capital budgeting

Question 1

what is capital budgeting?

Answer 1

Capital budgeting is the analysis and evaluation of investment projects which normally produce benefits over a number of years.

Question 2

what are typical projects dealt with in capital budgeting

Answer 2

typical projects include the acquisition of fixed assets, a marketing campaign or the opening of a new retailing outlet.

Question 3

why is cap budgeting decision important

Answer 3

the capital budgeting decision is important as it may result in a firm tying up a substantial amount of funds for a number of years.

Question 4

what are the two classifications of investment projects

Answer 4

replacement - the acquisition of an asset to maintain existing production.
expansion - either expansion in existing product lines or the introduction of new products.

Question 5

what does it mean for projects to be independent or mutually exclusive?

Answer 5

independent - we can accept both projects A and B

mutually excl - we can chose either A or B

Question 6

what are our main two capital budgeting techniques?

Answer 6

payback method and net present value (NPV)

Question 7

explain the payback method

Answer 7

This measures the time it takes for a firm to recover the cost of the investment from the cash flows generated by the project.

assumption - cash flows not used for anything else in the mean time

• cash flows exclude non cash items e.g. depreciation

Question 8

what is the decision rule relating to the payback method?

Answer 8

The decision rule – for a single project you must compare the payback to a standard or specific requirement otherwise for two or more projects accept the project with the shortest payback period

Question 9

advantages of the payback method

Answer 9

• easy to calculate and comprehend
• provides a measure of risk - shorter the pay back = the lesser the risk
• indicated the effect on liquidity
• widely used by banks for preliminary assessment

Question 10

disadvantges of the payback method

Answer 10

• ignores time value of money
• Ignores cash flows after the payback period. For example, Project I earns cash flows of R1,000 whilst Project J earns a much bigger cash flows of R8 000 which were ignored. - see lecture example 1

Question 11

decision for Net present value method

Answer 11

The decision rule – for a single project if the NPV is positive we will accept the project and for if we have to choose between two projects we select the greatest NPV