Chapter 13: Capital Budgeting Decisions

Building Blocks Co. is considering the purchase of a new specialty saw. The saw has a useful life of 10 years, but the salvage value is unknown. The net present value excluding the salvage value of the saw is negative $13,950. If the present value factor is 0.558, then the salvage value must be _____ in order to make this investment acceptable.

$25,000 Formula: Negative net present value to be offset / Present value factor $13,950 / 0.558 = $25,000

Most projects have at least three types of cash inflows:

1. A project will normally increase revenues or reduce costs. The amount involved should be treated as a cash inflow for capital budgeting purposes. 2. Cash inflows are also frequently realized from selling equipment for its salvage value when a project ends, although the company may actually have to pay to dispose of some low-value or hazardous items. 3. Any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time. Working capital is released, for example, when a company sells off its inventory or collects its accounts receivable.

Any decision that involves a cash outlay now in order to obtain a future return is a capital budgeting decision. Typical capital budgeting decisions include:

1. Cost reduction decisions. Should new equipment be purchased to reduce costs? 2. Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase capacity and sales? 3. Equipment selection decisions. Which of several available machines should be purchased? 4. Lease or buy decisions. Should new equipment be leased or purchased? 5. Equipment replacement decisions. Should old equipment be replaced now or later?

Match the net present value analysis with the appropriate reasoning.

Acceptable project with a positive net present value - The project promises a return greater than the required rate of return Acceptable project with a net present value of zero - The project promises a return equal to the required rate of return Unacceptable project with a negative net present value - The project promises a return less than the required rate of return

Formula of simple rate of return:

Annual incremental net operating income / Initial investment

When the annual net cash inflow is the same every year, this formula can be used to compute the payback period:

Payback period = Investment required / Annual net cash inflow

_____ _____, by contrast, relate to selecting from among several acceptable alternatives. To illustrate, a company may be considering several different machines to replace an existing machine on the assembly line. The choice of which machine to purchase is this type of decision.

Preference decisions

_____ _____ relate to whether a proposed project is acceptable--whether it passes a preset hurdle. For example, a company may have a policy of accepting projects only if they provide a return of at least 20% on the investment.

Screening decisions

True or false: When a company takes on a new project, the balances in the current asset accounts often increase.

True

True or false: When using the internal rate of return method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project.

True

True or false: When using the project profitability index to rank competing investments projects, the preference rule is: The higher the project profitability index, the more desirable the project.

True

_____ _____ is current assets less current liabilities.

Working capital

Reggie's Refrigerators is considering the purchase of some new equipment. The company has limited its purchase options to two alternatives. Option A has an internal rate of return of 10%, and option B has an internal rate of return of 13%. If the required rate of return on the project is 9.5%, what is the most preferred option? a) Option B b) Neither option c) Option A

a) Option B

Water World is planning to build a new attraction at its water park. A new wave pool would have a project profitability index of 0.09, and a new water slide would have a project profitability index of 0.14. Which attraction is the best choice for Water World? a) The new water slide b) The new wave pool

a) The new water slide

Calderon Kitchen Supplies is planning to invest $210,000 in a new product. The product is expected to generate a net present value of $56,700. The project profitability index is: a) 3.70 b) 0.27 c) 1.27 d) .787

b) 0.27

Which of the following capital budgeting decision tools focuses on net operating income rather than cash flows? a) Internal rate of return b) Simple rate of return c) Minimum required rate of return d) Net present value

b) Simple rate of return

The term _____ _____ is used to describe how managers plan significant investments in projects that have long-term implications such as the purchase of new equipment or the introduction of new products.

capital budgeting

The payback method, the net present value method, and internal rate or return method--all focus on analyzing the _____ _____ associated with capital investment projects.

cash flows

A company's _____ _____ _____ is usually regarded as its minimum required rate of return.

cost of capital

The _____ _____ _____ is the average rate of return that the company must pay to its long-term creditors and its shareholders for the use of their funds.

cost of capital * If the project's rate of return is less than the cost of capital, the company does not earn enough to compensate its creditors and shareholders. Therefore, any project with a rate of return less than the cost of capital should be rejected.

The simple rate of return method focuses on _____ _____ _____ _____.

incremental net operating income

The _____ _____ _____ _____ is the rate of return of an investment project over its useful life.

internal rate of return

The "_____ _____" refers to any cash outflows that occur at the beginning of the project, reduced by any salvage value recovered from the sale of old equipment. It also includes any investment in working capital that the project may need.

investment required

The _____ _____ _____ method compares the present value of a project's cash inflows to the present value of its cash outflows. The difference between the present value of these cash flows, called the net present value, determines whether or not a project is an acceptable investment.

net present value

The two capital budgeting approaches that use discounted cash flows are the _____ _____ value method and the _____ _____ of return method.

net present, internal rate

The _____ _____ of evaluating capital budgeting projects focuses on the _____ _____.

payback method, payback period

The _____ _____ is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates.

payback period *This period is sometimes referred to as "the time that it takes for an investment to pay for itself."

The _____ _____ _____ is an application of the techniques for utilizing constrained resources.

project profitability index

Capital budgeting decisions fall into two broad categories--_____ _____ and _____ _____.

screening decisions, preference decisions

The _____ _____ _____ _____ method is also often referred to as the accounting rate of return or the unadjusted rate of return.

simple rate of return

The payback period is expressed in _____.

years

The internal rate of return is computed by finding the discount rate that equates the present value of a project's cash outflows with the present value of its cash inflows. In other words, the internal rate of return is the discount rate that results in a net present value of _____.

zero