capital budgeting

Question 1

Define “capital budgeting.”

Answer 1

The process of measuring, evaluating, and
selecting long-term investment opportunities,
primarily in the form of projects or programs

Question 2

Define “risk premium.”

Answer 2

The rate of return expected above the risk-free
rate based on the perceived level of risk
inherent in an investment/undertaking

Question 3

Describe the relationship between a firm’s
capital projects and the firm’s capital that
funds those projects.

Answer 3

The rate of return earned on a firm’s capital
projects must be equal to or greater than the
rate of return required to attract and maintain
investors’ capital.

Question 4

Define “risk.”

Answer 4

The possibility of loss or other unfavorable
results that derives from the uncertainty
implicit in future outcomes

Question 5

Give examples of risk associated with

investments in capital projects.

Answer 5

Incomplete or incorrect analysis of a
project
Unanticipated actions of customers,
suppliers, and competitors
Unanticipated changes in laws,
regulations, and so on
Unanticipated macroeconomic changes
(e.g., interest rates, inflation/deflation,
tax rates, currency exchange rates,

Question 6

Describe the risk/reward relationship.

Answer 6

The greater the perceived risk of an
undertaking, the higher the expected reward
from the undertaking.

Question 7

Define “risk-free rate of return”.

Answer 7

The rate of return expected assuming virtually
no risk; rate of return expected solely for the
deferred current consumption that results from
making an investment. In the U.S., it is
measured by the rates paid on U.S. Treasury
obligations.

Question 8

Describe the payback period approach to

project evaluation.

Answer 8

It determines the number of years (or other
periods) needed to recover the initial cash
investment in the project and compares the
resulting time with a pre-established maximum
payback period. It uses undiscounted expected
future cash flows

Question 9

Under what circumstances would the payback
period approach to project evaluation be most
appropriate?

Answer 9

When:
Used as a preliminary screening
technique
Used in conjunction with other
evaluation techniques
When recovery of cash (liquidity) is of
critical importance

Question 10

Identify the advantages of the payback period

approach to project evaluation.

Answer 10

It is easy to use and understand.
It is useful in evaluating liquidity of a
project.
Use of a short payback period reduces
uncertainty

Question 11

Identify the disadvantages of the payback

period approach to project evaluation.

Answer 11

It ignores the time value of money.
It ignores cash flows received after the
payback period.
It does not measure total project
profitability.
The maximum payback period may be
arbitrary.

Question 12

Identify at least five different techniques for

evaluating capital budgeting projects.

Answer 12

Payback period approach

2. Discounted payback period approach
3. Accounting rate of return approach
4. Net present value approach
5. Internal rate of return approach

Question 13

risk premium

Answer 13

return expected above risk free rate

Question 14

hurdle rate

Answer 14

rate of return required to attract and maintain capital is the cost of capital to the firm and that cost of capital is the rate the firm must earn on its investments

Question 15

weighted average of total capital

Answer 15

weighted average is the rate of return that a firm must expect to earn on projects undertakes. the hurdle rate