What is the difference between capital budgeting screening decisions and capital budgeting preference decisions?
13-1 A capital budgeting screening decision is concerned with whether a proposed investment project passes a preset hurdle, such as a 15% rate of return. A capital budgeting preference decision is concerned with choosing from among two or more alternative investment projects, each of which has passed the hurdle.
Why isn't accounting net income used in the net present value and internal rate of return methods of making capital budgeting decisions?
13-4 Accounting net income is based on accruals rather than on cash flows. Both the net present value and internal rate of return methods focus on cash flows.
Why are discounted cash flow methods of making capital budgeting decisions superior to other methods?
13-5 Unlike other common capital budgeting methods, discounted cash flow methods recognize the time value of money and take into account all future cash flows.
Identify two simplifying assumptions associated with discounted cash flow methods of making capital budgeting decisions.
13-7 One assumption is that all cash flows occur at the end of a period. Another is that all cash inflows are immediately reinvested at a rate of return equal to the discount rate.
If a company has to pay interest of 14% on long-term debt, then its cost of capital is 14%. Do you agree? Explain.
13-8 No. The cost of capital is not simply the interest paid on long-term debt. The cost of capital is a weighted average of the costs of all sources of financing, both debt and equity.
Explain how the cost of capital serves as a screening tool when using "a" the net present value method and "b" the internal rate of return method.
13-10 The cost of capital is a hurdle that must be cleared before an investment project will be accepted. In the case of the net present value method, the cost of capital is used as the discount rate. If the net present value of the project is positive, then the project is acceptable because its rate of return is greater than the cost of capital. In the case of the internal rate of return method, the cost of capital is compared to a project's internal rate of return. If the project's internal rate of return is greater than the cost of capital, then the project is acceptable.
What is the major criticism of the payback and simple rate of return methods of making capital budgeting decisions?
13-15 Neither the payback method nor the simple rate of return method considers the time value of money. Under both methods, a dollar received in the future is weighed the same as a dollar received today. Furthermore, the payback method ignores all cash flows that occur after the initial investment has been recovered.