Lecture 3 Capital Budgeting

Question 1

What are the basic considerations in Capital Budgeting?

Answer 1

Basic Considerations:

1. Should a company invest in something that will generate cash flows
2. Will it be profitable
3. Will the return be high enough in relations to risks and costs

Question 2

Where are the corporate decisions in Capital Budgeting?

Answer 2

• Short Term Assets
• Long Term Assets (Area of Capital Budgeting)
• Financing Decisions : (Debt Equity Mix)
• Dividend Decisions: ( Payout Ratio)

Question 3

What is the corporate objective of every firm?

Answer 3

Corporate Objective is Wealth Maximization:

Question 4

What is Capital Budgeting?

Answer 4

• An analysis of potential projects
• Potential Addition to Fixed Assets
• Investment for long term nature
• Initial Cash outflow with subsequent cash inflows
• hence it is freaking important

Question 5

What are the most important questions to be adressed by decision makers?

Answer 5

Questions important for Decision Making:

• Estimate all cash flows that occur during the period
• Consider Time value of Money
• Assess the Risk
• Chose the required rate of Return

Question 6

What does a simple Project life look like in terms of cash flows?

Answer 6

Question 7

What are the two types of Projects?

Answer 7

1. Independent Projects, where cash flows are independent of each other
2. Mutually exclusive Projects, where accepting one, means excluding the other

Question 8

What are the differnet types of cash flows?

Answer 8

1. Standard: Cash flows are preceded by an initial cash outlay and followed by positive cash flows
2. Non Standard: initial Cash outlay is followed by both positive and negative cash flows, i.e closing of a nuclear plant.

Question 9

Give some characteristics of the Payback Period:

Answer 9

1. The payback period is considered to be the oldest form of assessment.
2. It tells the exact number of years required to mack back and investment
3. It tells how long it will take before the cash flows will have payed for the investment
4. It is a type of break even assessment

Question 10

What are the Pros of using PB?

Answer 10

Pros:

Simple and Logical
Possibly related to risk
Decent Measure of Liquidity

Question 11

What are the Cons of using PB?

Answer 11

Cons:

Ignores the Time Value of Money
Benchmarking it is subjective
Ignores Cash Flows generated after payback

Question 12

What is the Discounted PB?

Answer 12

Same as normal, however, cash flows are discounted to respect the principle of the time value of money”

Question 13

What is the NPV concept?

Answer 13

Question 14

What is the profitability index?

Answer 14

Question 15

What is the concpet of the IRR and what is the Formula?

Answer 15

Question 16

What are the differences between NPV and IRR?

Answer 16

IRRs can’t be added or averaged
IRR assumes reinvestment at IRR
More than one IRR
IRR can be misleading , NPV is not.
NPVs of individual projects can be added
NPV can be used with time varying discount rates.

Question 17

Give an example of misleading IRRs

Answer 17