Capital Budgeting: Decision Criteria

Capital Budgeting: Decision Criteria and Real Options

• Multiple internal rates of return can occur when there is more than one sign change in the pattern of cash flows over a project's life.
• The profitability index measures the present value return for each dollar of initial investment.
• The payback method is a crude measure of risk as it does not consider the variability of project returns.
• A project is acceptable using the profitability index if the index is greater than or equal to 1
• The payback period is the number of years required for the cumulative cash flows from a project to equal the initial outlay.
• NPV and IRR are likely to yield conflicting decisions when project sizes are significantly different.
• The objective of solving capital rationing problems is to maximize the NPV of the projects accepted.
• The profitability index approach always gives the same accept-reject decision for independent projects like using NPV and IRR
• The profitability index approach may not yield identical decision for mutually exclusive projects as NPV and IRR.
• In capital rationing problems, the objective is to maximize the NPV of the projects that are accepted.
• Capital rationing problems can be solved using linear programming, goal programming or ranking projects by payback or profitability index.
• To compensate for inflation in capital budgeting, it is necessary to use constant dollar estimates of costs and revenues.
• When a net present value analysis is positive for a project, then the internal rate of return is greater than the firm's cost of capital.
• When there is a conflict in decisions, the NPV method should be preferred to PI in mutually exclusive projects.
• The net present value method assumes the cash flows over a project's life are reinvested at the firm's cost of capital.
• The internal rate of return method assumes the reinvestment of the cash flows at the computed IRR.
• The value additivity principle implies that the value of a firm increases when an independent project is undertaken, by the net present value of the cash inflows from the project.
• The profitability index is computed as the ratio of the present value of future net cash flows to the net investment.
• The payback period is the length of time required for the cumulative cash inflows from a project to equal the initial investment.
• Real options in capital budgeting can include the abandonment option, investment option, purchasing power option, and shutdown option.
• When evaluating international capital expenditure projects, the analyst multiplies the present value of the cash flows in the local currency by the spot exchange rate.
• Some capital budgeting decisions are affected by the firm's marginal tax rate and the required rate of return
• The profitability index would be negative if the present value of the net cash flows over the life of a project were less than the net investment.

Test your knowledge on capital budgeting decision criteria including internal rates of return, profitability index, and payback methods. Understand the significance of NPV, IRR, and how to approach capital rationing problems. This quiz will help reinforce key concepts vital for evaluating investment projects.