Capital budgeting chap. 10 fin 3414

10-2. The two types of decision practices that financial managers apply when selecting between mutually exclusive capital budgeting projects are___________________ and ___________________.

Accept/reject; ranking

10-1. _________________________ is the process of evaluating proposed large, long-term investment projects.

Capital budgeting

10-9. The practice of placing dollar limits on the total size of the capital budget is called ___________________________.

Capital rationing

10-22. What is capital rationing, and is it consistent with the goal of maximizing shareholder wealth? Why or why not?

Capital rationing is the process of setting dollar limits on the total size of the capital budget. Although this practice may not be strictly consistent with shareholder value maximization, it is not uncommon for firms to ration capital. Some of the possible reasons for doing so include a desire to avoid external financing in unfavorable economic climates, concerns about potential loss of control, and the possible inadequacy of resources such as managerial talent.

10-12. When projects differ in risk, the manager should estimate the riskiness by comparing the _________________ of the firm's portfolio with and without the projects under consideration.

Coefficient of variation

10-23. When NPV and IRR give inconsistent ranking for mutually exclusive projects, which method should be chosen and why?

For mutually exclusive projects, conflicts in ranking based on NPV and IRR may sometimes occur. These are generally due to differences in timing of cash flows or scale of the projects. For example, a small project may have a very large IRR but will add very little to the value of the firm. Another project may have an IRR fairly close to the hurdle rate, but the sheer size of the project means that it will add significantly to firm value. When conflicts arise, the decision should be based on NPV because this is a measure of the impact on the firm's value.

10-15. For independent projects, firms should accept every project with net present value _______________ than zero and internal rate of return ______________ than the required rate of return.

Greater; greater

10-10. ____________________ is often the preferred capital budgeting decision method because managers and owners prefer to work with percentage returns that can be compared easily with alternatives.

IRR

10-5. A cash flow that will occur if a project is undertaken but will not occur if the project is not undertaken is an ___________________________ cash flow to the project.

Incremental

10-3. Projects that do not compete with each other are called ___________________ .

Independent

10-8. The projected rate of return that a proposed project will earn, given its incremental cash flows and required initial cash outlay, is called the _____________________________.

Internal rate of return

10-7. The __________________________________ is a more realistic rate of return expectation than that of IRR as it uses cost of capital to reinvest future cash flows.

MIRR

10-4. If a firm is deciding between leasing a fleet of trucks and buying the trucks, these capital budgeting projects are ________________________ since the firm can only accept one of them.

Mutually exclusive

10-11. Conflicts between decision methods occasionally arise when projects are __________________________; in such a case, the one with the highest __________________________ should be chosen.

Mutually exclusive; NPV

10-14. A ________________________________ , a graph that shows a project's NPV at many different discount rates, is used to show how sensitive a project's NPV is to changes in the discount rate.

NPV profile

10-21. What are risk-adjusted discount rates?

One way to factor risk into the capital budgeting process is to adjust the required returns used in NPV and the IRR hurdle rate upward for higher-than-average risk projects and downward for projects that have lower-than-average risk. The resulting required return is called a risk-adjusted discount rate (RADR) and is called a "hurdle rate" because it is the rate that IRR must be greater than to be acceptable.

10-6. The number of time periods that it will take to recoup the initial cash outlay for a capital budgeting project is called the _____________________.

Payback period

10-13. For projects that are determined to be riskier than average, _______________ ____________________ should be used to calculate NPV and to evaluate IRR.

Risk-adjusted discount rates

10-20. What are the main advantages and disadvantages of using internal rate of return to make capital budgeting decisions?

The benefits of IRR are that it focuses on all cash flows associated with the project, it adjusts for the time value of money, and it describes projects in terms of the rate of return they earn which makes them easier to compare to other investments and the firm's hurdle rate. The problems with the IRR measure are that it does not show how much the project will add to firm value and the IRR earned only if all incremental cash flows are reinvested at the IRR. For high IRR 130 projects, this may not be likely. Furthermore, for some projects, there may be more than one IRR.

10-16. What are the four major steps in the capital budgeting process?

The four major steps in the capital budgeting process are: (a) finding projects; (b) estimating the incremental cash flows associated with the projects; (c) evaluating and selecting projects; and (d) implementing and monitoring projects.

10-19. What are the main advantages and disadvantages of using net present value to make capital budgeting decisions?

The major advantage of the NPV rule is that it is consistent with the goal of maximizing shareholder value. If a firm consistently picks the projects with highest NPV, this will ensure that they are choosing the projects that add value to the firm. Furthermore, the NPV method considers all incremental cash flows and takes into account the time value of money. However, it has two main disadvantages. First, it is difficult to explain this method to non-finance people. Second, the fact that the measure is in dollars instead of percent terms makes it more difficult for managers to compare alternatives.

10-18. What are the main advantages and disadvantages of using the payback method to make capital budgeting decisions?

The major advantage of the payback method is its simplicity. It is useful as a rough measure of a project's risk and liquidity. Its major disadvantages are that it does not consider cash flows that occur beyond the payback period, and it does not consider the time value of money.

10-17. What are the three major capital budgeting decision methods?

The three major capital budgeting decision methods that are introduced in this chapter are: payback, net present value, and internal rate of return.