Capital Budgeting Overview
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Which stage in capital budgeting involves acquiring necessary information about potential projects?

  • Selection Stage
  • Search Stage
  • Information-Acquisition Stage (correct)
  • Identification Stage

    • The payback period measures the time needed to recover the initial investment from cash inflows.

    True

    What is the meaning of Net Present Value (NPV)?

    It represents the extra money a project is expected to generate beyond its initial cost, adjusted for the value of money over time.

    The _____ rate is the minimum acceptable rate of return that should be earned on a project.

    <p>hurdle</p> Signup and view all the answers

    Match the following capital budgeting techniques with their meanings:

    <p>Payback Period = Time required to recover the initial investment NPV = Extra money generated beyond initial investment Profitability Index = Ratio of present value of cash flows to initial investment IRR = Discount rate that makes NPV zero</p> Signup and view all the answers

    Which of the following describes mutually exclusive projects?

    <p>Acceptance of one project precludes acceptance of another</p> Signup and view all the answers

    Projects with a Profitability Index (PI) less than 1 are considered acceptable.

    <p>False</p> Signup and view all the answers

    What does the term 'post payback period amount' refer to?

    <p>Cash inflows generated after the initial investment has been fully recovered.</p> Signup and view all the answers

    What is the decision rule for selecting projects using the Internal Rate of Return (IRR)?

    <p>Select projects with IRRs above the cost of capital.</p> Signup and view all the answers

    What is the Profitability Index (PI) calculated based on the provided cash flows?

    <p>1.10</p> Signup and view all the answers

    Modified Internal Rate of Return (MIRR) assumes inconsistent reinvestment of cash flows.

    <p>False</p> Signup and view all the answers

    The average investment used in the ARR calculation is equal to the total cash inflow divided by 5.

    <p>False</p> Signup and view all the answers

    What does cash inflow mean in the context of ARR?

    <p>Cash flow after tax only</p> Signup and view all the answers

    What is the calculated Payback Period (PBP) from the given cash flows?

    <p>2.25 years</p> Signup and view all the answers

    Cash flow after tax before depreciation for a project with initial cash flow of Rs. 20,000 is Rs. _____

    <p>12,500</p> Signup and view all the answers

    Match the following cash flows to their corresponding values after tax and depreciation for Rs. 25,000 cash inflow:

    <p>Cash flow = 25,000 Depreciation = 5,000 Cash flow before tax = 20,000 Tax = 10,000 Cash flow after tax = 10,000 Cash flow after tax before depreciation = 15,000</p> Signup and view all the answers

    The discounted cash flow method is used to calculate the NPV, which assesses the __________ of cash inflows over time.

    <p>present value</p> Signup and view all the answers

    What is a general format for calculating earnings before tax?

    <p>Profit (Revenue) - Operating Expenses - Depreciation</p> Signup and view all the answers

    Match the following financial metrics with their definitions:

    <p>PBP = Time taken to recover initial investment NPV = Difference between present value of cash inflows and outflows ARR = Average annual profit as a percentage of investment IRR = Rate at which NPV equals zero</p> Signup and view all the answers

    Which year has the lowest Profit After Tax (PAT) in the profitability statement?

    <p>Year 5</p> Signup and view all the answers

    Depreciation is added back to earnings after tax for all calculations including ARR.

    <p>False</p> Signup and view all the answers

    What is the cash flow after tax for an initial cash inflow of Rs. 27,000?

    <p>11,000</p> Signup and view all the answers

    What is the Average Earnings calculated based on the provided figures?

    <p>40,000</p> Signup and view all the answers

    The Internal Rate of Return (IRR) is equal to the cost of capital when NPV is positive.

    <p>False</p> Signup and view all the answers

    What is the cost of capital for the firm?

    <p>15%</p> Signup and view all the answers

    The total compounded future value for the given cash flows is Rs. 10 Cr.

    <p>False</p> Signup and view all the answers

    What is the cash flow for Year 1?

    <p>Rs. 2.5 Cr</p> Signup and view all the answers

    The compounded future value for Year 4 is ___ Cr.

    <p>4.03</p> Signup and view all the answers

    Match the following years with their corresponding cash flows:

    <p>Year 1 = Rs. 2.5 Cr Year 2 = Rs. 3.5 Cr Year 3 = Rs. 3.5 Cr Year 5 = Rs. 3.5 Cr</p> Signup and view all the answers

    How much is the cash flow for Year 3?

    <p>Rs. 3.5 Cr</p> Signup and view all the answers

    The compounding factor for Year 2 is greater than that for Year 1.

    <p>True</p> Signup and view all the answers

    What is the formula used to calculate the compounding factor?

    <p>(1+r)^(n-1)</p> Signup and view all the answers

    The formula for Present Value (PV) is ___ = FV / (1+r).

