FM-Capital Budgeting

Question 1

Capital Budgeting

Answer 1

Capital budgeting is the process of measuring, evaluating, and selecting long-term investment opportunities. These opportunities are typically in the form of projects or programs being considered by a firm and almost always would involve significant cost and extend over many periods.
-major responsibility for financial management.

Question 2

hurdle rate

Answer 2

When used in evaluating capital projects, the weighted average cost of capital is called the hurdle rate.

Question 3

weighted average cost of capital

Answer 3

The weighted average cost of capital is more appropriate to use as the minimum rate of return on projects than the cost of capital of an individual capital element.
-Weighted‐average of the costs of all financing sources should be used, with the weights determined by the usual financing proportions.

Question 4

The weighted‐average of project risk (betas)

Answer 4

level of risk that concerns investors who supply capital to a diversified company

Question 5

Risk

Answer 5

Risk is the possibility of loss or other unfavorable result that derives from the uncertainty implicit in future outcomes. In the context of a portfolio of projects, it is the uncertain outcome associated with any project.

Question 6

Risk‐free rate.

Answer 6

The risk‐free rate of interest, as the term implies, is the interest that would be charged on a borrowing that carried no risks (e.g., of default, inflation, etc.). This interest is required by lenders, not to cover risks, but to compensate the lender for deferring use of the funds by making an investment.

Question 7

Payback Period Approach

Answer 7

determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. If the expected payback period for a project is equal to or less than the pre-established maximum, the project is deemed acceptable; otherwise, it would be considered unacceptable.

• The payback period is computed by dividing the initial investment by the annual net cash inflow. Depreciation expense is not subtracted from cash inflow; only the income taxes that are affected by the depreciation deduction are subtracted. One of the weaknesses of the payback period is that it ignores the time value of money.
• can be useful in evaluating the liquidity of a project.
• provides the years needed to recoup the investment in a project.

Question 8

Discounted payback period approach

Answer 8

The discounted payback period method is a variation of the payback period approach, which takes the time value of money into account. It does so by discounting the expected future cash flows to their present value and uses the present values to determine the length of time required to recover the initial investment. Because the present value of the cash flows will be less than their future (nominal) values, the discounted payback period will be longer than the undiscounted payback period.
-used primarily to decide whether to accept or reject a project based on the economic feasibility of the project.

Question 9

Net present value approach

Answer 9

Net present value approach is a technique used for evaluating capital budgeting opportunities.

Question 10

Profitability index approach.

Answer 10

The profitability index approach to capital project evaluation is primarily concerned with the relative economic ranking of projects by taking into account the cost of a project as well as with its net present value.

Question 11

Accounting Rate of Return

Answer 11

The Accounting Rate of Return (also called the Simple Rate of Return) method:Assesses a project by measuring the expected annual incremental accounting income from the project as a percent of the initial (or average) investment.

ARR =Average annual incremental income/Initial (or Average) investment.
(Average Annual Incremental Revenues − Average Annual Incremental Expenses) / Initial (or Average) Investment

Question 12

net present value method

Answer 12

The net present value method of a capital project is computed as the difference between its discounted future cash flows and its initial cost.

-assumes that new cash inflows or savings will be immediately reinvested at the hurdle rate of return.

Question 13

hurdle rate of return

Answer 13

The hurdle rate of return is determined by a firm’s weighted average cost of capital.

Question 14

A depreciation tax shield is

Answer 14

The benefit of depreciation in cash flow analysis is the resulting tax savings (reduction in income taxes).

Question 15

A project’s net present value, ignoring income tax considerations, is normally affected by the

Answer 15

Proceeds from the sale of the asset to be replaced.

Question 16

Internal Rate of Return

Answer 16

(also called the Time Adjusted Rate of Return) method:Evaluates a project by determining the discount rate that equates the present value of the project’s future cash inflows with the present value of the project’s cash outflows.

• equates the present value of a project’s expected cash inflows to the present value of the project’s expected costs. It does so by determining the discount (interest) rate that equates the present value of the project’s future cash inflows with the present value of the project’s cash outflows. The rate so determined is the rate of return earned on the project.
• The discount rate at which the net present value of the project equals zero.

Question 17

Calculation of Internal Rate of Return

Answer 17

Annual Cash Inflow (or Savings) × PV Factor = Investment Cost, or

PV Factor = Investment Cost/Annual Cash Inflow (or Savings)

Question 18

Both the net present value method and the internal rate of return method of evaluating capital projects assume that all cash inflows (or savings) that result from the project are immediately reinvested to earn a return for the company.

