Capital Budgeting

Question 1

Principals of capital budgeting

Answer 1

Based on incremental, after-tax cash flows

Externalities and cash opportunity costs (project sequencing) must be included in CF projections

Question 2

Payback (discounted) period

Answer 2

period of time to recover the original cost of the project or (original cost in PV terms)

discounted payback period =number of years until the year before full recovery + (unrecovered cost at start of year/CF from last year)

Where unrecovered cost = CFo - Cumulative PV cash flows to date

Question 3

Profitability index

Answer 3

= PV of FCFs/CFo

When > 1, NPV is positive

Question 4

Steps of Capital Budgeting

Answer 4

(1) Generate investment ideas; (2) Analyze project ideas; (3) Create firm-wide capital budget; and (4) Monitor decisions and conduct a post-audit

Question 5

Categories of Capital Projects

Answer 5

(1) Replacement projects for maintaining the business or for cost reduction; (2) Expansion projects; (3) New product or market development; (4) Mandatory projects to meet environmental or regulatory requirements;

Increasing risk in categories 1-3