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ch10sm - CHAPTER 10 The Fundamentals of Capital Budgeting...

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Page 1 of 45 CHAPTER 10 The Fundamentals of Capital Budgeting Critical Thinking Questions 10.1 Explain why the cost of capital is referred to as the “hurdle” rate in capital budgeting. The cost of capital is the minimum required return on any new investment that allows a firm to break even. Since we are using the cost of capital as a benchmark or “hurdle” to compare the return earned by any project, it is sometimes referred to as the hurdle rate. 10.2 a. A company is building a new plant on the outskirts of Smallesville. The town has offered to donate the land, and as part of the agreement, the company will have to build an access road from the main highway to the plant. How will the project of building the road be classified in capital budgeting analysis? b. Sykes, Inc., is considering two projects—a plant expansion and a new computer system for the firm’s production department. Classify each of these projects as independent, mutually exclusive, or contingent projects and explain your reasoning. c. Your firm is currently considering the upgrading of the operating systems of all the firm’s computers. The firm can choose the Linux operating system that a local computer services firm has offered to install and maintain. Microsoft has also put in a bid to install the new Windows Vista operating system for businesses. What type of project is this? a. This is a contingent project. Acceptance of the road-building project is contingent on the new plant being a financially viable project. If the new plant will not have a positive value, then the firm will not even consider this project. However, this project’s cost will have to be considered along with the cost of building the new plant in the capital budgeting analysis. b. These two projects are independent projects. Accepting or rejecting one will not influence the decision on the other project. The cash flows of the two projects are unrelated. c. These are two mutually exclusive projects. The company’s computers need only one operating system. Either the Linux or the Windows operating system needs to be installed, not both. Hence, the selection of one will eliminate the other from consideration. 10.3 In the context of capital budgeting, what is “capital rationing”? Capital rationing implies that a firm does not have the resources necessary to fund all of the available projects. In other words, funding needs exceed funding resources. Thus, the available capital will be allocated to the projects that will benefit the firm and its shareholders the most. Projects that create the largest increase in shareholder wealth will be accepted until all the available resources have been allocated. 10.4 Explain why we use discounted cash flows instead of actual market price data.
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Page 2 of 45 While market price data would be preferable to estimating future cash flows in determining an asset’s value, it is often not available. Thus, the discounted cash flow approach is used as a proxy for actual market price of an asset’s value.
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ch10sm - CHAPTER 10 The Fundamentals of Capital Budgeting...

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