Capital Budgeting
What is the process of selecting long-term investments, primarily in plant and equipment, called?
Capital Budgeting
What does NPV stand for in capital budgeting?
Net Present Value
What does IRR stand for?
Internal Rate of Return
What term describes the risk of an investment considered independently from a portfolio?
Stand-alone risk
What happens when two investments cannot be undertaken simultaneously?
They are mutually exclusive
Capital budgeting decisions are conceptually similar to investing in what types of financial instruments?
Stocks or bonds
The formula for NPV involves subtracting what from the present value of cash inflows?
The present value of cash outflows (investment cost)
The IRR is the rate that equates the present value of what two things?
Cash inflows and cash outflows
What type of risk considers how an investment interacts with other investments?
Portfolio risk
Conflicts between NPV and IRR can occur due to differences in what two factors?
Timing of cash flows and investment costs
What two types of cash flows are essential in capital budgeting analysis?
Cash outflows (investment cost) and cash inflows (returns)
If a project’s NPV is greater than zero, what should the firm do?
Accept the investment
If the IRR is higher than the cost of capital, should the investment be accepted or rejected?
Accepted
What is used to measure the variability of cash flows in capital budgeting?
Standard deviation
Which method is generally preferred when there’s a conflict between NPV and IRR results?
The NPV method
Which is more important for decision making—accounting profits or cash flows?
Cash flows
What discount rate is used in calculating NPV?
The firm’s cost of capital
How does IRR differ from NPV in terms of reinvestment assumption?
IRR assumes reinvestment at the project’s IRR rate
The coefficient of variation is the standard deviation divided by what?
The expected value (mean)
What adjustment can be made to reflect a project’s higher risk?
Increase the discount rate (add a risk premium)
What is the primary goal of capital budgeting decisions for a firm?
To increase the firm’s value through profitable long-term investments
Why is NPV considered a better method than IRR when there are conflicting project rankings?
NPV assumes reinvestment at the cost of capital, making it more conservative
Financial managers often prefer IRR because it provides what type of measure of profitability?
A percentage rate of return
In the CAPM formula, ke=rf+(rm−rf)βk_e = r_f + (r_m - r_f)\betake=rf+(rm−rf)β, what does β (beta) represent?
The investment’s volatility relative to the market or the firm’s typical investment
In scenario analysis, the probabilities of specific outcomes are used to measure what?
The variability and risk of potential returns