Lecture 2 Advanced Cap Budgeting

Question 1

Capital Budgting?

Answer 1

Process of evaluating long-term investment decisions

Question 2

Incremental Cash flows?

Answer 2

Difference in firm cash flows with Vs without the project

Question 3

Independent Projects?

Answer 3

Can accept multiple

Question 4

Mutually exclusive projects?

Answer 4

Accepting one excludes others?

Question 5

Capital Rationing?

Answer 5

Limited capital, so projects should be selected to maximize NPV within budget.

Question 6

What costs are excluded from capital budgeting analysis?

Answer 6

Sunk costs

Question 7

What costs are included in capital budgeting analysis?

Answer 7

Incremental cash flows
Opportunity costs
Externalities

Question 8

What are the evaluation methods of capital budgeting analysis?

Answer 8

NPV
Payback Period
Discounted Payback
AAR
IRR
MIRR
PI

Question 9

For NPV, explain:
- Key feature
- Pros
- Cons

Answer 9

Key Feature: PV of inflows - outflows
Pros:
- Uses all of CFs
- Time value
- Aligned with value maximisation
Cons:
- Biased toward longer projects

Question 10

For Payback Period, explain:
- Key feature
- Pros
- Cons

Answer 10

Key feature: Time to recover initial outlay
Pros:
- Simple
Cons:
- Ignores CFs after payback
- No TVM

Question 11

For Discounted Payback, explain:
- Key Feature
- Pros
- Cons

Answer 11

Key feature: Payback using PV of CFs
Pros:
- Accounts for TVM
Cons:
- Still ignores CFs after payback

Question 12

For AAR, explain:
- Key feature
- Pros
- Cons

Answer 12

Key feature: Avg accounting return / avg book value
Pros:
- Uses accounting data (readily available)
Cons:
- Ignores CFs and TVM

Question 13

For IRR, explain:
- Key features
- Pros
- Cons

Answer 13

Key features: Rate that sets NPV = 0
Pros:
- % return is useful
Cons:
- Multiple IRRs

Question 14

For MIRR, explain:
- Key feature
- Pros
- Cons

Answer 14

Key feature: Modified IRR with realistic reinvestment rate (e.g. WACC)
Pros:
- Fixes reinvestment flaw of IRR
Cons:
- Requires additional calculation (complex)

Question 15

For PI, explain:
- Key feature
- Pros
- Cons

Answer 15

Key feature: PV of inflows / initial outlay
Pros:
- Scaled version of NPV
Cons:
- Ignores scale of project