Sec E - Investment Decisions

Question 1

Net Working Capital in Capital Budgeting

Answer 1

Net Working Capital in Capital Budgeting:

⬆️ Net Working Capital
⬇️ Cash Flows

⬇️ Net Working Capital
⬆️ Cash Flows

Question 2

Real Options (aka Strategic Options)

Answer 2

Real Options (aka Strategic Options) are opportunities that exist within a capital project. These options arise as the environment or circumstances surrounding the investment change or when new information becomes available.

• Abandonment
• Growth Options
• Flexibility Options
• Timing Options

Question 3

Qualitative considerations involved in the capital budgeting decision

Answer 3

Qualitative considerations involved in the capital budgeting decision:

• Environmental impact
• Employee morale
• Ancillary benefits
• Strategic factors

Question 4

Relevant cash flows of a capital investment

Answer 4

Relevant cash flows of a capital investment:

IDF:

(I)ncremental or (D)ifferential
and
(F)uturistic

Question 5

Real Rate of Return

Answer 5

Real Rate of Return =

Monetary Rate of Return
—————————————-
1 + Inflation Rate

Question 6

Steps in the capital budgeting process

Answer 6

Steps in the capital budgeting process:

Identify
Evaluate
Decide
Monitor

(IEDM)

Question 7

Net Present Value

investments

Answer 7

Net Present Value =

n CFt
Σ ————— - CF0
t= 1 (1 + r)^t

Question 8

Net Present Value (NPV)

disadvantages

Answer 8

Net Present Value (NPV)
disadvantages:

• NPV does not provide any information regarding length of time before investment breaks even or adds value
• NPV provides a dollar value, rather than information about the return on investment, ie., efficiency of the initial investment

Question 10

Payback Period

Answer 10

Payback Period =

Final Period of Negative Cash Flows
\+
  Remaining Unrecovered Cash Flows
————————————————————
  After-Tax Cash Inflow During Final Year

Question 11

Payback Period

disadvantages

Answer 11

Payback Period
disadvantages:

• Does not account for after-tax cash flows above and beyond recovery of initial investment (i.e., only up until breakpoint)
• Does not reflect information regarding vale-maximization for shareholders; may result in a company accepting a less-profitable project that has more cash flows in early years vs more profitable project that has more cash flows in later years
• Does not take the time value of money into account or cost of capital

Question 12

Internal Rate of Return (IRR)

disadvantages

Answer 12

Internal Rate of Return (IRR)
disadvantages:

• There may be multiple IRRs or no IRR; this can happen when there are multiple changes in sign of cash flows
• IRR method not appropriate to use when comparing mutually exclusive projects; small project may have much higher IRR than larger project, while larger project may have higher NPV
• An IRR that is significantly higher than the actual reinvestment rate will overestimate the annual return of an equivalent project