chp 17 instructor manual

chp 17 instructor manual - Chapter 17 CAPITAL BUDGETING...

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Chapter 17 CAPITAL BUDGETING QUESTIONS AND ANSWERS Q17.1 “The decision to start your own firm and go into business can be thought of as a capital budgeting decision. You only go ahead if projected returns look attractive on a personal and financial basis.” Discuss this statement. Q17.1 ANSWER The decision to start your own firm and go into business can indeed be thought of as a capital budgeting decision. You only go for it if projected returns look attractive on a personal and financial basis. Formally, capital budgeting is described as the process of planning expenditures that generate cash flows expected to extend beyond one year. The choice of one year is arbitrary, of course, but it is a convenient cutoff for distinguishing between classes of expenditures. Examples of capital outlays are expenditures for land, buildings, equipment and for additions to working capital (e.g., inventories and receivables) made necessary by expansion. New advertising campaigns or research and development programs are also likely to have impacts beyond one year and come within the classification of capital budgeting expenditures. Practically speaking, the firm is an investment project, so the decision to go into business is a decision to fund a capital budgeting project. Both monetary and nonpecuniary benefits are often vital considerations. Nobody can afford to finance a money-losing operation indefinitely, so self-finance businesses must cover out of pocket costs and a reasonable rate of return on investment. Still, many entrepreneurs are attracted by the opportunity to “run their own show,” and take some of their overall pay in the form of nonpecuniary benefits, like work schedule flexibility or personal satisfaction. Q17.2 What major steps are involved in the capital budgeting process? Q17.2 ANSWER Conceptually, the capital budgeting process involves six logical steps. First, the cost of the project must be determined. This is similar to finding the price that must be paid for a stock or bond. Next, management must estimate the expected cash flows from the project, including the value of the asset at a specified terminal date. This is similar to estimating the future dividend or interest payment stream on a stock or bond. Third, the risk of projected cash flows must be estimated. To do this, management needs information about the probability distributions of the cash flows.
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21 Chapter 17 Fourth, given the risk of projected cash flows and the cost of funds under prevailing economic conditions as reflected by the risk-fee rate, R F , the firm must determine the appropriate discount rate, or cost of capital, at which the project’s cash flows are to be discounted. This is equivalent to finding the required rate of return on a stock or a bond investment. Fifth, expected cash flows are converted to a present value basis to obtain a clear estimate of the investment project’s value to the firm. This is equivalent to finding the present value of expected future dividends or interest plus
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This note was uploaded on 03/08/2011 for the course ECONABA 635 taught by Professor Leiter during the Summer '10 term at Andrew Jackson.

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chp 17 instructor manual - Chapter 17 CAPITAL BUDGETING...

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