Capital Budget Paper
Integrative Problem and Study Questions
Mark Camagong
FIN 370
January 20, 2010 Art Philibert Week 4 Assignment
Integrative Problem and Study Questions
1. Why is the capital-budgeting process so important?
Capital budgeting decisions involve investments requiring large cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively long period of time. As such, they are costly and difficult to reverse, both because of: (1) their large cost and (2) the fact that they involve fixed assets, which cannot be liquidated easily.
2. Why is it difficult to find exceptionally profitable projects? It is hard to find extremely profitable projects, because it is hard to keep competition out. Profitability attracts competition, and unless a company can set up barriers to entry successfully, competition will drive the profit margin down to the required rate of return.
4. What are the criticisms of the payback period?
The criticisms of using the payback period as a capital budgeting technique are:
(1) It ignores the timing of the free cash flows that occur during the payback period. (2) It ignores all free cash flows occurring after the payback period. (3) The selection of the maximum acceptable payback period is arbitrary. The advantages associated with the payback period are:
(1) It deals with cash flows rather than accounting profits, and therefore focuses on the true timing of the project's benefits and costs. (2) It is easy to calculate and understand. (3) It can be used as a rough screening device, eliminating projects whose returns do not materialize until later years. Chapter 10 Study Questions
10-1. Why do we focus on cash flows rather than accounting profits in making our capital- budgeting decisions? Why are we interested only in incremental cash flows rather
Mark Camagong
FIN 370
January 20, 2010 Art Philibert Week 4 Assignment
Integrative Problem and Study Questions
1. Why is the capital-budgeting process so important?
Capital budgeting decisions involve investments requiring large cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively long period of time. As such, they are costly and difficult to reverse, both because of: (1) their large cost and (2) the fact that they involve fixed assets, which cannot be liquidated easily.
2. Why is it difficult to find exceptionally profitable projects? It is hard to find extremely profitable projects, because it is hard to keep competition out. Profitability attracts competition, and unless a company can set up barriers to entry successfully, competition will drive the profit margin down to the required rate of return.
4. What are the criticisms of the payback period?
The criticisms of using the payback period as a capital budgeting technique are:
(1) It ignores the timing of the free cash flows that occur during the payback period. (2) It ignores all free cash flows occurring after the payback period. (3) The selection of the maximum acceptable payback period is arbitrary. The advantages associated with the payback period are:
(1) It deals with cash flows rather than accounting profits, and therefore focuses on the true timing of the project's benefits and costs. (2) It is easy to calculate and understand. (3) It can be used as a rough screening device, eliminating projects whose returns do not materialize until later years. Chapter 10 Study Questions
10-1. Why do we focus on cash flows rather than accounting profits in making our capital- budgeting decisions? Why are we interested only in incremental cash flows rather