Chapter 11

Question 1

Capital Budgeting

Answer 1

The process of creating, evaluating, choosing, and implementing proposed Business Investment Projects to create or maintain products and jobs that can help management produce at least a fair return for the Business Owners.

The process of planning expenditures on assets with cash flows that are expected to extend beyond one year.

Question 2

Types of Proposed Capital Projects: Risk Profile

Answer 2

1. Replacement: needed to continue operations LOW RISK
2. Replacement: cost reduction |
3. Expansion: existing products or markets |
4. Expansion: new products or markets v
5. Mergers/acquisitions: whole companies HIGH RISK
   - ————————————————————–
6. Safety/regulatory: government mandate

Question 3

Types of Proposed Capital Projects: Functional

Answer 3

1. To Grow Sales
2. To Reduce Operating Expenses
3. To Minimize Investment in Total Assets

Question 4

Net Present Value (NPV):

Answer 4

A financial management project evaluation method.

A method of ranking investment proposal using the NPV, which is equal to the present value of the project’s free cash flows discounted at the cost of capital.

Question 5

Internal Rate of Return (IRR):

Answer 5

A financial management project evaluation method.

The discount rate that forces a project’s NPV to equal zero.

Question 6

Assumptions for MPV and IRR?

Answer 6

The NPV assumes reinvestment at the WACC, while the IRR assumes reinvestment at the IRR.

Most firms, assume reinvestment at the WACC is more reasonable for the following reasons:

• If a firm has reasonably good access to the capital markets, it can raise all the capital it needs at the going rate.
• Because the Firm can obtain capital at 10%

Question 7

Payback Period:

Answer 7

The length of time required for an investment’s cash flows to cover its cost.

Question 8

Payback Period Flaws?

Answer 8

1. All dollars received in different years are given the same weight (the time value of money is ignored).
2. Cash Flows beyond the payback year are given no consideration regardless of how large they might be.
3. Unlike the NPV, which tells us how much wealth a project adds, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we will recover our investment.

Question 9

Profitability Index:

Answer 9

A financial management project evaluation method.

-To what extent does the Gross Present Value exceed the upfront costs?