SU6 - Capital Budgeting

Question 1

Explain Capital Budgeting.

Answer 1

Capital budgeting refers to the process of identifying and evaluating potential investments in long-lived assets to determine whether they will add value to the firm, and the implementation and monitoring of such investments.

Question 2

Through which methods can the rate of return be measured?

Answer 2

1. NPV

2. IRR

Question 3

Explain NPV

Answer 3

The NPV - the net cash flows have to be discounted back to present value using the cost of capital as the required rate of return. An investment will only add value if the sum of the present values of the cash flows exceeds the initial investment.

Question 4

Explain IRR

Answer 4

The IRR - the investment will only add value if the IRR exceeds the required rate of return as measured by the weighted average cost of capital (WACC)

Question 5

What are the three basic discount cash flow techniques are?

Answer 5

1. Net present value (NPV)
2. Profitability index (PI)
3. Internal rate of return (IRR)

Question 6

The profitability index is also know as

Answer 6

Benefit-cost ratio

Question 7

Formula for PI

Answer 7

The PI is calculated by dividing the present value of cash inflows by the initial investment. :

PI = (Total present values of the net cash flows) / (initial investment)

If the PI is ≧ to one, accept the project

Question 8

How is the IRR calculated?

Answer 8

After calculated NPV, press the function key on you calculated and then press IRR.

If the IRR is ≧ to the cost of capital (k), accept the project.