Chapter 9 (Jmbalavo)

Question 1

Essentially, what are capital budgeting decisions?

Answer 1

> Essentially, these are decisions related to investments in property, plant, and equipment.

Question 2

What is the approach to capital management decisions?

Answer 2

> As you will see, the approach to the proper analysis of these decisions requires that we take into account the fact that a dollar today is worth more than a dollar tomorrow.

> In other words, we must consider the time value of money.

Question 3

Why are investment decisions extremely important?

Answer 3

> investment decisions are extremely important because they have a major, long-term effect on a firm’s operations.

Question 4

What are capital expenditure decisions?

Answer 4

> Investment decisions involving the acquisition of long-lived assets

Question 5

Investment decisions involving the acquisition of long-lived assets are often referred to as capital expenditure decisions because of what reason?

Answer 5

> because they require that capital (company funds) be expended to acquire additional resources.

Question 6

What is another way to refer to investment decisions?

Answer 6

> Investment decisions are also called capital budgeting decisions.

Question 7

What is the capital budget and what is capital budgeting?

Answer 7

> Investment decisions are also called capital budgeting decisions.

Question 8

Crucial to an understanding of capital budgeting decisions is an understanding of what?

Answer 8

> Crucial to an understanding of capital budgeting decisions is an understanding of

Question 9

In evaluating an investment opportunity, a company must know what?

Answer 9

> must know not only how much cash it receives from or pays for an investment but also when the cash is received or paid.

Question 10

What does the time value of money concept recognize?

Answer 10

> The time value of money concept recognizes that it is better to receive a dollar today than it is to receive a dollar next year or any other time in the future.

> This is because the dollar received today can be invested so that at the end of the year, it amounts to more than a dollar.

Question 11

When would a company not invest money into a project?

Answer 11

> Obviously, the company would not invest money in a project unless it expected the total amount of funds received in the future to exceed the amount of the original investment.

Question 12

But by how much must the future cash flows exceed the original investment? To make it worth it (explain what is required)?

Answer 12

> Because money in the future is not equivalent to money today, we need to develop a way of converting future dollars into their equivalent current, or present, value.

> The techniques developed to equate future dollars to current dollars are referred to as present value techniques or time value of money methods.

Question 13

What are the steps to the NPV method?

Answer 13

> The first step in using the net present value method is to identify the amount and time period of each cash flow associated with a potential investment.

> The second step is to equate or discount the cash flows to their present values using a required rate of return.

> The third and final step is to evaluate the net present value

Question 14

What two cash flows are used in investments and what cash flows are relevant in the NPV method?

Answer 14

> Investment projects have both cash inflows (which are positive) and cash outflows (which are negative).

> the only relevant cash flows are those that are incremental—the cash flows that will be incurred if the project is undertaken. Cash flows that have already been incurred are sunk and have no bearing on a current investment decision.

Question 15

What is the required rate of return?

Answer 15

> The second step is to equate or discount the cash flows to their present values using a required rate of return.

Question 16

What is the net present value?

Answer 16

> The sum of the present values of all cash flows (inflows and outflows) is the net present value (NPV) of the investment.

Question 17

According to the NPV, when should an investment be undertaken?

Answer 17

> If the NPV is zero, the investment is generating a rate of return exactly equal to the required rate of return. Thus, the investment should be undertaken.

> If the NPV is positive, it should also be undertaken because it is generating a rate of return that is even greater than the required rate of return.

Question 18

When should an investment be rejected under NPV?

Answer 18

> Investment opportunities that have a negative NPV are not accepted because their rate of return is less than the required rate of return.

Question 19

What is the difference between the NPVs of any two alternatives? What is a secondary way to assess the difference of two alternatives?

Answer 19

> The difference between the NPVs of any two alternatives

> Another way to evaluate alternatives is to compute the present values of their incremental cash flows.

Question 20

What is the internal rate of return method?

Answer 20

> The internal rate of return method is an alternative to net present value for evaluating investment possibilities.

> Like net present value, it takes into account the time value of money. Specifically, the internal rate of return (IRR) is the rate of return that equates the present value of future cash flows to the investment outlay. In other words, it is the return that makes the NPV equal to zero.

Question 21

According to the IRR, when should an investment be undertaken? When should it not?

Answer 21

> If the IRR of a potential investment is equal to or greater than the required rate of return, the investment should be undertaken.

> less than the required rate of return = reject the investment

Question 22

When can IRR not be calculated? What do we do instead in those situations?

Answer 22

> For cases where cash flows are not equal each year, because we cannot divide the initial investment by a single cash flow annuity to yield a present value factor.

> Instead, we must estimate the internal rate of return and use the estimate to calculate the net present value of the project.

Question 23

When should the IRR rate be increased and decreased?

Answer 23

> If the net present value is greater than zero (implying an internal rate of return greater than the estimate), the estimate of the internal rate of return should be increased.

