What are the stages
in capital budgeting?
1) Identification stage
2) Search stage
3) Information-acquisition stage
4) Selection stage
5) Financing stage
6) Implementation and control stage
© 2022 HOCK international 1
What are the common cash flows in
Year 0 in capital budgeting?
1) The initial investment
2) Initial working capital investment (treated as a cash
outflow)
3) Cash received from the sale of old assets
© 2022 HOCK international 2
How is the gain or loss
on the disposal of the
old asset calculated?
The difference between the cash received and the tax
value of the asset.
The gain or loss is a tax event and will increase, or
decrease, the taxable income of the company. The tax
effect of the gain or loss also changes the cash flow of the
disposal of the old asset.
© 2022 HOCK international 3
What are the common
cash flows during the project
in capital budgeting?
1) Increased sales
2) Decreased operating expenses
3) Another capital investment (treated as a cash outflow)
4) Another working capital investment
5) Depreciation tax shield
© 2022 HOCK international 4
What is the tax depreciation shield
and how is the amount calculated?
The tax benefit that the company received from the tax
depreciation of its fixed assets.
Full Cost of Asset
× Annual Depreciation Rate
× Tax Rate
= Tax Depreciation Shield
© 2022 HOCK international 5
What are the cash flows
at the end of the project?
1) Cash received from the disposal of the equipment
2) Recovery of working capital (treated as a cash inflow)
© 2022 HOCK international 6
What are the four
capital budgeting methods?
1) Payback period or payback method
2) Discounted payback period
3) Net present value
4) Internal rate of return
© 2022 HOCK international 7
What is the payback method?
A method in which it is determined how long it takes for the
UNdiscounted cash inflows of the project to equal the cash
outflow of the project.
© 2022 HOCK international 8
How is the payback method
calculated with
constant cash flows?
Initial net investment
Periodic constant expected cash inflow
© 2022 HOCK international 9
What is the discounted
payback method?
A method in which it is determined how long it takes for the
discounted cash inflows of the project to equal the cash
outflow of the project.
© 2022 HOCK international 10
What is the
net present value method
of capital budgeting?
All expected cash inflows and outflows are discounted to
the beginning of the project, using the required rate of
return.
The NPV of an investment or project is the difference
between the present value of all future cash inflows and
the present value of all (initial and future) cash
outflows, using the required rate of return.
© 2022 HOCK international 11
What discount rate should be used
to calculate the NPV of a project?
The rate used should be the required rate of return, as
determined by the company.
© 2022 HOCK international 12
What is the internal rate of return
in capital budgeting?
The internal rate of return is the interest rate (that is, the
discount rate) at which the present value of the project’s
expected cash inflows equals the present value of its
expected cash outflows.
In other words, the IRR is the interest (discount) rate at
which the NPV is equal to zero.
© 2022 HOCK international 13
How is the IRR evaluated?
If the IRR is higher than the required rate of return for the
project, the project is acceptable.
If the IRR is lower than the required rate of return, the
project is not acceptable and should not be considered
further.
© 2022 HOCK international 14
What are the steps to
calculate the IRR when the
project cash inflows are equal?
1) Divide the net initial investment by the annual cash flow.
The result will be a factor that represents the present
value of an annuity.
2) Find that value on the PV of an Annuity factor table for
the correct number of periods.
© 2022 HOCK international 15
What is the crossover rate?
The discount rate at which a manager is indifferent to two
projects because their NPVs are the same.
© 2022 HOCK international 16
Which project should be selected
when the NPV and IRR give
different indications?
When a company has limited funds, it should invest to
maximize its return. Therefore, projects with the highest
NPV should be selected.
© 2022 HOCK international 17
What do the terms nominal and
real mean in respect to inflation?
• Nominal cash flow and nominal rate of return include
inflationary increases.
• Real cash flow and real rate of return do not include
inflationary increases.
© 2022 HOCK international 18
How are nominal cash flows
converted to real cash flows?
Real Expected Cash Flow = Nominal Cash Flow
(1 + Inflation Rate)n
© 2022 HOCK international 19
How is a nominal rate of return
converted to a real rate of return?
Real Rate of Return = 1 + Nominal Rate – 1
1 + Inflation Rate
© 2022 HOCK international 20
What are the market risks
in capital budgeting?
1) Interest-rate risk
2) Purchasing-power risk
3) Exchange-rate risk
© 2022 HOCK international 21
What are the nonmarket risks
in capital budgeting?
1) Portfolio risk
2) Liquidity risk
3) Financial risk
4) Business risk
© 2022 HOCK international 22
What are the circles and boxes
in a decision tree?
A circle represents a probability node (or chance node), in
effect any condition that exists and cannot be controlled. At
each probability node, the “tree” branches out, and the branch
that is taken is a matter of probability or chance, not a matter
that management can control through a decision.
A box represents a decision node, the point at which a
decision is to be made. At a decision node, the branch of the
tree that is taken depends on specific decisions made by the
company.
© 2022 HOCK international 23
What is a real option?
An option within a larger project to make decisions as the
project happens.
© 2022 HOCK international 24
What are common real options?
1) The option to make follow-on investments if the
immediate investment project succeeds.
2) The option to abandon a project.
3) The option to wait and learn more before investing.
4) The option to vary the inputs to the production process,
the production methods, or the firm’s output or product
mix.
© 2022 HOCK international 25
