Lecture 6 - Capital budgeting analysis

What is the primary focus of capital budgeting?

• Managing short-term assets

• Financing operations

• Long-term investment decisions

• Managing debt

Answer explanation

A) is not not completely wrong. however, it is not the main reason why statement of cash flows is valuable for investors.

Which of the following best describes sunk cost in the context of financial decision-making

• A cost that will only be incurred if a project is accepted.

• It is a cost that has already been incurred and cannot be changed by any decision made today

• It is a cost that can be recovered if a project is rejected

• It is a cost that has a significant impact on the future cash flows of a project.

One should consider net working capital (NWC) in project cash flows because

• Typically firms must invest cash in short-term assets to produce finished goods.

• NWC represents sunk costs

• Firm needs positive NPV projects for investment

• Inclusion of NWC typically increases calculated NPV

In the context of capital budgeting, what does the term ' mutually exclusive projects' mean?

• Projects that can be undertaken simultaneously

• Selecting one project excludes the others

• Projects that are not affected by the decision of other projects

• Projects that have the same NPV

True or False: Initial investment outlay and net working capital are typically considered when calculating the terminal cash flow at the end of a project.

• True

• False

Answer explanation

False. Only net working capital is recovered at the end. Initial outlay is not part of the terminal cash flow calculation.

It is an upfront cost incurred at the start of a project

Investments in inventories include investments in

• raw material only

• raw material and work-in-progress

• raw material, work-progress, and finished goods

• finished goods only

Answer explanation

Inventories typically include all goods that are part of the company's business operations and that it intends to sell or use to produce goods to be sold.

True of False: Project cash flows should take account of interest paid on any borrowing undertaken to finance the project

• True

• False

Answer explanation

Project cash flows typically should not include interest paid on any borrowing undertaken to finance the project - Interest expense is a financing cost.

Accountants do not depreciate investment in net working capital because

• It is not a cash flow

• It is recovered or at the end of the project, therefore not a depreciating assets

• It is a sunk cost

• Working capital appears on the balance sheet, not the income statement

Answer explanation

working capital is not considered a depreciating asset because it does not lose value over time.

Inventories are not intended for long-term use to a company.

Which is considered the gold standard for valuation?

• Payback period

• Internal rate of return (IRR)

• Financial ratios

• Discounted cash flows

What should a company do if both projects have negative NPV?

• Accept both projects to avoid losses

• Give up

• Reject both projects and re-evaluate assumptions

• Ignore the NPV and proceed based on intuition

Answer explanation

Both scenario and sensitivity analyses are used primarily to understand how changes in different variables or scenarios can impact NPV.

This helps in assessing the project's risk and uncertainty and help managers make more informed decisions