> If the net present value is less than zero (implying an internal rate of return less than the estimate), the estimate should be decreased.

Question 24

Although both the net present value method and the internal rate of return method take into account the time value of money, they differ in their approach to evaluating investment alternatives. Explain the difference:

Answer 24

> With net present value, any investment with a zero or positive net present value should be undertaken.

> With the internal rate of return method, any investment with an internal rate of return equal to or greater than the required rate of return should be undertaken

Question 25

Ignoring soft benefits may lead firms to do what?

Answer 25

> Ignoring soft benefits may lead firms to pass up investments that are of strategic importance, especially investments in advanced manufacturing technology.

Question 26

if the NPV of a potential investment is negative, managers should do what?

Answer 26

> if the NPV of a potential investment is negative, managers should calculate the amount of additional cash inflows needed to have a positive NPV.

Question 27

Managers should make a reasonable effort to calculate the cash value of what when evaluating investment opportunities?

Answer 27

> Managers should make a reasonable effort to calculate the cash value of soft benefits when analyzing investment opportunities.

Question 28

In practice, the required rate of return must be estimated by who?

Answer 28

> management >

Question 29

What is a cost capital?

Answer 29

> The cost of capital is the weighted average of the costs of debt and equity financing used to generate capital for investments.

Question 30

What is the cost of debt and the cost of equity?

Answer 30

> The cost of debt arises because interest must be paid to individuals, banks, and other companies that lend money to the firm. > Essentially, the cost of equity is the return demanded by shareholders for the risk they bear in supplying capital to the firm.

Question 31

What considerations play a major role in capital budgeting decisions?

Answer 31

> tax considerations play a major role in capital budgeting decisions, and we discuss them here.

Question 32

How do taxes increase or decrease cash flow?

Answer 32

> If an investment project generates taxable revenue, cash inflows from the project will be reduced by the taxes that must be paid on the revenue. > Similarly, if an investment project generates tax-deductible expenses, cash inflows from the project will be increased by the tax savings resulting from the decrease in income taxes payable.

Question 33

Does depreciation affect cash flow? If so, what is this term know as?

Answer 33

> depreciation does not directly affect cash flow, it indirectly affects cash flow because it reduces the amount of tax a company must pay. > That is, it acts to shield income from taxes. The term depreciation tax shield is used to refer to the tax savings resulting from depreciation.

Question 34

How is inflation taken into consideration?

Answer 34

> Inflation can be taken into account by multiplying the current level of cash flow by the expected rate of inflation.

Question 35

If inflation is ignored in net present value analysis, what happens?

Answer 35

> If inflation is ignored in net present value analysis, many worthwhile investment opportunities may be rejected b ecause current rates of return for debt and equity financing already include estimates of future inflation

Question 36

What are long run decisions?

Answer 36

> Long-run decisions are those that affect the cash flows of a number of future periods.

Question 37

What other long-run decisions should be assessed?

Answer 37

1) Decision to outsource grounds maintenance 2) Decision to drop a product line 3) Decision to buy rather than make a subcomponent of a product 4) Decision to conduct a multiyear advertising campaign 5) Decision involving customers paying for goods with alternative payment plans (e.g., large upfront payment and smaller annual payments versus small upfront payment and larger annual payments)

Question 38

Compared to NPV and IRR, what are two simpler methods?

Answer 38

> the payback period method and the accounting rate of return method

Question 39

What is the payback period?

Answer 39

> The payback period is the length of time it takes to recover the initial cost of an investment. > companies always like projects with short payback periods.

Question 40

What is one approach to using the payback method? But what should be noted about this

Answer 40

> One approach to using the payback method is to accept investment projects that have a payback period less than some specified requirement. > The problem is that the payback method does not take into account the total stream of cash flows related to an investment. It only considers the stream of cash flows up to the time the investment is paid back. > A further limitation of the payback method is that it does not consider the time value of money.

Question 41

What is the accounting rate of return?

Answer 41

> The accounting rate of return is equal to the average after-tax income from a project divided by the average investment in the project.

Question 42

The accounting rate of return can be used to evaluate investment opportunities in what way?

Answer 42

> The accounting rate of return can be used to evaluate investment opportunities by comparing their accounting rates of return with a required accounting rate of return.

Question 43

What is the limitation of the accounting rate of return method?

Answer 43

The primary limitation of this approach is that, like the payback period method, it ignores the time value of money.

Question 44

However, in some companies, managers may be discouraged from using present value techniques for evaluating investments - why?

Answer 44

> because of the way in which their own performance is evaluated.

Question 45

what is a solution to managers not using present value techniques?

Answer 45

> is to make sure managers realize that, if they approve projects with positive net present values that lower reported income in the short run, evaluations of their performance and their compensation will take the expected future benefits into account.