Corporate Finance: Capital Budgeting Questions
and Answers Grade 2023
capital budgeting process - -the process of identifying and evaluating capital projects (projects
where the cash flow to the firm will be received over a period longer than one year)
-4 administrative steps of capital budgeting process - -1. idea generation
2. analyzing project proposals (decision to accept/reject)
3. create firm-wide capital budget
4. monitoring decisions and conducting post-audit
-5 key principles of capital budgeting process - -1. decisions based on cash flows, not accounting
income
2. cash flows based on opportunity cost
3. timing of cash flows is important
4. cash flows analyzed on after-tax basis
5. financing costs reflected in project's required rate of return
-sunk costs - -costs that cannot be avoided, even if project is not undertaken
- not included in analysis (do not affect accept/reject decision)
-incremental cash flows - -relevant cash flows to consider as part of the capital budgeting process
changes in cash flows that will occur if project is undertaken
-externalities - -the effects the acceptance of a project might have on other firm cash flows
-cannibalization - -negative externality - occurs when a new project takes sales from an existing
product
-conventional vs unconventional cash flow pattern - -conventional: sign changes once - one or
more cash outflows followed by series of inflows
unconventional: more than one sign change (outflow then inflow then outflow, etc)
-opportunity cost - -cash flows the firm will lose by undertaking the project under analysis
- ex: if firm already owns land, it is still a cost because without the project they could sell it
- should be included in project costs
-independent projects - -projects that are unrelated to each other and allow for each project to be
evaluated based on its own profitability
-mutually exclusive projects - -only one project in a set of possible projects can be accepted; the
projects compete with each other
and Answers Grade 2023
capital budgeting process - -the process of identifying and evaluating capital projects (projects
where the cash flow to the firm will be received over a period longer than one year)
-4 administrative steps of capital budgeting process - -1. idea generation
2. analyzing project proposals (decision to accept/reject)
3. create firm-wide capital budget
4. monitoring decisions and conducting post-audit
-5 key principles of capital budgeting process - -1. decisions based on cash flows, not accounting
income
2. cash flows based on opportunity cost
3. timing of cash flows is important
4. cash flows analyzed on after-tax basis
5. financing costs reflected in project's required rate of return
-sunk costs - -costs that cannot be avoided, even if project is not undertaken
- not included in analysis (do not affect accept/reject decision)
-incremental cash flows - -relevant cash flows to consider as part of the capital budgeting process
changes in cash flows that will occur if project is undertaken
-externalities - -the effects the acceptance of a project might have on other firm cash flows
-cannibalization - -negative externality - occurs when a new project takes sales from an existing
product
-conventional vs unconventional cash flow pattern - -conventional: sign changes once - one or
more cash outflows followed by series of inflows
unconventional: more than one sign change (outflow then inflow then outflow, etc)
-opportunity cost - -cash flows the firm will lose by undertaking the project under analysis
- ex: if firm already owns land, it is still a cost because without the project they could sell it
- should be included in project costs
-independent projects - -projects that are unrelated to each other and allow for each project to be
evaluated based on its own profitability
-mutually exclusive projects - -only one project in a set of possible projects can be accepted; the
projects compete with each other
