CHAPTER 20

CAPITAL BUDGETING DECISIONS

I. Questions

1. A capital investment involves a current commitment of funds with the expectation of generating a satisfactory return on these funds over a relatively extended period of time in the future.

2. Cost of capital is the weighted minimum desired average rate that a company must pay for long-term capital while discounted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project.

3. The basic principles in capital budgeting are:

1. Capital investment models are focused on the future cash inflows and outflows - rather than on net income. 2. Investment proposals should be evaluated according to their differential effects on the company’s cash flows as a whole. 3. Financing costs associated with the project are excluded in the analysis of incremental cash flows in order to avoid the “double-counting” of the cost of money. 4. The concept of the time value of money recognizes that a peso of present return is worth more than a peso of future return. 5. Choose the investments that will maximize the total net present value of the projects subject to the capital availability constraint.

4. The major classifications as to purpose are:

1. Replacement projects - those involving replacements of worn-out assets to avoid disruption of normal operations, or to improve efficiency. 2. Product or process improvement - projects that aim to produce additional revenue or to realize cost savings. 3. Expansion - projects that enhance long-term returns due to increased profitable volume.

5. Greater amounts of capital may be used in projects whose combined returns will exceed any alternate combination of total investment.

6. No.