Question

2. The basic process and rules for capital budgeting Aa Aa The capital budgeting process consists of the following activities: I. Estimating the relevant cash flows II. Reviewing a project's post-implementation and post-termination performance III. Evaluating alternatives and selecting the projects to be implemented IV. Generating capital investment project proposals What is the correct sequence for these activities? O IV, II, III, I O I, IV, II, III There are several practical aspects of capital budgeting that complicate what appears to be a straightforward procedure. Which of the following can add significant complexity to the practice of capital budgeting? O At any point in time, the firm will know with certainty all of the capital projects that should be considered but can probably only make uncertain estimates of the firm's marginal cost of capital and each project's future costs and revenues O At any point in time, the firm will know with certainty all of the capital projects that should be considered and will know with certainty the shape of its future marginal cost of capital schedule and each project's future costs and revenues. O At any point in time, the firm will not know all of the capital projects that should be considered but will know with certainty the shape of its future marginal cost of capital schedule O At any point in time, the firm will not know all of the capital projects that should be considered and can probably only make uncertain estimates of the firm's marginal cost of capital and each project's future costs and revenues There are several basic principles that should be applied when the future expected cash flows of a proposed project are estimated. Read the following statements and indicate whether they reflect best practices when performing a capital budgeting analysis A project's cash flows should be measured by their effect on the revenue, cost, and tax cash flow streams of the entire firm Only the direct effects of a project need be considered in the cash flow stream irrelevant. ; any indirect effects are True or False: This represents a recommended practice for the estimation of a project's cash flows. True or False: This represents a recommended practice for the estimation of a project's cash flows. O False; there is a better way to measure the O False; there is a better way to measure the project's cash flows. project's cash flows. O True; this represents the best way to measure O True; this represents the best way to measure the cash flows of the project. the cash flows of the project.

Answer 1

Capital budget process includes following sterps and the right order is :

Option 3 ( IV, I , III, II )

IV - Generating capital investment proposal ( Here, company decides which are the avalable projects can be inplemented like introducing new product, capacity expansion, buying new plant & machinery)

I - Estimating relevant cashflows ( Thru calculating cashflows, company wants to measure the earning potential from the project . For cashflow, FCF or free cashflow is measured.

FCF = Earning before profit & Interest & Tax ( 1- tax) + Depriciation - change in capex - cange in working capital

III - Evaluating alternatives & select the prject ( Diifferent criteria is set like NPV, IRR, paybacj period and comparision is drwan between projects and with pre set criteria. Like if IRR > cost of capital, then project should be selected.

II - Here, company reviews its pre and post implemention to check if projects are in right track or not. Some times, although project is not projfitable, still its is carried on since exit cost of the project is very high.

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The 4th option are the best which can complicate the capital budgeting decision:

(At any given point, firm wil not know all the of capital projects that should be considered and can probably only make uncertain estimates of firms' marginal cost of capital and each project future costs and revenue)

Company's all capital projects options are decisded by hiuman being and human beings are bounded rational which means human takes decsision based on the information or data we have in our hand at given moment. Hence, this is not possible to have information of all the capital projects should ideally be selected.

Cost of capital - Cost of capital is decided by capital structure, tax, cost of debt and and cost of equity. Cost of equity can only be estimated , can't be calculated accurately. Sometimes, firm sets hurdle rate same as company for the divisional projects. But company's overall hurdle rate may be irrelevant for a project for a division. Hence, divisional hurdle rate should be used, otherwise we may select wrong project (select Bad project with lower cost of capital / reject good project with higher cost of capital)

Estimating revenue and cost is very difficult. Revenue is dependent on external market consideration

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False - A project cashflows should be measured by their effect on the revenue , cost , tax cashflow streams of the entire firm. Finally, cashflow is determined from revenue - cost - tax. This is not the best way.There is a better way , where we should include depriciation, cange in capex and change in working capital. By adjusting these , we will get free cash flows which will give better idea.

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Only direct effects of a project needs to be considered in cashflow stream; any indirect effects are irrelevant

False ; There is better way. Indirect effect like cannibalization after introducing new product or opportunity cost must be introduced in the calculation.