Study Guide Test 3.docx - Study Guide Test#3 Chapter 10 The Fundamentals of Capital Budgeting 1 Why are Capital Budgeting decisions the most important

Study Guide Test 3.docx - Study Guide Test#3 Chapter 10 The...

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Study Guide Test #3 Chapter 10: The Fundamentals of Capital Budgeting 1. Why are Capital Budgeting decisions the most important investment decisions made by a firm’s management? Capital budgeting is the process by which management decides which productive assets the firm should invest in . Because capital expenditures involve large amounts of money , are critical to achieving the firm’s strategic plan , define the firm’s line of business over the long term , and determine the firm’s profitability for years to come, they are the most important investment decisions made by management. 2. Explain the benefits of using the Net Present Value (NPV) method to analyze capital expenditure decisions and calculate the NPV for a capital project: The NPV method leads to better investment decisions than other techniques because it: 1. Uses the discounted cash flow valuation approach, which accounts for the time value of money. 2. Provides a direct measure of how much a capital project is expected to increase the dollar value of the firm. Thus, NPV is consistent with the top management goal of maximizing stockholder value . Positive NPV projects increase shareholder wealth Negative NPV projects decrease shareholder wealth In theory, managers should be indifferent about accepting or rejecting zero NPV projects 3. Describe the strengths and weaknesses of the payback period as a capital expenditure decision making tool and compute the payback period for a capital project: The payback period is the length of time it will take for the cash flows from a project to recover the cost of the project. Strengths: o Easy to calculate and understand for people without a strong accounting and finance background. o A simple measure of a project’s liquidity risk . Weaknesses:
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o Most common version does not account for time value of money . o Does not consider cash flows past the payback period. o Bias against long-term projects such as research and development and new product launches. o Arbitrary cutoff point . 4. Explain the benefits of post-audit and periodic review of capital projects: Post-audit review: Management compares the actual performance of a project with what was projected in the capital budgeting proposal . A post-audit examination would determine why the project failed to achieve its expected financial goal. Projects reviews keep all people involved in the capital budgeting process honest because they know that the project and their performance will be reviewed and that they will be held accountable for the results . Periodic review: provides useful information about a firm’s business plan, including the cash flow projections and the operating cost assumptions . Business plans are management’s best estimates of future events at the time they are prepared, but as new information becomes available , managers use this information to adjust their plans .
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  • Fall '08
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