General Banking

Chapter 14

Capital Budgeting Decisions

Solutions to Questions

14-1 Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as a 15% rate of return. Capital budgeting preference decisions are concerned with choosing from among two or more alternative investment projects, each of which has passed the hurdle. 14-2 The “time value of money” refers to the fact that a dollar received today is more valuable than a dollar received in the future. A dollar received today can be invested to yield more than a dollar in the future. 14-3 Discounting is the process of computing the present value of a future cash flow. Discounting gives recognition to the time value of money and makes it possible to meaningfully add together cash flows that occur at different times. 14-4 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. 14-5 Discounted cash flow methods are superior to other methods of making capital budgeting decisions because they recognize the time value of money and take into account all future cash flows. 14-6 Net present value is the present value of cash inflows less the present value of the cash outflows. The net present value can be negative if the present value of the outflows is greater than the present value of the inflows. 14-7 One simplifying assumption is that all cash flows occur at the end of a period. Another is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. 14-8 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 individual costs of all sources of financing, both debt and equity. 14-9 The internal rate of return is the rate of return on an investment project over its life. It is computed by finding that discount rate that results in a zero net...