14-1.
Difference between capital budgeting screening decisions and preference decisions:
• Screening decisions determine whether a proposed investment meets a minimum required
return (the “hurdle rate”).
• Preference decisions (or ranking decisions) rank acceptable investments based on profitability or
other criteria when capital is limited .
14-2. Time value of money:
• The concept that a dollar today is worth more than a dollar in the future because of its potential
earning capacity.
14-3. Discounting:
• Discounting is the process of converting future cash flows into their present value by applying a
discount rate, reflecting the time value of money.
14-4. Why accounting net income isn’t used in NPV and IRR:
• Net income includes non-cash expenses like depreciation and is affected by accounting
conventions. NPV and IRR rely on cash flows, which better reflect the economic value of a
project .
14-5. Why discounted cash flow (DCF) methods are superior:
• DCF methods consider the time value of money and all cash flows, providing a more accurate
measure of a project’s value.
14-6. What is net present value (NPV)? Can it be negative?
• NPV is the difference between the present value of cash inflows and outflows. It can be negative
if the project's returns are less than the required rate of return.
14-7. Two simplifying assumptions in DCF methods:
1. Cash flows are assumed to occur at the end of each period.
2. All cash flows can be reinvested at the discount rate or internal rate of return.
14-8. Is cost of capital equal to 14% if interest on debt is 14%?
• Not necessarily. The cost of capital considers the cost of all sources of financing (debt and
equity), not just the interest rate on debt.
14-9. Internal Rate of Return (IRR):
• IRR is the discount rate that makes the NPV of an investment zero. It is found through trial and
error or financial calculators and software .
14-10. How cost of capital is a screening tool:
• (a) In NPV, a project is acceptable if NPV is positive using the cost of capital.
• (b) In IRR, a project is acceptable if IRR exceeds the cost of capital.
14-11. Does present value increase with discount rate?
• No, as the discount rate increases, present value decreases. They are inversely related.
14-12. Exhibit 14–8 return analysis:
• The investment has a return slightly less than 14%, since its NPV at 14% is negative. If the NPV
were zero, the return would be exactly 14%.
14-13. Profitability Index (PI):
• PI = Present Value of Future Cash Flows ÷ Initial Investment. It measures the value created per
dollar invested.
14-14. Payback Period:
• It is the time it takes to recover the initial investment from cash inflows. It is calculated by adding
annual cash inflows until the initial investment is recovered. Useful for assessing liquidity and
risk.
14-15. Major criticism of payback and simple rate of return methods:
• They ignore the time value of money and cash flows beyond the payback period, which can
mislead decision-makers.
What is the difference between capital budgeting screening decisions and capital budgeting
preference decisions?
• Screening decisions determine whether a proposed project is acceptable based on a preset
hurdle rate.
• Preference decisions involve selecting from several acceptable alternatives.
14–2 What is meant by the term time value of money?
• The time value of money is the concept that a dollar today is worth more than a dollar in the
future because you could invest it and earn more than a dollar in the future.
14–3 What is meant by the term discounting?
• Discounting cash flows is a technique used to translate the value of future cash flows to their
present value.
14–4 Why isn't accounting net income used in the net present value and internal rate of return
methods of making capital budgeting decisions?
• The text explains that the net present value and internal rate of return methods focus on
analyzing cash flows, not accounting net income.
14–5 Why are discounted cash flow methods of making capital budgeting decisions superior to
other methods?
• Discounted cash flow methods, such as net present value and internal rate of return, are
superior because they recognize the time value of money.
14–6 What is net present value? Can it ever be negative? Explain.
• The textbook defines net present value, but it doesn't explicitly state whether it can be negative.
However, it can be negative; a negative NPV would imply that the present value of cash outflows
is greater than the present value of cash inflows.
14–7 Identify two simplifying assumptions associated with discounted cash flow methods of making
capital budgeting decisions.
• The textbook mentions assumptions are made to simplify CVP calculations, but does not specify
simplifying assumptions for discounted cash flow methods.
14–8 If a company has to pay interest of 14% on long-term debt, then its cost of capital is 14%. Do
you agree? Explain.
• The text does not directly answer this question. The cost of capital is the minimum rate of return
a project must yield to be acceptable. It's related to, but not necessarily the same as, the interest
rate on debt.
14–9 What is meant by an investment project's internal rate of return? How is the internal rate of
return computed?
• The textbook discusses the internal rate of return method but does not provide a specific
definition in the provided excerpts.
14–10 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.
• The cost of capital is described as the minimum rate of return a project must yield to be
acceptable and is used in screening decisions.
• (a) In the net present value method, the cost of capital is used as the discount rate.
• (b) In the internal rate of return method, the internal rate of return is compared to the cost of
capital to determine acceptability.
14–11 As the discount rate increases, the present value of a given future cash flow also increases.
Do you agree? Explain.
• No, I do not agree. As the discount rate increases, the present value of a future cash flow
decreases. The higher the discount rate, the less a future cash flow is worth in today's terms.
14–12 Refer to Exhibit 14–8. Is the return on this investment proposal exactly 14%, more than 14%,
or less than 14%? Explain.
• To answer this question accurately, I would need to see Exhibit 14-8. However, in general, if 14%
is used as the discount rate and the net present value is zero, then the return is 14%.
14–13 How is the profitability index computed, and what does it measure?
• The textbook does not include the formula for the profitability index in the provided chapter
excerpts.
14–14 What is meant by the term payback period? How is the payback period determined? How can
the payback method be useful?
• The payback period is the length of time it takes for a project to recover its initial cost from the
net cash inflows it generates.
• It is calculated by dividing the initial investment by the annual net cash inflow.
• The payback method can be useful as a screening tool and for companies that are cash-poor.
14–15 What is the major criticism of the payback and simple rate of return methods of making
capital budgeting decisions?
• A major criticism of the payback method is that it does not consider the time value of money.
• The simple rate of return method is not discussed in detail in the provided excerpts, so a
comparison cannot be made.
