Capital Budgeting

Estudia en línea en https://quizlet.com/_168gl0

1. what is the capital the process of identifying and evaluating capital pro-
budgeting process? jects, that is, projects where the cash flow to the firm
will be received over a period longer than a year

2. what are the four main 1. idea generation

administrative steps 2. analyzing project proposals
to the capital budget- 3. create the firm-wide capital budget
ing process? 4. monitoring decisions and conducting a post-audit

3. describe the "idea must generate good ideas, ideas can come from a
generation" step of number of sources including senior management,
the capital budgeting functional divisions, employees, or sources outside
process? the company

4. describe the "analyz- a financial manager must create a cashflow forecast

ing project proposals" for each product to determine its expected profitabil-
step of the capital bud- ity
geting process?

5. describe the "create firms must prioritize profitable projects according to

the firm-wide capi- the timing of the project's cash flows, available com-
tal budget" step of pany resources, and the company's overall strategic
the capital budgeting plan
process?

6. describe the "monitor- follow up on all capital budgeting decisions, compare

ing decisions and con- actual results to expected results (because capital
ducting a post-audit" budgeting process is only as good as the estimates
step of the capital bud- of the inputs into the model used to forecast cash
geting process? flows)

7. describe "replace- made without detailed analysis, basically we ask the

ment projects to main- question, should existing operations continue
tain the business"
when talking about
different types of capi-
tal budgeting projects.

8. describe "replace- determine whether equipment that is obsolete, but

ment projects for cost still useable, should be replaced
1/5
 Capital Budgeting
Estudia en línea en https://quizlet.com/_168gl0
reduction" when talk-
ing about different
types of capital bud-
geting projects.

9. describe "expansion taken on to grow the business and involve a complex

projects" when talking decision-making process because they require an
about different types explicit forecast of future demand
of capital budgeting
projects.

10. describe "new prod- complex decision-making process that will require
uct or market devel- lots of detailed analysis because of all of the uncer-
opment" when talking tainty
about different types
of capital budgeting
projects.

11. describe "mandatory required by the government or an insurance compa-

projects" when talking ny, typically involve safety-related or environmental
about different types concerns (generate little to no revenue)
of capital budgeting
projects.

12. what are the five
key principles of
the capital budgeting
process?
1. decisions are based on cash flows, not accounting
income
2. cash flows are based on opportunity costs
3. the timing of cash flows is important
4. cash flows are analyzed on an after-tax basis
5. financing costs are reflected in the project's re-
quired rate of return

13. describe why only in- they are the only relevant cash flows, they are the
cremental cash flows changes in cash flows that will occur if the project is
are relevant in undertaken
the capital budgeting
process?

14. what are sunk costs? costs that cannot be avoided, even if we decide not
to do the project
2/5
 Capital Budgeting
Estudia en línea en https://quizlet.com/_168gl0

15. what is cannibaliza- occurs when a new project takes sales from an ex-
tion? isting product (negative externality)

16. what is a conventional if the sign on the cash flows changes only once, with
cash flow pattern? one of more cash outflows followed by one or more
cash inflows

17. what is a unconven- if the sign on the cash flows changes more than once
tional cash flow pat-
tern?

18. what are opportunity cash flows that a firm will lose by undertaking the
costs in the context of project under analysis (cash flows forgone if you take
capital budgeting? on the project)

19. what is the definition projects that are unrelated to each other and allow
of independent pro- for each project to be evaluated based on its own
jects? profitability

20. what is the definition only one project in a set of possible projects can
of mutually exclusive be accepted and that the projects compete with ea-
projects? chother

21. if we assume a firm if the return on the project exceeds the cost of capital
has unlimited access then they should undertake the project
to capital then what
does this infer about
the possible projects
they look to take on?

22. what does capital ra- a company only has so much capital they can em-
tioning refer to? ploy, and therefore they will need to prioritize their
projects depending on which ones will yield the max-
imize shareholder value

23. what is the payback the number of years it takes to recover the initial cost
period (PBP)? of an investment

24.
3/5
 Capital Budgeting
Estudia en línea en https://quizlet.com/_168gl0
what is the main ben- it is a good measure of liquidity, however it is a
efit of calculating pay- horrible measurement of profitability since it doesn't
back period? take into account CFs after you are paid back

25. what is the discounted number of years it takes a project to recover its initial
payback period? investment in PV terms, and therefore is greater than
payback period without discounting (uses the PVs of
the project's estimated cash flows)

26. what is the profitabili- the PV of a project's future cash flows divided by the
ty index or PI? initial cash outlay (NPV / initial cash outlay)

27. if PI is greater than 1, greater than 1 you accept, less than one you reject
you do what with the
project? and if PI is
less than one you do
what with the project?

28. what is a project's NPV a graph that shows a project's NPV for different
profile? discount rates

29. graph two projects'

NPV profiles and show
where the crossover
rate is.

30. what is the crossover the rate in which the NPVs are equal for two different
rate when talking projects
about NPV?

31. how can you eas- subtract the cash flows from each project from each
ily calculate the other for each period and calculate the IRR of the net
crossover rate be- cash flows for each period
tween two projects?

32. what is a key advan- it is a direct measure of the expected increase in the
tage of NPV? value of the firm (theoretically the best method)

33. what is the main weak- it doesn't take into account the size of the project,
ness of NPV? just shows you value added from project
4/5
 Capital Budgeting
Estudia en línea en https://quizlet.com/_168gl0

34. what is a key advan- it measures profitability as a percentage, showing

tage of IRR? the return on each dollar invested (we can also tell
how much below the IRR the actual project return
could fall in percentage terms before the project
becomes uneconomic)

35. what are the main dis- 1. the possibility of producing rankings of mutually
advantages of IRR? exclusive projects are different from those of NPV
analysis
2. the possibility that a project has multiple IRRs or
no IRR

36. when might IRR and
NPV conclude dif-
ferent outcomes as
to which project we
should do?
1. when there are differences in project size (initial
outlay is a factor)
2. cash flow timing differences

37. what is the main rea- IRR assumes reinvestment at IRR rate (not realistic)
son we rank projects whereas NPV assumes reinvestment at the discount
according to NPV and rate (which is more realistic)
not IRR?

38. describe the multiple
IRR or no IRR prob-
lem that is sometimes
faced.
projects with an unconventional cash flow pattern
might have more than 1 IRR (there may be more
than one discount rate that will product an NPV of
0), other times there could be profitable projects that
mathematically no IRR can be calculated

5/5