P2E.1 Capital Budgeting

Question 1

Capital Budgeting

Answer 1

Process of identifying, evaluating, deciding or choosing and monitoring capital investments.

Reason for capital budgeting: replacement, improvement and/or expansion, taking advantage of perceived competitive advantage.

Question 2

Steps in Capital Budgeting Process

Answer 2

1. Strategize: develop strategic plan that supports mission statement.
2. Identify: potential opportunities
3. Assess: numerous means of evaluation capital investment options
4. Decide
5. Fund: available cash or from debt or equity financing
6. Implement

Question 3

Stages of Capital Budgeting Process

Answer 3

1. Identification and definition of programs
2. Search for potential investments
3. Information acquisition (thorough & extensive review of specific programs)
4. Selection of programs
5. Financing of programs
6. Implementation and monitoring of programs

Question 4

Post Audit

Answer 4

Compares investment’s actual to expected results. Generally not used after capital budget projects are completed.

Benefits

1. Budget allocation
2. Accountability
3. Objective evaluation

Limitations

1. Expensive
2. Outliers

Question 5

Relevant Cash Flows of a Capital Investment

Answer 5

Requirements

1. Incremental or Differential
2. Futuristic

Question 6

Hurdle Rate

Answer 6

Company’s minimum acceptable rate of return for an investment.

Decision rule: rate of return must be higher than the hurdle rate.

Question 7

Impact of Income Taxes on Cash Flows

Answer 7

Income tax is a burden on company’s net cash flows.

Question 8

Depreciation

Answer 8

1. Not a cash flow item.
2. Relevant in capital budgeting purposes because it affects net income upon which taxes must be assessed.
3. Tax depreciation is relevant.
4. Book depreciation isn’t relevant despite its effects on net income.

Question 9

Depreciation Tax Shield

Answer 9

Reduction in income taxes resulting from deduction of depreciation expense in the computation of taxable income.

= depreciation amount * tax rate

Question 10

Changes in Net Working Capital & Cash Flows

Answer 10

Increase in Net Working Capital = Decrease in Cash Flows

Decrease in Net Working Capital = Increase in Cash Flows

Question 11

Effects of Inflation & Capital Budgeting

Answer 11

Included in proper after-tax incremental cash flow.

Real Value = Nominal Value/Price Index
Real Value = Monetary Rate / (1 + Inflation Rate)n

Nominal: dollar stated at historical value (increases due to inflation)
Real dollar: purchasing power at time zero. (doesn’t change)

Question 12

Monetary Rate of Return

Answer 12

Company’s cost of capital including the inflation element.

Question 13

Real Rate of Return

Answer 13

Cost of capital without the inflation element.

Question 14

Risk in Capital Investments

Answer 14

1. Results from uncertainty of future cash flows

2. Actual cash flows will differ significantly from expected cash flows

Question 15

Sensitivity Analysis (What-if Analysis)

Answer 15

Analysis of how sensitive a change in ONE VARIABLE to the expected cash flows.

Question 16

Scenario Analysis

Answer 16

1. Similar to sensitivity analysis but BROADER IN SCOPE.
2. Used to analyze the effect of SIMULTANEOUS CHANGES IN MORE THAN ONE VARIABLE such as sales levels, cost of investment and cost of capital to the expected cash flows.

Question 17

Simulation Analysis

Answer 17

Statistical method that uses RANDOM variables to simulate expected cash flows.

Question 18

Monte Carlo Analysis

Answer 18

Simulation of random variables which leads to a PROBABILITY DISTRIBUTION that projects a range of expected cash flows.

Question 19

Risk-Adjusted Discount Rates (RADR)

Answer 19

Axiom: risk-return trade off

Required rate of return or cost of capital which ASSUMES THE ADDITIONAL RISK DEMANDED BY THE INVESTORS (OWNERS).

Question 20

Real Options

Answer 20

1. Abandonment: allows managers to terminate project before end of its expected life.
2. Growth: allows company to increase its operations.
3. Flexibility: allows company to adjust its inputs or outputs in response to internal or external factors.
4. Timing: allows company when to begin a project or to delay invesment.

Question 21

Nominal Value

Answer 21

Nominal value increases due to inflation and is stated at historical value.

Question 22

Real Dollars

Answer 22

Refers to purchasing power stated time zero.