Corporate Finance- Capital Budgeting- Reading 35

Question 1

Capital Budgeting: Definition & Process

Answer 1

Process that companies use for making long-term investment decisions.
Process Steps:
i) Generating Ideas
ii) Analyzing Individual Proposals
iii) Planning the Capital Budget
iv) Monitoring & Post -auditing

Question 2

Capital Budgeting Projects: Classification

Answer 2

i) Replacement Projects
ii) Expansion Projects
iii) New product & services
iv) Regulatory, Safety & Environmental Projects
v) Other Projects

Question 3

Principal of Capital Budgeting

Answer 3

i) Decisions based on cashflows.
ii) Timing of cashflows is crucial.
iii) Cashflows are based on Opportunity costs.
iv) Financing cost are ignored. Included in required rate of return (WACC).
v) Cashflows are analyzed on after-tax basis.
vi) A/c Net Income is not used.

Question 4

Independent Vs Mutually Exclusive Projects

Answer 4

Independent Projects- Projects whose cashflows are independent of each other.

Mutually Exclusive Projects- Compete directly with each other, either one of the two can be done.

Question 5

Project Sequencing

Answer 5

Many projects are sequenced through time, so that investing in a project creates the option to invest in future projects.

Question 6

Unlimited Funds Vs Capital Rationing

Answer 6

An unlimited funds environment assumes that the company can raise the funds it wants for all profitable projects simply by paying the required rate of return.

Capital rationing exists when the company has a fixed amount of funds to invest. If the company has more profitable projects than it has funds for, it must allocate the funds to achieve the maximum shareholder value subject to the funding constraints.

Question 7

Net Present Value (NPV)

Answer 7

(NPV) is the present value of the future after-tax cash flows minus the investment outlay..

Question 8

NPV Rules

Answer 8

Invest if NPV > 0

Do not Invest if NPV < 0

Question 9

Internal Rate of Return (IRR)

Answer 9

IRR is the discount rate at which NPV equals zero.
Discount rate that makes the sum of present values of the future after-tax cash flows equal to the initial investment outlay.

Question 10

IRR Rules

Answer 10

Invest if IRR > r
Do not Invest if IRR < r

• r = Required Rate of return for the project

Question 11

Payback Period

Answer 11

Payback period equals the time it takes for the initial investment for the project to be recovered through after-tax cash flows from the project.

Project with the shortest Payback period is preferred.

Question 12

Merits/ Demerits of Payback Period

Answer 12

Merits

i) Easy to calculate
ii) Good measure of liquidity

DeMerits

i) Does not consider Project risk, Required rate of return not considered.
ii) Ignore cashflows after the payback period.
iii) Needs to be used in conjunction with NPV & IRR to arrive at overall profitability of project.

Question 13

Discounted Payback Period

Answer 13

The discounted payback period equals the number of years it takes for cumulative discounted cash flows from the project to equal the project’s initial investment outlay.
DPB always > PB

Question 14

Merits/ Demerits of Payback Period

Answer 14

Merits:
i) Accounts for the TVM & Risk (rate of return) associated with the project.

De-merits:
i) Ignore cashflows after the payback period. Does not consider the overall profitability.

Question 15

Average Accounting Rate of Return (AAR)

Answer 15

The AAR is the ratio of the project’s average net income to its average book value.

AAR= (Average net income/Average book value)

Question 16

Merits/ Demerits of Average Accounting Rate of Return (AAR)

Answer 16

Merits:
i) Easy to calculate

De-merits:

i) Based on accounting numbers and not cashflows.
ii) Does not consider TVM.
iii) No conceptually sound cutoff for the AAR that distinguishes between profitable and unprofitable investments.

Question 17

Profitability Index (PI)

Answer 17

The PI equals the ratio of discounted future cash flows to the initial investment

It is also known as the “benefit-cost” ratio..

Question 18

PI Rule

Answer 18

Invest if PI > 1, if PI > 1, NPV is +tive.

Do not Invest if PI < 1, if PI < 1, NPV is -tive

Question 19

NPV Vs IRR

Answer 19

For a Mutually Exclusive Project, choose NPV over IRR. Since, we cannot reinvest the cashflows at the stated IRR rate for future periods. NPV is a more realistic measure. Hence always choose NPV.

The IRR assumes that all cash flows are reinvested at the IRR, while the NPV assumes that interim cash flows are reinvested at the cost of capital.