Chapter 13 notes

Question 1

Describe the capital budgeting process

Answer 1

usually companies follow a carefully prescrivbed process

because capital budgeting decisions are VERY important

Question 2

What does the capital budgeting process involve

Answer 2

involves top management and the board of directors

Question 3

What is important about the capital budget

Answer 3

the decisions often have a significant impact on a compay’s future profitability
- poor capital budgeting decisions can cost the company a lot of money

Question 4

What is done at least once a year in capital budgeting

Answer 4

1. project proposals are requested from departments, plants and authorized personnel
2. proposals are examined by capital budget committee
3. officers determine which projects are worthy of funding
4. the board of directors approves the capital budget

Question 5

Capital budgeting decsions depend on a variety of considerations. What are they

Answer 5

1. availability of funds
2. relationships among proposed projects
3. company’s basic decision making approach
4. risk associated with the particular project

Question 6

Regarding budgeting what is cash flow information

Answer 6

for the purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs

Question 7

What are some typical cash outflows

Answer 7

1. initial investment
2. repairs and maintenance
3. increased operating costs
4. overhaul of equipment

Question 8

what are some typical cash inflows

Answer 8

1. sale of old equipment
2. increased cash received from customers
3. reduced cash out flow from operating costs
4. salvage value of old equipment when project is complete

Question 9

What are the several methods that can help companies make effective capital budgeting decisions

Answer 9

1. cash payback technique
2. the net present value method
3. the internal rate of return method
4. annual rate of return method

Question 10

What do most of the capital budgeting methods uses

Answer 10

most of them use cash flow numbers rather than accrual accounting revenues and expenses

Question 11

Describe the cash payback method

Answer 11

• identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment

Question 12

What determines the attractiveness of an investment in the cash payback method

Answer 12

the shorter the payback period, the more attractive the investment

True for 2 reasons:

1. the earlier the investment is recovered, the sooner the cash can be used for other purposes
2. the risk of loss from obsolescence and change economic conditions is less in a shorter payback period

Question 13

what is the cash payback formula

Answer 13

cost of capital investment / net annual cash flow (inflows - outflows) = cash payback period

Question 14

describe the net present value method

Answer 14

• generally recognized as the best conceptual approach to making capital budgeting decisions
• considers both the estimated total cash inflows and the time value of money

Question 15

What are two methods used with the discounted cash flow technique

Answer 15

1. net present value

2. internal rate of return

Question 16

What is the formula for Net Present value

Answer 16

present value of net cash flows - capital investment = net present value

Question 17

Net present values: in choosing discount rate a company usually sues what ?

Answer 17

a discount rate that is equal to its cost of capital (rate it must pay to obtain funds from creditors and shareholders)

Question 18

Net PRsent Value: cost of capital is what

Answer 18

the weighted average of the rates paid on borrowed funds as well as on funds that are provided by investors in the company’s common and preferred shares

Question 19

Net Present Value: if a project is believed to be of higher risk than the company’s usual line of business what happens to the discount rate

Answer 19

it is increased

Question 20

what are some other names for the discount rate

Answer 20

1. Hurdle -rate
2. Required rate of return
3. cut-off rate

Question 21

What are the simplifying assumptions in Net present value method

Answer 21

1. all cash flows come at the end of the year
2. all cash flows are immediately reinvested in another project that has a similar return
3. all cash flows can be predicted with certainty

Question 22

In reality what are the assumptions for Net present value method

Answer 22

project results are only estimates

- based on forecasters belief about what is most likely to happen

Question 23

What is the one approach for dealing with uncertainty in the net present value method

Answer 23

Sensitivity analysis

Question 24

describe the sensitivity analysis

Answer 24

uses several outcome estimates to get a sense of the variability among potential returns

Question 25

Net Present Value: What are two approach that suggested to avoid rejecting projects that actually should be accepted

Answer 25

1. calculate net present value ignoring intangible benefits 2. project rough, conservative estimates of the value of the intangible benefits - and incorporate these values into the NPV Calculation

Question 26

describe calculate the net present value ignoring intangible benefits

Answer 26

if the NPV is negative, ask | whether the intangible benefits are worth at least the amount of negative NPV

Question 27

The Net Present Value: Profitability Index | what is it

Answer 27

considers both the size of the original investment and the discounted cash flows

Question 28

What is the formula for profitability index

Answer 28

present value of net cash flows / initial investment = profitability index

Question 29

Post Audition of investment projects | why is it important

Answer 29

1. if managers know that their estimates will be compared to actual results - managers will be more likely to submit reasonable and accurate data 2. provides a formal mechanism to determine whether existing projects should be supported or terminated 3. improve future investment proposals by evaluating past successes and failures, managers improve their estimation techniques

Question 30

What is the internal rate of return method

Answer 30

finds the interest yield of the potential investment - this is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows

Question 31

Which two methods are most widely used

Answer 31

1. internal rate of return | 2. cash payback method

Question 32

Internal rate of return: how do you determine the true interest rate

Answer 32

step 1: calculate the internal rate of return factor (capital investment / annual cash inflows = internal rate of return factor) Step 2: use the factor and the present value of an annuity of table to find the internal rate of return

Question 33

how do you find the internal rate of return on a table

Answer 33

locate the discount factor that is closest to the internal rate of return factor for the time period covered by the annual cash flows

Question 34

How does net present value calculate a dollar amount or percentage

Answer 34

dollar amount

Question 35

how dose internal rate of return calculate a dollar amount or percentage

Answer 35

percentage

Question 36

what is the decision rule in net present value

Answer 36

if the net present value is zero or positive, accept the proposal. - if it is negative, reject it

Question 37

what is the decision rule internal rate of return

Answer 37

if the internal rate of return is equal to or greater than the required rate of return - accept

Question 38

What is the annual rate of return technique

Answer 38

based on accounting data - indicates the profitability of a capital expenditure - compared with its required minimum rate of return for investments of similar risk

Question 39

What is the minimum rate of return based on

Answer 39

company's cost of capital | - which is the rate of return that management expects to pay on all borrowed and equity funds

Question 40

What is the formula for annual rate of return

Answer 40

expected net income / annual average investment = annual rate of return

Question 41

what is the formula for computing the annual average investment

Answer 41

expected annual net income is obtained from the projected income statement formula: original investment + value at tend of useful life / 2

Question 42

What is the decision rule for the annual rate of return technique

Answer 42

project is acceptable if its rate of return is greater than management's minimum rate of return when choosing among several acceptable projects, - the higher the rate of return for a given risk, the more attractive the investment