Lecture 6

Question 1

What is Capital Assets and what are they used for.

Answer 1

Capital assets are long-term assets used to:

- Generate future revenues or cost savings
- Provide distribution, service, or production capacity
      - Tangible Assets (Land, buildings, machinery, etc)
      - Intangible Assets (Copyrights, Patents, etc)

Question 2

Capital Budgeting

What is the difference between Quantitative Research and Qualitative Research?

Answer 2

Quantitative Research is used to quantify the problem by way of generating numerical data or data that can be transformed into usable statistics.

Qualitative Research is primarily exploratory research. It is used to gain an understanding of underlying reasons, opinions, and motivations

Question 3

Capital Budgeting

What is the 6 Quantitative Methods used in Capital Budgeting?

(What are capital budgeting techniques?)

Answer 3

• Account rate of return
• Payback Period
• Discounted Payback Period
• Net Present Value
• Profitability Index (PI)
• Internal Rate of Return (IRR)

Question 4

Capital Budgeting

What is the 7 Qualitative Methods used in Capital Budgeting?

Answer 4

• Employee morale, safety, and responsibility
• Corporate Image
• Growth
• Social responsibility
• Sustainability
• Market Share
• Strategic Planning

Question 5

What is the cost of capital?

Answer 5

It represents the overall cost of financing to the firm.

Question 6

What sources of long-term capital do firms use?

Answer 6

• Long-Term Debt
• Preference Share
• Equity
  
  • Retained Earnings
  • New Shares

Question 7

What is WACC?

Answer 7

Weighted Average Cost of Capital

Question 8

What is the WACC formula?

Answer 8

WACC = (Cost of debt x weight) + (Cost of preference shares x weight) + (Cost of Equity x weight of equity)

Question 9

The Payback Period Method

What is the Payback Period Method?

Answer 9

This is how long it takes the project to “payback” its initial investment.

Payback Period = number of years to recover initial costs

Question 10

The Payback Period Method

Minimum Acceptance Criteria
Ranking Criteria

Answer 10

Both set by management

Question 11

The Payback Period Method

Advantages?

Answer 11

• Easy to understand

- Biased toward liquidity

Question 12

The Payback Period Method

Disadvantages?

Answer 12

• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires an arbitrary acceptance criteria
• A project accepted based on the payback criteria may not have a positive NPV

Question 13

The Discounted Payback Period Method

What is the Discounted Payback Period?

Answer 13

How long does it take the project to “payback” its initial investment, taking the time value of money into account.

It has similar advantages and disadvantages as standard payback method.

Question 14

Average Accounting Return

What does this measure?

Answer 14

Measures accounting profits relative to book value:

AAR = Average Net Income / Average Book Value of
Investment

Question 15

Average Accounting Return

Minimum Acceptance Criteria
Ranking Criteria

Answer 15

Both set by management

Question 16

Average Accounting Return

Advantages?

Answer 16

• The accounting information is usually available

- Easy to calculate

Question 17

Average Accounting Return

Disadvantages?

Answer 17

• Ignores the time value of money
• Uses an arbitrary benchmark cut off rate
• Based on book values, not cash flows and market values

Question 18

The Net Present Value

What is the formula?

Answer 18

NPV = Initial Investment + PV of future CF’s

Question 19

The Net Present Value

Minimum Acceptance Criteria
Ranking Criteria

Answer 19

Minimum Acceptance Criteria
Accept if NPV>0

Ranking Criteria
Choose the highest NPV

Question 20

The Net Present Value

Accepting positive NPV projects ________ shareholders.

Answer 20

Accepting positive NPV projects BENEFITS shareholders.

Question 21

The Net Present Value
Interpreting NPV

NPV=0
Actual rate of return ______ desired rate of return.
NPV>0
Actual rate of return is _______ ____ desired rate or
return
NPV<0
Actual rate of return is ____ ____ desired rate of
return.

Answer 21

The Net Present Value
Interpreting NPV

NPV=0
Actual rate of return EQUALS desired rate of return.
NPV>0
Actual rate of return is GREATER THAN desired rate or
return
NPV<0
Actual rate of return is LESS THAN desired rate of
return.

Question 22

Mutually Exclusive VS Independent

What is a Mutually Exclusive Projects?

Answer 22

Only ONE of several potential projects can be chosen, e.g., acquiring a new machine.

Question 23

Mutually Exclusive VS Independent

What is a Independent Projects?

Answer 23

Accepting or Rejecting one project does not affect the decision of the other projects.

Question 24

Mutually Exclusive VS Independent

Advantages?

Disadvantages?

Answer 24

Advantages

• May be useful when available investment funds are limited
• Easy to understand and communicate
• Correct decision when evaluating independent projects

Disadvantages
- Problems with mutually exclusive investments Scale of Project

Question 25

The Internal Rate of Return

Answer 25

The discount rate that sets NPV to zero.

Question 26

The Internal Rate of Return

Minimum Acceptance Criteria
Ranking Criteria

Answer 26

Minimum Acceptance Criteria
- Accept if the IRR exceeds the required return
Ranking Criteria
- Select alternative with the highest IRR

Question 27

The Internal Rate of Return

Advantages?

Disadvantages?

Answer 27

Advantages
- Easy to understand and communicate

Disadvantages
- IRR may not exist, or there may be multiple IRRs
- Does not distinguish between investing and
borrowing
- Problems with mutually exclusive investment