12 Lecture

1. In capital budgeting decisions with limited capital, which technique is used to determine which projects to pursue? a) Internal rate of return (IRR) b) Net present value (NPV) c) Capital rationing d) Sensitivity analysis Answer: c) Capital rationing

2. Which of the following methods considers the time value of money in capital budgeting decisions? a) Payback period b) Accounting rate of return (ARR) c) Net present value (NPV) d) Profitability index (PI) Answer: c) Net present value (NPV)

3. Which of the following is an advantage of using the internal rate of return (IRR) method? a) It provides a dollar amount for the project's profitability. b) It is easy to understand and calculate. c) It considers the time value of money. d) It does not require a discount rate. Answer: c) It considers the time value of money.

4. Which of the following is a limitation of using the payback period method? a) It does not consider the time value of money. b) It is difficult to calculate. c) It is based on estimates and assumptions. d) It does not provide a clear indication of profitability. Answer: a) It does not consider the time value of money.

5. What is the primary goal of capital budgeting? a) To maximize profits b) To minimize costs c) To maximize shareholder wealth d) To break even Answer: c) To maximize shareholder wealth

6. Which of the following is a disadvantage of using the profitability index (PI) method? a) It does not consider the time value of money. b) It can be difficult to interpret. c) It does not provide a dollar amount for the project's profitability. d) It requires a discount rate. Answer: c) It does not provide a dollar amount for the project's profitability.

7. Which of the following is a limitation of using the net present value (NPV) method? a) It does not consider the time value of money. b) It can be difficult to interpret. c) It requires a discount rate. d) It is based on estimates and assumptions. Answer: d) It is based on estimates and assumptions.

8. When capital is limited, which of the following is a factor to consider in selecting projects? a) Projects with high internal rates of return (IRRs) b) Projects with low net present values (NPVs) c) The timing of the project's cash flows d) Projects with high payback periods Answer: c) The timing of the project's cash flows

9. Which of the following is an advantage of using the modified internal rate of return (MIRR) method? a) It considers the time value of money. b) It is easy to calculate. c) It provides a clear indication of profitability. d) It does not require a discount rate. Answer: c) It provides a clear indication of profitability.

10. Which of the following methods calculates the rate of return that makes the net present value (NPV) of a project equal to zero? a) Payback period b) Internal rate of return (IRR) c) Profitability index (PI) d) Sensitivity analysis Answer: b) Internal rate of return (IRR)

1. What is the difference between the NPV and IRR methods? Which method would you prefer when investing in a new project and why?

Answer: The NPV method calculates the net present value of cash inflows and outflows, while the IRR method calculates the rate of return that equates the present value of cash inflows with the present value of outflows. I would prefer the NPV method when investing in a new project because it takes into account the time value of money and provides a more accurate picture of the project's profitability.

2. How can a company decide which projects to invest in when there is limited capital available?

Answer: The company can use various techniques such as ranking projects by their profitability index (PI) or by their NPV per dollar of investment. This will help the company to choose the projects that provide the highest return on investment with the limited capital available.

3. How do sunk costs and opportunity costs affect capital budgeting decisions?

Answer: Sunk costs are costs that have already been incurred and cannot be recovered, and should not be considered when making capital budgeting decisions. Opportunity costs are the costs of the next best alternative foregone, and should be taken into account when making capital budgeting decisions.

4. What is the difference between mutually exclusive and independent projects? How would you choose between two mutually exclusive projects?

Answer: Mutually exclusive projects are projects where choosing one project precludes the selection of other projects. Independent projects are projects that can be selected regardless of the choice of other projects. To choose between two mutually exclusive projects, we would select the project with the highest NPV.

5. What is the difference between the payback period and discounted payback period? Which method do you think is better and why?

Answer: The payback period is the time required for the initial investment to be recovered from the cash inflows. The discounted payback period takes into account the time value of money. I think the discounted payback period is better because it accounts for the time value of money and provides a more accurate picture of the project's profitability.

6. How does sensitivity analysis help in capital budgeting decisions?

Answer: Sensitivity analysis helps in assessing the risk associated with a project by determining the effect of changes in key variables on the project's profitability. This helps in making more informed decisions by identifying the most critical variables and the extent to which they affect the project's profitability.

7. What is the difference between capital budgeting and operational budgeting? How are they related?

Answer: Capital budgeting involves making long-term investment decisions, while operational budgeting involves planning short-term operational expenses. The two are related because operational budgets are used to forecast cash inflows and outflows for capital budgeting decisions.

8. How can a company deal with uncertainty in capital budgeting decisions?

Answer: A company can deal with uncertainty by using techniques such as scenario analysis, sensitivity analysis, and real options analysis. These techniques help in identifying potential risks and uncertainties associated with a project and provide a more accurate picture of the project's profitability.

9. What are the advantages and disadvantages of using the modified internal rate of return (MIRR) method over the traditional IRR method?

Answer: The advantage of using the MIRR method is that it assumes that cash inflows are reinvested at a rate equal to the cost of capital, which is more realistic than the IRR method, which assumes that cash inflows are reinvested at the IRR rate. The disadvantage of using the MIRR method is that it can be more difficult to calculate than the IRR method.

10. How can a company determine the optimal level of capital investment in a given period?

Answer: A company can determine the optimal level of capital investment by comparing the expected return on investment to

Capital budgeting involves selecting investment opportunities that are expected to provide higher returns than the cost of capital. However, when capital is limited, it becomes important to prioritize projects based on their potential for generating higher returns. In such cases, the interpretation of IRR and NPV becomes crucial for effective capital budgeting. Interpretation of IRR: IRR represents the rate of return that a project generates over its life. The interpretation of IRR depends on whether it exceeds the required rate of return or not. If the IRR is greater than the required rate of return, then the project is acceptable because it generates returns higher than the cost of capital. However, if the IRR is lower than the required rate of return, the project should be rejected because it does not generate returns that are sufficient to cover the cost of capital. Interpretation of NPV: NPV represents the difference between the present value of cash inflows and the present value of cash outflows. A positive NPV indicates that the project is acceptable because it generates returns that are higher than the cost of capital. However, if the NPV is negative, the project should be rejected because it does not generate returns that are sufficient to cover the cost of capital. When capital is limited, the capital rationing technique is used to prioritize projects based on their potential for generating higher returns. Under capital rationing, the projects are ranked based on their profitability index (PI), which is calculated as the ratio of the present value of cash inflows to the initial investment. The projects with the highest PI are given priority for funding. In conclusion, capital budgeting is an important aspect of financial management, and the interpretation of IRR and NPV is crucial for effective capital budgeting when capital is limited. Capital rationing is a useful technique for prioritizing projects based on their potential for generating higher returns.