Capital Budgeting

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1. Why is capital budgeting analysis so important to the firm?

Answer: The fundamental goal of the financial manager is to maximize shareholder wealth. Capital investments with positive NPV or APV contribute to shareholder wealth.

Additionally, capital

investments generally represent large expenditures relative to the value of the entire firm.


investments determine how efficiently and expensively the firm will produce its product. Consequently, capital expenditures determine the long-run competitive position of the firm in the product marketplace.

2. What is the intuition behind the NPV capital budgeting framework?

Answer: The NPV framework is a discounted cash flow technique. The methodology compares the present value of all cash inflows associated with the proposed project versus the present value of all project outflows. If inflows are enough to cover all operating costs and financing costs, the project adds wealth to shareholders.

3. Discuss what is meant by the incremental cash flows of a capital project.

Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash outflows that can be traced directly to the project under analysis.

4. Discuss the nature of the equation sequence, Equation 18.2a to 18.2f.

Answer: The equation sequence is a presentation of incremental annual cash flows associated with a capital expenditure. Equation 18.2a presents the most detailed expression for calculating these cash flows; it is composed of three terms. Equation 18.2b shows that these three terms are: i) incremental net profit associated with the project; ii) incremental depreciation allowance; and, iii) incremental after-tax interest expense associated with the borrowing capacity created by the project. Note, the incremental “net profit” is not accounting profit but rather net cash actually available for shareholders. Equation 18.2c cancels out the after-tax interest term in 18.2a, yielding a simpler formula. Equation 18.2d shows that the first term in 18.2c is generally called after-tax net operating income. Equation 18.2e yields yet a computationally simpler formula by combining the depreciation terms of 18.2c. Equation 18.2f shows that the first term in 18.2e is generally referred to as after-tax operating cash flow.

5. What makes the APV capital budgeting framework useful for analyzing foreign capital expenditures?

Answer: The APV framework is a value-additivity technique. Because international projects frequently have cash flows not encountered in domestic projects, the APV technique easily allows the analyst to add terms to the model that represent the special cash flows.

6. Relate the concept of lost sales to the definition of incremental cash flow.

Answer: When a new capital project is undertaken it may compete with an existing project(s), causing the old project(s) to experience a loss in sales revenue. From an incremental cash flow standpoint, the new project’s incremental revenue is the total sales revenue associated with the new project minus the lost sales revenue from the old project(s).

7. What problems can enter into the capital budgeting analysis if project debt is evaluated instead of the borrowing capacity created by the project?

Answer: If project debt is greater (less) than the borrowing capacity created by the capital project, and tax shields on the actual new debt are used in the analysis, the APV will be overstated (understated) making the project unjustly appear more (less) attractive than it actually is.

8. What is the nature of a concessionary loan and how is it handled in the APV model?

Answer: A concessionary loan is a loan offered by a governmental body at below the normal market rate of interest as an enticement for a firm to make a capital investment that will economically...
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