Answer 18

1) The net present value method implicitly assumes that reinvestment of cash inflows earns the hurdle rate of return, the same rate used to discount future cash flows to get present value.
2) The internal rate of return method implicitly assumes that reinvestment of cash inflows earns a rate of return equal to the internal rate of return.

Since the internal rate of return determines the discount rate, which equates the present value of future cash inflows with the cost of the investment, if the project has a positive net present value, the discount rate (or internal rate of return) must be greater than the hurdle rate.

Question 19

profitability index

Answer 19

Project Net Present Value divided by Project Cost

limitations-It requires detailed long‐term forecasts of the project’s cash flows.

-(also called the cost/benefit ratio) is primarily intended for use in ranking projects. It does so by taking into account both the present value and the cost of each project.

Question 20

Payback Period and Ranking

Answer 20

limitations:
-failure to consider the time value of money (i.e., it does not discount future cash flows)
-failure to consider economic results after the payback period.
Therefore, use of the payback period method to rank projects would place them in order of how quickly invested capital would be recovered (measured in nominal dollars), and not their relative economic value to the firm. Relative payback periods may be important, however, when liquidity issues are a major concern to a firm, since the payback period measures how quickly an investment will be recovered.

Question 21

Discounted Payback Period and Ranking

Answer 21

• evaluates a project based on how quickly an investment will be recovered.
• uses discounted payback period method discounts future cash flows and uses the discounted present value to determine the payback period. Because it uses discounted values it is better than the undiscounted payback period approach, but for ranking purposes it fails to consider the total economic performance of a project.
• It only measures the outcome up until the initial investment is recovered. Use of this method for ranking would be appropriate only when liquidity issues are a major concern.

Question 22

Accounting Rate of Return and Ranking

Answer 22

• uses estimated future accrual-based net income and the cost of the investment (or average cost of the investment) to develop a rate of return on the investment.
• ignores the time value of money and would not take into account the impact of different net incomes earned in different future periods. For example, two projects with the same accounting rate of return, based on average expected net incomes, may have very different timings of those incomes.

Question 23

Net Present Value and Ranking

Answer 23

derived by discounting future cash inflows (or savings) and determining whether the resulting present value is more or less than the cost of the investment and any other cash outflows.
-If the net present value is zero or positive, the project is economically feasible; if the net present value is negative, the project should be rejected. Because the net present value approach uses discounted cash flows, it provides a means of ranking projects in terms of a comparable dollar value of each project.
-For example, other things being equal, the project with the highest positive net present value would be ranked first, the second highest positive value ranked second, and so on.
While the net present value method enables not only a basis for accepting or rejecting a project, but also a useful ranking of projects, it does not address the issue of differences in initial cost of each project. This issue is addressed by the use of a profitability index, which is described below. Despite this issue, ranking projects by the level of their positive net present values is usually a preferred basis.

Question 24

Internal Rate of Return and Ranking

Answer 24

• incorporates the present value of future cash flows. Specifically, it determines the rate of return inherent in a project by determining the discount rate that equates the present value of the inflows with the present value of the outflows of the project. -it does not address the issue of differences in initial cost of each project, which is addressed by the profitability index. If the IRR method is used to rank projects, the project with the highest internal rate of return would be ranked first, the second highest rate next, and so on. However, when comparing projects of very different sizes (initial costs), different life spans or different timings of cash flows, the rankings resulting from using IRR (the rates) may not indicated the most desirable project.
• While both the NPV and IRR approaches will result in the same accept or reject outcome, differences between the methodologies used in the two approaches can result in different rankings for a given set of projects. These ranking may be different depending on:
  1. Project size
  2. Timing of cash flows
  3. Project life-span

Question 25

Profitability Index and Ranking

Answer 25

• primarily intended for use in ranking projects. It does so by taking into account both the present value and the cost of each project.
• dividing either the present value of cash inflows or the net present value of the project by the initial cost of the project. As a result of that division, if present value of cash inflows is used an index of 1.0 is logically the lowest acceptable outcome. If net present value is used an index equal to or greater than 0 (zero) would be the lowest feasible value. As values on the profitability index increase, so does the financial attractiveness of the proposed project.
• designed to rank projects by taking into account both the time value of money and the initial cost of the project.