    <p>PV</p> Signup and view all the answers

    What is the total cash flow from Year 0 to Year 5?

    <p>Rs. 21.85 Cr</p> Signup and view all the answers

    What is the financing cost in the given calculations?

    <p>5%</p> Signup and view all the answers

    The reinvesting rate mentioned in the content is 5%.

    <p>False</p> Signup and view all the answers

    What is the final interest rate (r) calculated in the content?

    <p>16.29%</p> Signup and view all the answers

    The total discounted positive cash flows equal ______.

    <p>3705</p> Signup and view all the answers

    Match the following cash flow terms with their definitions:

    <p>Negative cash flows = Outflows that reduce cash availability Positive cash flows = Inflows that increase cash availability Financing cost = The cost associated with acquiring funds Reinvesting rate = The return expected from reinvesting cash flows</p> Signup and view all the answers

    What is the value obtained for the Present Value (PV) in relation to the financing project?

    <p>2,809</p> Signup and view all the answers

    The reinvesting rate is higher than the financing cost.

    <p>True</p> Signup and view all the answers

    What is the formula for calculating Present Value (PV)?

    <p>PV = FV / (1 + r)</p> Signup and view all the answers

    Study Notes

    Capital Budgeting Overview

    • Definition: Capital budgeting is the process of evaluating and selecting long-term investments that align with a company's objectives.
    • Stages: Capital budgeting consists of distinct stages:
      • Identification: Recognizing opportunities for investment.
      • Search: Exploring potential investment opportunities.
      • Information Acquisition: Gathering detailed information for analysis.
      • Selection: Choosing the most promising investment options using various techniques.
      • Financing: Arranging the necessary capital for approved projects.
      • Implementation and Control: Executing the project and monitoring its progress.

    Capital Budgeting Characteristics

    • Significant Investments: Capital budgeting involves large amounts of money.
    • Time Consuming: The process requires thorough research and analysis.
    • Irreversible: Once a decision is made, it's often difficult to reverse.
    • Long-Term Implications: The effects of capital budgeting decisions extend over a significant time period.

    Project Types

    • Independent Projects: The cash flows of one project are unaffected by the acceptance of another.
    • Mutually Exclusive Projects: Accepting one project automatically eliminates the possibility of accepting another.

    Hurdle Rate (Discount Rate)

    • Meaning: The minimum acceptable rate of return that a project should achieve.
    • Purpose: It reflects the opportunity cost of capital and the minimum return required to justify an investment.

    Capital Budgeting Techniques

    • Payback Period:
      • Meaning: The time it takes to recover the initial investment from cash flows.
      • Decision Rule: Select the project with the shortest payback period.
    • Net Present Value (NPV):
      • Meaning: The extra value a project generates beyond its initial cost, accounting for time value of money.
      • Formula: NPV = Present value of cash inflows - Initial Investment.
      • Decision Rule: Choose projects with the highest positive NPV.
    • Profitability Index (PI):
      • Meaning: Ratio of the present value of cash flows to the initial investment.
      • Decision Rule: Accept projects with a PI greater than 1.
    • Internal Rate of Return (IRR):
      • Meaning: The discount rate that makes the NPV of a project equal to zero.
      • Decision Rule: Select projects with an IRR greater than the cost of capital.
    • Modified Internal Rate of Return (MIRR):
      • Meaning: An adjusted IRR that assumes consistent reinvestment of cash flows at the cost of capital.
      • Decision Rule: Select projects with a MIRR greater than the cost of capital.

    Cash Flow Considerations

    • Cash Inflow Definition:
      • For all techniques except Accounting Rate of Return (ARR), cash inflow is calculated after taxes but before depreciation.
      • For ARR, cash inflow is calculated only after taxes.

    Example: Profitability Statement and Analysis

    • Assumptions:
      • Cost of capital is 10%.
      • Initial investment: Rs. 10 crores.
      • Annual profits before depreciation and taxes: Rs. 1,00,000 (Year 1 and 2), Rs. 80,000 (Year 3 and 4), Rs. 40,000 (Year 5).

    Terminal Method

    • Example: Project cost Rs. 10 crores.
      • Financing cost: 5%.
      • Reinvesting rate: 10%.
      • Steps: Use the terminal method to calculate the IRR for this project.

    Negative Cash Flows

    • Meaning: Cash outflows due to expenses.
    • Handling: Discount negative cash flows to their present value and compare them with future positive cash flows, both in a discounted form.
    • MIRR: Use the MIRR technique to account for the reinvestment of negative cash flows at the cost of capital.

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    Description

    This quiz covers the essential aspects of capital budgeting, a critical process for selecting long-term investments in a business. It includes definitions, stages, and characteristics that define effective capital budgeting practices. Test your understanding of how to identify, analyze, and select investment opportunities for your organization.

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