Finance for Non-Finance Managers Capital Budgeting 5 — Questions and Answers
Question 1: A company's Weighted Average Cost of Capital (WACC) is most commonly used in capital budgeting as:
- The expected return on equity for new shareholders
- The discount rate to calculate NPV of average-risk projects (Correct answer)
- The target debt ratio for project financing
- The minimum dividend yield required by investors
Correct answer: The discount rate to calculate NPV of average-risk projects
WACC represents the blended cost of all capital sources and serves as the appropriate discount rate for projects with risk similar to the firm's average.
Question 2: The 'replacement decision' in capital budgeting involves comparing:
- Two entirely new projects competing for the same budget
- Keeping existing equipment versus investing in new equipment (Correct answer)
- Debt financing versus equity financing for a project
- Short-term and long-term versions of the same project
Correct answer: Keeping existing equipment versus investing in new equipment
A replacement decision evaluates whether the incremental cash flows from new equipment justify its cost relative to continuing with existing assets.
Question 3: Capital rationing occurs when a firm:
- Has unlimited funds but limits projects to reduce risk
- Has more profitable projects than available capital to fund them all (Correct answer)
- Rations profits equally among shareholders and reinvestment
- Limits borrowing to maintain a specific credit rating
Correct answer: Has more profitable projects than available capital to fund them all
Capital rationing means the firm faces a binding budget constraint and must choose among competing positive-NPV projects it cannot all fund.
Question 4: Which cash flow item is typically included in a project's Year 0 (initial) cash flow?
- Annual operating revenues the project will generate
- Cost of installing and commissioning the new asset (Correct answer)
- Tax shield from the first year's depreciation
- Terminal salvage value of the asset
Correct answer: Cost of installing and commissioning the new asset
Year 0 captures the upfront costs including purchase price, installation, shipping, and NWC increases required to launch the project.
Question 5: If inflation rises significantly, which adjustment to the capital budgeting analysis is most critical?
- Use nominal cash flows with a nominal discount rate, or real flows with a real rate — but not mix them (Correct answer)
- Always switch to real (inflation-adjusted) cash flows only
- Ignore inflation since it affects all projects equally
- Increase the payback period cutoff to compensate
Correct answer: Use nominal cash flows with a nominal discount rate, or real flows with a real rate — but not mix them
Consistency is essential: nominal cash flows must be discounted at a nominal rate, and real cash flows at a real rate — mixing them produces incorrect NPV results.
Question 6: A project has a positive NPV but a very long payback period. A risk-averse manager might still prefer a project with a shorter payback because:
- Shorter payback projects always have higher NPVs
- A long payback exposes the firm to more uncertainty over time (Correct answer)
- Long paybacks reduce depreciation tax shields
- Payback period determines the project's IRR directly
Correct answer: A long payback exposes the firm to more uncertainty over time
A longer payback period means the firm's capital is at risk for more years, increasing exposure to forecast errors, competition, and economic changes.
Question 7: Post-audit (post-completion review) of capital projects is valuable because it:
- Allows the firm to recover sunk costs if projections were wrong
- Improves future forecasting by comparing actual to projected results (Correct answer)
- Legally protects managers from liability on failed projects
- Resets the project's NPV based on actual cash flows
Correct answer: Improves future forecasting by comparing actual to projected results
Post-audits compare projected versus actual outcomes, helping the organization learn and improve the quality of future capital budgeting decisions.
Finance for Non-Finance Managers Capital Budgeting 5
A company's Weighted Average Cost of Capital (WACC) is most commonly used in capital budgeting as: