C214 FINANCIAL MANAGEMENT Topic 11 Capital Budgeting

11.2 What and Why?
Assessment Section 1
1
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What is capital budgeting?

 The process of budgeting a firm’s monthly revenue and expenses
 Correct


The process of deciding which projects increase firm value

Correct. Capital budgeting is the process of selecting long-lived projects that will
enhance firm value.

 The process of estimating the life of a new project
 The process of estimating the cost to start a new project

Capital budgeting is the overall process of selecting long-lived projects that will enhance
firm value. Estimating the cost to start a new project, finding differential cash flows, and
estimating the life of a new project are all activities that provide inputs for capital
budgeting.

2
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When evaluating a potential capital project, which of the following should be considered?

 Timing of the cash flows
 Size of the initial investment
 Riskiness of the project
 Correct


All of these choices

Timing of cash flows, size of the initial investment, and riskiness of the project should all be considered when
performing capital budgeting.

3
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What is the terminal cash flow?

 Correct

, The cash flows associated with unwinding the project

Correct. This is the definition of terminal cash flow.

 The outflow required to start a new project
 You Selected


The last year’s annual cash flows plus the cash flows from unwinding the project

Incorrect. This is the sum of the last year’s differential cash flow and the terminal
cash flow.

 The annual cash flows generated by the project

Terminal cash flow refers to the cash flows associated with unwinding the project.

The outflow required to start a new project is the definition of initial outlay. The annual cash
flows generated by the project are the terminal cash flow. The last year’s annual cash flows
plus the cash flows from unwinding the project is not a relevant calculation.

4
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Which of the following is NOT part of the capital budgeting calculation?

 Calculating the cash flow when the firm terminates the project
 Correct


Calculating the estimated value of the stock when the firm terminates the project

Correct. Calculating the estimated value of the stock when the firm terminates the
project is not a part of capital budgeting.

 Calculating annual cash flows for the life of the new project
 Calculating the initial cost to start the new project

Calculating the estimated value of the stock when the firm terminates the project is not a
part of capital budgeting. The other three options help us cash flows that are relevant
to captial budgeting, including the initial outlay, annual differential cash flows, and terminal
cash flow.

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What is the term for decisions about how a firm builds the asset side of the balance sheet by
allocating funds, time, and other resources?

 Working capital management

,  Dividend decisions
 Correct


Investment decisions

Correct. Investment decisions refer to decisions that involve various resources of the
firm to be invested to maximize shareholder wealth.

 Financing decisions

Investment decisions refer to decisions that involve various resources of the firm to be
invested to maximize shareholder wealth.

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Why is the payback method one of the most popular capital budgeting techniques used by
firms?

 It always provides the right answer.
 It considers time value of money.
 It helps explain the need for the internal rate of return.
 Correct


It is simple and intuitive.

Correct. Payback is one of the most popular techniques because it is simple and
intuitive.

Payback is one of the most popular techniques because it is simple and intuitive.


11.3 Stuff You Need to Know to Estimate
Cash Flows
Assessment Section 1
1
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Which of the following should be included in the capital budgeting calculation?

 The cost of a market study conducted prior to the decision
 The cost of feasibility consulting incurred before the decision point
 Correct


The cost of scrapping an old machine to replace with a new machine