Chapter 15
Capital Budgeting
Questions
1.
Capital assets are the longlived assets that are acquired by a firm.
Capital assets
provide the essential production and distributional capabilities required by all
organizations.
2.
Cash flows are the final objective of capital budgeting investments just as cash flows
are the final objective of any investment. Accounting income ultimately becomes cash
flow but is reported based on accruals and other accounting assumptions and
conventions. These accounting practices and assumptions detract from the purity of
cash flows and, therefore, are not used in capital budgeting.
3.
Time lines provide clear visual models of the expected cash inflows and outflows for
each point in time for a project. They provide an efficient and effective means to
help organize the information needed to perform capital budgeting analyses.
4.
The payback method measures the time expected for the firm to recover its
investment. The method ignores the receipts expected to occur after the investment
is recovered and ignores the time value of money.
5.
Return of capital means the investor is receiving the principal that was originally
invested. Return on capital means the investor is receiving an amount earned on
the investment.
6.
The NPV of a project is the present value of all cash inflows less the present values of
all outflows associated with a project.
If the NPV is zero, it is acceptable because, in
that case, the project will exactly earn the required cost of capital rate of return. Also,
when NPV equals zero, the project’s internal rate of return equals the cost of capital.
7.
It is highly unlikely that the estimated NPV will exactly equal the actual NPV
achieved because of the number of estimates necessary in the original computation.
These estimates include the project life, the discount rate chosen and the timing and
amounts of cash inflows and outflows. The original investment may also include an
estimate of the amount of working capital that is needed at the beginning of the
project life.
8.
The NPV method subtracts the initial investment from the discounted net cash
inflows to arrive at the net present value. The profitability index is calculated by
dividing the discounted cash inflows by the initial investment. Thus, each
computation uses the same set of amounts in different ways. The PI model attempts
to measure the planned efficiency of the use of the money (i.e., output/input) in that
it reflects the expected dollars of discounted cash inflows per dollar of investment in
the project.
A PI equal to or greater than 1.00 is equivalent to a NPV equal to or
greater than zero and indicates that the investment will provide an acceptable return
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Chapter 15
on capital.
9.
The IRR is the rate that would cause the NPV of a project to equal zero. A project is
considered potentially successful (all other factors being acceptable) if the
calculated IRR equals or exceeds the company's cost of capital.
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 Fall '08
 NaceMagner
 Cost Accounting, Net Present Value

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