Capital Budgeting Decisions Flashcards

A replacement project's relevant cash flows are based on:

Answer: Incremental differences between new and old machines

Replacement analysis uses the incremental change in cash flows versus keeping the old asset.

The weighted average cost of capital is most appropriate as the hurdle rate when a project:

Answer: Has risk similar to the firm's existing operations

WACC suits projects of average risk; differing risk requires a risk-adjusted rate.

A real (managerial) option such as the option to abandon a project tends to:

Answer: Add value by providing flexibility

Real options like abandonment, expansion, or delay add value through flexibility under uncertainty.

When financing costs (interest) are already captured in the discount rate, including them in cash flows would cause:

Answer: Double counting

Interest is reflected in the discount rate, so adding it to cash flows double counts financing costs.

Monte Carlo simulation in capital budgeting is used to:

Answer: Generate a probability distribution of NPV outcomes

Simulation samples many input combinations to produce a distribution of possible NPVs.

A project with a positive NPV but a payback period longer than the firm's cutoff would be:

Answer: Accepted under NPV but rejected under a strict payback rule

NPV signals acceptance while a strict payback cutoff may reject it, illustrating method conflict.

The after-tax cash flow from selling an asset above its book value includes:

Answer: Sale price minus tax on the gain

Selling above book value creates a taxable gain, so tax on that gain reduces net proceeds.