Ch 14 - Capital Budgeting

Question 1

Why are capital investments promising earlier cash flows more preferable to those promising later cash flows.

Answer 1

Time value of money; A dollar today is worth more than a dollar a year from now if for no other reason than you could put the dollar in a bank today and have more than a dollar a year from now.

Question 2

What is capital budgeting?

Answer 2

the planning and decision-making processes companies use to evaluate investment projects with multiyear profit and cash flow implications

Question 3

Four methods for capital budgeting

Answer 3

using cashflows:
payback method
(TVM) net present value method
(TMV) internal rate of return method

using incremental NOI:
simple/accounting rate of return method

Question 4

The Payback Method

Answer 4

Focuses on payback period (the length of time needed for a project to recover its initial cost from the net cash inflows it generates); the more quickly the cost of an investment can be recovered, the more desirable it is

Question 5

Payback period formula

Answer 5

for equal cash flows:
investment required/annual net cash inflow

for unequal cash flows:
years up to payoff year + (unrecovered investment/cash inflow of payoff year)

Question 6

Net Present Value Method

Answer 6

accounts for time value of money through discounted cash flows; compares the present value of cash inflows with the present value of cash outflows

Question 7

What must we assume when using the net present value method?

Answer 7

all cash flows occur at the end of the period (beside initial investment and all cash flows generated are reinvested at a rate of retrun equal to the discount rate

Question 8

When should you accept or reject the project based on NPV? What does 0 NPV mean?

Answer 8

Accept if NPV >=0
Reject if NPV < 0

When PV is 0, it is achieving required rate of return exactly.

Question 9

Which of the statements are true?

I. A positive NPV always means that the project will recover the initial investment.

II. A negative NPV always means that the project will not recover the initial investment.

Answer 9

Only I; negative NPV means project never recoveres initial investment because it has two components. It must recovr initial investment AND required rate of return.

Question 10

what does the Internal Rate of Return mean?

Answer 10

It sets net present value to zero and gives the highest discount rate that makes a project remain acceptable

Question 11

weaknesses of the payback period?

Answer 11

payback period ignores any future cash flows and time value of money

Question 12

what methods are screening tools and what methods are preference tools?

Answer 12

payback = screening
cost of capital = screening
NPV = preference