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FM11 29 - Answer Projects are independent if the cash flows...

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Mini Case: 11 - 29 a. What is capital budgeting? Answer: Capital budgeting is the process of analyzing additions to fixed assets . Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company's course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved: 1. Estimate the cash flows --interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate , based on the riskiness of the cash flows and the general level of interest rates. This is called the project cost of capital in capital budgeting. 4. Evaluate the cash flows. b. What is the difference between independent and mutually exclusive projects?
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Unformatted text preview: Answer: Projects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if acceptance of one impacts adversely the cash flows of the other; that is, at most one of two or more such projects may be accepted. Put another way, when projects are mutually exclusive it means that they do the same job. For example, a forklift truck versus a conveyor system to move materials, or a bridge versus a ferry boat. Projects with normal cash flows have outflows, or costs, in the first year (or years) followed by a series of inflows. Projects with nonnormal cash flows have one or more outflows after the inflow stream has begun. Here are some examples: Inflow (+) Or Outflow (-) In Year 0 1 2 3 4 5 Normal - + + + + + - - + + + + - - - + + + Nonnormal - + + + + - - + + - + - + + + - - -...
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