Exam 3 - Capital Budgeting Quizlet

ANSWER: True EXPLANATION: Capital budgeting can be used to determine if a plant should be shut down or if additional plants are needed. Capital Budgeting will help make decisions on whether to expand or contract a business.

(T/F) Capital budgeting can provide a detailed analysis to determine if a business should continue to expand or contract its operations?

ANSWER: A, When the profitability index is greater than 1 EXPLANATION: When using capital budgeting to measure a project based on its profitability index (PI), projects with a PI of greater than 1 are considered acceptable. In mutually exclusive projects the project with the highest PI would be selected measure profitability in relation to the amount of the investment.

The profitability index measures a project's "bang for the buck", when would you accept a project based on the profitability index (PI)? A. When the profitability index is greater than 1 B. When the profitability index is less than 1 C. When the profitability index is greater than the hurdle rate defined as r D. When the profitability index is less than the hurdle rate defined as r E. When the profitability index is higher than the NPV

ANSWER: False EXPLANATION: Capital budgeting is the process in which a business determines and evaluates significant expenses or investments. (EXAMPLE: opening a new plant or investing in a new long-term venture).

(T/F) Capital Budgeting is the process that a firm uses to make sure it has enough funds to run its business on a day to day basis.

ANSWER: A, True EXPLANATION: Under Internal Rate of Return (IRR) method, accept projects that have an IRR greater than the cost of capital. In this situation, the cost of capital is also known as the hurdle rate because it is the rate that the project must exceed to be accepted.

(T/F) Internal rate of return (IRR) is another method used in capital budgeting. Under IRR the project is accepted if its IRR is greater than the cost of capital.

ANSWER: True The longer the payback period, the more risk involved in the project due to the length of time necessary to forecast into the future.

(T/F) Payback and Discounted Payback provide indications of a project's liquidity and risk. A long payback period means that cash flows must be forecast far into the future, and the probably makes the project riskier than one with less number of years until the project is completed. Capital Budgeting is typically done for projects with long term cash flow projections and not day to day operations.

ANSWER: True EXPLANATION: True. Reinvestment at the IRR is generally not correct, so the MIRR is considered a better estimation.

(T/F) The difference between the internal rate of return (IRR) method, and the modified internal rate of return (MIRR) method is that MIRR assumes returned are reinvested at the WACC, while IRR does not take reinvestment into consideration.

ANSWER: A, The discount payback method gives a better estimate because it takes the TMV into consideration and the payback method does not. EXPLANATION: The discount payback method takes the time value of money into consideration, and the payback method does not.

How does the discount payback method differ from the payback method? A. The discount payback method gives a better estimate because it takes the TMV into consideration and the payback method does not. B. The discount payback method is easier to calculate than the payback method. C. The discount payback method averages out the cash flow into a longer time frame and the payback method does not.

ANSWER: A, Net Present Value EXPLANATION: NPV is considered to be the best indicator because it provides a direct measure of the value a project adds to shareholder wealth. When deciding which projects to accept, NPV is generally regarded as the best single criterion. If other methods give conflicting responses as to which project should be selected, go with the NPV result.

If the NPV, IRR, MIRR, Payback Method, and Discount Payback Method all give different capital budgeting results, as a manager which capital budgeting method would you use to base your final decision on to invest or not invest in a new project? A. Net Present Value (NPV) B. Internal Rate of Return (IRR) C. Modified Internal Rate of Return (MIRR) D. Payback Method E. Discount Payback Method

ANSWER: D, Ignores the time value of money EXPLANATION: The payback method ignores the time value of money and does not take any cash flows that occur after the payback period into consideration. The discount payback method gives a better estimate because it takes TMV into consideration.

In capital budgeting, the payback method measures how many years it will take to recover the funds invested in a project. Basically, the payback method is a break-even analysis. Which of the following are considered to be a weakness of the payback period method? A. Not a good indicator of a project's risk B. Not easy to calculate C. Not a good indicator of a project's liquidity D. Ignores the time value of money

ANSWER: A, Accept the project if the NPV > 0 EXPLANATION: In capital budgeting, when using the Net Present Value (NPV) calculation accept projects with an NPV of greater than zero. If the projects are mutually exclusive, accept the project with the highest NPV.

Net Present Value is one method used in the capital budgeting process. It takes the present value of a project's expected cash flows (including its initial cost) and discounts it at the appropriate risk-adjusted rate. When calculating the results of NPV in the capital budgeting process, when do you accept a project under the NPV calculation? A. Accept the project if the NPV > 0 B. Accept the project if the NPV < 0 C. Accept the project if the NPV > r D. Accept the project if the NPV < r

ANSWER: E, All of the above EXPLANATION: A firm's ability to remain competitive and to survive depends on a constant flow of ideas for new products, improvements in existing products, and ways to operate more efficiently. Therefore, it is vital for a company to evaluate proposed projects accurately. Analyzing project proposals requires skill, effort, and time. For certain types of projects an extremely detailed analysis may be warranted, whereas simpler procedures are adequate for other projects. Accordingly, firms generally categorize projects and analyze those in each category somewhat differently.

Why is capital budgeting important? A. It provides a way to analyze and compare the cost of new business ventures B. It helps determine which projects would be most beneficial for a department within a company to accept in terms of cost and estimated return. C. It is important for a firm to use capital budgeting to continue to improve its existing product lines D. It is a way for a firm to avoid projects that may cost more to undertake, and help the company avoid poor business decisions. E. All of these responses are correct. F. None of these responses are correct.