

Question 52

what 3 methods give same accept/reject decision and why?

Answer 52

NPV, IRR, PI

Question 53

why must firm participate in capital rationing

Answer 53

Firm’s must limit its capital budget (ration its capital) due to real world constraints so firm’s need to rank projects

Question 54

what does ranking projects by PI tell the firm?

Answer 54

Ranking project by PI lets the firm know which projects generate the highest return per dollar invested

Question 55

when does ranking PI only work?

Answer 55

Ranking by PI works only if projects use all of the budgeted capital. The goal is to choose projects that combine to the highest NPV and sometimes the top ranked PI projects don’t do that

Question 56

PI advantage

Answer 56

useful as aid in ranking

Question 57

PI disadvantage

Answer 57

should not replace NPV as it can rank projects incorrectly when capital is rationed and does not provide measure of increase in firm value like NPV

Question 58

``` Question: Which capital budgeting technique is most useful for ranking projects when faced with capital​ rationing? A.IRR. B.Payback period. C.NPV. D.PI. ```

Answer 58

PI

Question 59

True or​ False? Using the PI to rank projects will always result in maximizing NPV.

Answer 59

false

Question 60

Which of the following is an advantage of the net present value​ (NPV) technique for evaluating cash​ flows? A.Easy comparison of separate NPV projects. B.Ease of understanding. C.Discount rate adjusts for risk. D.100% accurate.

Answer 60

discount rate adjusts for risk

Question 61

All of the following are true about profitability index​ (PI) except: A.Calculated by dividing the present value of inflow by the present value of the outflows. B.Will always give the same​ accept/reject decision as NPV. C.Works well as a supplement for the NPV method. D.Is best used by itself.

Answer 61

is best used by itself

Question 62

define IRR

Answer 62

Discount rate that sets PV of cash inflows equal to present value of cash outflows (sets NPV = 0)

Question 63

what is the hurdle rate?

Answer 63

cost of capital

Question 64

2 advantages of IRR

Answer 64

1) Easy to interpret and explain | 2) Investors like to speak in terms of annual percentage returns when evaluating investment options

Question 65

5 disadvantages of IRR

Answer 65

1) Assumes cash flows are reinvested at IRR when they are received 2) Cannot be used to rank mutually exclusive projects because it does not evaluate projects at particular discount rates 3) Ignores differences in scale since cash flows are converted to percentages 4) Will generate multiple IRRs(or no IRR solution) if cash flows change direction.

Question 66

on NPV profile, where can we find IRR?

Answer 66

On an NPV profile, the IRR (or multiple) are where the graph crosses the x axis

Question 67

what happens if there are multiple IRRs

Answer 67

we cannot use IRR, it is invalid

Question 68

Question: Which of the following is NOT a disadvantage of the IRR method for capital​ budgeting? A.The reinvestment assumption may lead to wrong ranking decisions. B.Results are hard to interpret. C.May not be a single solution. D.IRR does not provide information for project scale.

Answer 68

B.Results are hard to interpret.

Question 69

Question: The problem with the reinvestment rate assumption​ is: A.IRR assumes all cash flows are not reinvested. B.IRR assumes all cash flows are reinvested at the IRR. C.IRR assumes all cash flows are reinvested at the highest return available. D.IRR assumes all cash flows are reinvested at the cost of capital.

Answer 69

B.IRR assumes all cash flows are reinvested at the IRR.

Question 70

what are future value of cash flows called?

Answer 70

terminal value

Question 71

what does modified IRR solve?

Answer 71

Solves the IRR problem of reinvestment rate because cash flows are compounded at cost of capital. Also solves problem of changing CF signs resulting in multiple IRR’s

Question 72

explain MIRR in terms of interest rate

Answer 72

Is the interest rate that grows the present value to equal the future value

Question 73

MIRR: where are cash inflows compounded to?

Answer 73

Cash inflows are compounded to the point at which the last cash inflow is received

Question 74

The internal rate of return​ (IRR) can be defined​ as: A.The results of the NPV converted to a ratio. B. The discount rate that sets NPV to 0. C.The number of years required to recover the initial investment. D.The sum of the future cash flows discounted back to the current period.

Answer 74

B.The discount rate that sets NPV to 0.

Question 75

The difference between the internal rate of return​ (IRR) and the modified internal rate of return​ (MIRR) is: A.MIRR is a simpler version of IRR that does not require a calculator to solve. B.IRR is more accurate. C.MIRR solves the reinvestment rate assumption problem. D.IRR deals with outflows where the MIRR deals with inflows.

Answer 75

C.MIRR solves the reinvestment rate assumption problem.

Question 76

What major problem with IRR does the MIRR​ solve? A.The ranking problem. B.Evaluation of the timing of the cash flows. C.The scaling issue. D.The reinvestment rate assumption issue.

Answer 76

D.The reinvestment rate assumption issue.

Question 77

what do we need to pay attention to payback period?

Answer 77

if payback period exceeds years of revenue, there is no payback (if PV cost exceeds PV revenues)