The Capital Budgeting Process

Question 1

Capital Budget

Answer 1

is the process of identifying , analyzing and selecting investment in long term projects.

Question 2

what is capital budgeting challenges as result of its long term aspect ?

Answer 2

1- by their nature , capital budget affect multiple accounting periods and will constrain the organization’s financial planning well into future . once made capital budgeting decision tends to be relatively inflexible, unless real option exist
2- An opportunity cost is the maximum benefits forgone by using a scarce resource for a given purpose and not for the next-best alternative.

Question 3

capital budget applications or examples

Answer 3

1- Buying Equipment 
2- Building Facilities 
3- Acquiring a business
4- Developing a product or a product line 
5 - Expanding into new Markets

Question 4

Why planning is crucial in budgeting process?

Answer 4

Planning is crucial because of possible changes in capital markets, inflation, interest rates, and the money supply.

Question 5

The tax consequences of a new investment

(and possible disinvestment of a replaced asset) must be considered. Why?

Answer 5

All capital budgeting decisions need to be evaluated on an after-tax basis because taxes may affect decisions differently. Companies that operate in multiple tax jurisdictions may find the decision process more complex. Another possibility is that special tax concessions may be negotiated for locating an investment in a given locale.

Question 6

Relevant Costs definition.

Answer 6

Relevant costs vary between different alternatives.

• Avoidable
• incremental cost

Question 7

Irrelevant Costs Definition

Answer 7

b. Irrelevant costs do not vary between different alternatives and therefore do not affect the decision.
- sunk
- Committed

Question 8

Avoidable Cost

Answer 8

Avoidable costs may be eliminated by ceasing an activity or by improving efficiency.

Question 9

Incremental cost

Answer 9

is the increase in total cost resulting from selecting one option instead of another.

Question 10

Sunk Cost

Answer 10

A sunk cost cannot be avoided because it occurred in the past.
a) A sunk cost is irrelevant because it has already been incurred and cannot
be changed.
b) An example is the amount of money already spent on manufacturing equipment.

Question 11

A committed cost

Answer 11

A committed cost is a cost that will be incurred in the future due to previously
made decisions.
a) An example is a future lease payment in a long-term lease.

Question 12

The Stages In Capital Budget

Answer 12

1- Identification 
2- Search
3-Information Acquisition
4- Selection 
5- Financing
6- Implementation and Monitoring

Question 13

Steps in Ranking Potential Investments

Answer 13

1- Determine the Asset Cost or net Investment
2- Calculate estimated cash flows
3- Relate the cash-flow benefits to their cost
4- Rank the Investments

Question 14

What Hurdle Rate?

Answer 14

is the minimum rate of return on a project or investment that an investor willing to accept.

• The risker the project, the higher the hurdle rate.
• The lower the firm’s discount rate, the lower the acceptable hurdle rate.
• A common pitfall in capital budgeting is the tendency to use the company’s current rate of return as the hurdle rate. This can lead to rejecting projects that should be accepted.

Question 15

Cash Flows (relevant cash flow)

Answer 15

Relevant cash flows are a much more reliable guide when judging capital projects because only they provide a true measure of a project’s potential to affect shareholder value.

The incremental cash flows that must be evaluated in capital budgeting process

Question 16

Capital Budget Other Consideration

Answer 16

a. Effects of inflation on capital budgeting.
1) In an inflationary environment, future dollars are worth less than today’s dollars. Thus, the firm will require a higher rate of return to compensate.
b. Post-audits should be conducted to serve as a control mechanism and to deter managers from proposing unprofitable investments.
1) Actual-to-expected cash flow comparisons should be made, and unfavorable
variances should be explained. The reason may be an inaccurate forecast or
implementation problems.
2) Individuals who supplied unrealistic estimates should have to explain
differences. Knowing that a post-audit will be conducted may cause managers
to provide more realistic forecasts in the future.
3) The temptation to evaluate the outcome of a project too early must be overcome.
Until all cash flows are known, the results can be misleading.
4) Assessing the receipt of expected nonquantitative benefits is inherently difficult.

Question 17

What are the four capital budget techniques ?

Answer 17

1 - Net Present Value ( Use the time Value of Money)
2 - Internal Rate Of return ( use the time value of money)
3 - Payback Method
4 - Discounted Payback Method

Question 18

With regards to Relevant Cash Flows , Which is Consist of 3 Categories The 1st is
Net initial Investment, Demonstrate it in details.

Answer 18

Net Initial Investment
1- Cost of New Equipment
2- Initial Working Capital Requirements
3- After-tax Proceeds from disposal of old equipment

Question 19

The 2nd Category to find out the relevant cash flows is

Annual Net Cash Flows

Answer 19

Annual Net Cash Flows
1- After-tax cash collection
2- Tax savings form depreciation deduction (Depreciation tax Shield)

Question 20

Remember That “Relevant Cash Flows are a much more reliable guide when judging capital projects , Explain ?

Answer 20

because only they provide a true measure of a project`s potential to affect shareholder Value

Question 21

Relevant Cash Flow 3rd Category and the last is

Project Termination cash flows

Answer 21

Project Termination Cash Flow

• After tax Proceeds from disposal on new equipment
• Recovery Working Capital (untaxed)

Question 22

MACRS

Answer 22

Modified Accelerated Cost Recovery System

Question 23

Tax Shield

Answer 23

-Any Expenses that is lower taxes paid is tax shield.

Question 24

How to Calculate the Depreciation Tax Shield?

Answer 24

• Find the depreciation expense
• Multiply Depreciation by the Income Tax Rate
• By multiplying Depreciation Expense by the Income Tax Rate, you calculate the taxes saved

Question 25

Alfalfa Corporation has a tax rate of 21%. The amount of depreciation that it can deduct is $100,000. Based on this information, find the depreciable tax shield?

Answer 25

depreciation tax shield is $21,000

Question 26

If the existing equipment has a tax basis higher than market value the results will be ?

Answer 26

Tax benefits of loss on old equipment .
Example 
Tax Basis 100000 $
Market Value 80000 $
=(80K-100K)*.4 = 8000$

Question 27

Identification stage (Regarding to capital Budgeting)

Answer 27

is the first stage, management identifies which capital expenditure projects are necessary to accomplish its objective.

Question 28

Search Stage (Regarding to capital budgeting)

Answer 28

the second stage., Potential investments are subjected to a preliminary evaluation by representatives from each function in the entity’s value chain .

Question 29

What is a tax basis?

Answer 29

A tax basis is the value of an asset that is used when determining the gain or loss when the asset is sold. Generally, it equals the asset purchase price minus any accumulated depreciation.

Question 30

How to calculate after-tax proceeds from disposal of the existing equipment.

Answer 30

1- Calculate the tax gain or loss ( Disposal value - tax basis)
2- Calculate the after tax effect on cash (Disposal value + Tax Saving)