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Chapter 25

Capital Budgeting and Managerial Decisions

QUESTIONS

1. Capital budgeting is the process of planning the acquisition or sale of plant assets.
2.
Capital budgeting decisions are risky because: (1) the outcomes are uncertain, (2) large amounts of money are usually involved, (3) the investment involves a long-term commitment, and (4) the decisions may be difficult or impossible to reverse.



3. Capital budgeting decisions require careful analysis because they are generally the most difficult and risky decisions that management face
4. The payback period ignores both the present value of cash flows and all cash flows after the payback period.
5. A shorter payback period is desirable because management prefers to reduce the risk that the investment might not be profitable over the long run. As a result of acquiring assets with shorter payback periods, a company is both less vulnerable to inaccurate long-term predictions of future cash flows and is less subject to changes in external factors that might adversely affect the investment project.
6. If net income is earned evenly throughout each year and straight-line depreciation is used, the average investment is the original cost plus the salvage value, divided by 2. For this machine, the average investment equals $110,000, computed as ($200,000 + $20,000)/ 2.
7. When the present value of expected net cash flows, discounted at 10%, exceeds the amount invested it indicates that the expected rate of return on the investment is greater than 10 percent. On the other hand, when the present value of expected net cash flows, discounted at 10%, is less than the amount invested it indicates that the expected rate of return on the investment is less than 10 perce
8. Receiving $100 one year from today is worth less than $100 today because a return can be earned on a $100 investment during the year. If $100 to be received one year from today is discounted at 12%, the present value is $100 x 0.8929 = $89.29 (the present value factor is taken from Table B.1). This means that if $89.29 is invested at 12% for one year, it will be worth $100 at the end of that year. This amount also can be found by dividing $100 by 1.12.
9. The return on an investment must cover the interest and provide an additional profit to reward the company for risk. For example, if money can be borrowed at 10%, a required after-tax return of about 15% is usually acceptable for companies with average risk projects.
10. Accelerated depreciation produces larger tax deductions and lower tax payments in the early years of an assets life compared with straight-line depreciation. This is because the larger depreciation expense for accelerated methods in earlier years reduces both taxable income and taxes paid in the short run (in the long run there is no difference except for the time value of money). Therefore, net cash inflows will be larger in earlier years, which will increase the present va