Topic 9 Capital Budgeting I

Question 1

What is investment decision?

Answer 1

The decision as to which projects should be undertaken by corporation is known as the ‘investment decision’ (earning revenue and saving costs) and the process is known as ‘capital budgeting’.

Question 2

What is the key consideration in the decision to invest in a project?

Answer 2

Whether or not the proposal provides value to shareholders?

Question 3

When are projects independent?

Answer 3

Projects are independent from each other if there is no impact on each other’s cash flows.

Question 4

When are projects mutually exclusive?

Answer 4

Projects are mutually exclusive if the acceptance of one project leads to the rejection of all other options.

Question 5

What is the criteria in the method for assessing and selecting projects?

Answer 5

1. Increase value for the firm (=increase shareholder wealth)
2. Be based on cash flows
3. Allow for the time value of money  appropriate discount rate to reflect the risk of the cash flow
4. Adjust for differences in risk
5. Correctly rank competing projects
6. Be easily understandable

Question 6

What is net present value?

Answer 6

The difference between an investment’s market value and its initial investment.

Question 7

What is the decision rule for NPV?

Answer 7

Accept project if NPV > 0
Reject project if NPV < 0
Indifferent to project if NPV = 0

Question 8

What are the advantages for the NPV rule?

Answer 8

1. Makes a decision which maximises the wealth of shareholders
2. Takes into account the time value of money
3. Considers all cash flows and cost of project
4. Adjusts for risk

Question 9

What is the disadvantage for NPV rule?

Answer 9

1. Requires forecast (just a prediction and may not be accurate)

Question 10

What is the internal rate of return (IRR)?

Answer 10

the discount rate that makes the NPV equal to 0.

Question 11

What is the decision rule for IRR

Answer 11

Accept project if IRR > required rate of return
Reject project if IRR < required rate of return

Question 12

What are the advantages of the IRR rule?

Answer 12

1. Summarises project information into one number
2. Takes into account the time value of money
3. Considers all cash flows and cost of project

Question 13

What are the disadvantages of IRR rule?

Answer 13

1. There can be multiple IRR’s if there are multiple cash flows
2. Can’t do mutually exclusive cash flows

Question 14

When do NPV and IRR rule lead to identifcal decisions?

Answer 14

1. NPV of a project is a steadily declining function of the discount rate
2. Only one project is under consideration: you are not ranking projects

Question 15

What do we want when we invest in a project with conventional cash flows?

Answer 15

we want a high internal rate of return (accept project if IRR > required rate of return)

Question 16

What do want when we are borrowing/financing?

Answer 16

Cash flows are non-conventional, NPV increases as the discount rate increases  we want a low internal rate of return (Accept project IRR < cost of capital)

Question 17

Why can multiple IRRs occur?

Answer 17

Certain cash flows can generate NPV = 0 at two (or more different discount rates).
* Usually this occurs when there is a reversal in the sign of the cash flows
* This makes it difficult to use the IRR methodology as it is not possible to know which IRR result should be used for evaluation.

Question 18

Why are mutually exclusive projects a pitfall?

Answer 18

can accept one project or reject all projects, but cannot accept all or some at the same time.

Question 19

What should you do when choosing one project among mutually exclusive projects?

Answer 19

For mutually exclusive projects, accept the project with the higher NPV. A project with higher NPV need not be the one with a higher IRR or vice versa.

Question 20

What is another pitfall of IRR related to scale of project?

Answer 20

IRR sometimes ignores the magnitude or scale of project.

Question 21

What is the profitability Index (PI)?

Answer 21

the PV of an investment’s future cash flows divided by its initial costs.

Question 22

What is the decision for PI rule?

Answer 22

Accept project if PI > 1
Reject project if PI < 1

Question 23

What are the advantages of the PI rule?

Answer 23

1. Usually leads to same decision or ranking as NPV rule
2. Takes into account the time value of money
3. Considers all cash flows and cost of project
4. Adjusts for risk
5. When resources are limited, PI provides a tool for selecting amongst various project combinations and alternatives

Question 24

What is the disadvantage of the PI rule?

Answer 24

1. Difficult to calculate PI if projects have different useful lives or are mutually exclusive

Question 25

What is the payback period (PBP)?

Answer 25

the amount of time required to recover the initial costs of a project.

Question 26

What is the decision rule for payback period?

Answer 26

Accept project with the shortest PBP (mutually exclusive projects)
Accept project(s) with a PBP less than some pre-determined limit (non-mutually exclusive projects)

Question 27

What is the advantage of the PBP rule?

Answer 27

1. Simplicity of calculation and interpretation of decision rule

Question 28

What are the disadvantages of the PBP rule?

Answer 28

1. Ignore cash flows beyond the payback period.
2. No measurement of changes to shareholders’ wealth
3. Does not take into account the time value of money (unless using the discounted payback period method)

Question 29

Which technique is used in practice?

Answer 29

1. Most of the companies surveyed use more than one technique
2. These companies used all of the techniques reviewed in this lecture
3. The techniques relying on DCF (ie. NPV and IRR) are the most popular and have become more prevalent in recent times
4. The payback method has also increased in popularity.