Corporate financeLesson 1 of 1 in the course How Companies Think about Investing

Capital Budgeting: Project Comparisons, Capital Constraints, and Uncertainty

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

Save course
Lesson progress
0 / 5

Your progress is kept in this browser only.Sign up to save it

Summary

When a company must choose one project instead of another, it needs to compare the value each option creates—not merely decide whether each option is individually acceptable. This lesson explains how to evaluate mutually exclusive projects using net present value (NPV).

Mutually exclusive projects compete with one another: choosing one prevents the company from choosing the other. For example, a sporting-goods store that can purchase only one embroidery machine must choose between its regular machine and a more expensive heavy-duty machine.

All flashcards

How should a company choose between mutually exclusive projects?
Generally, choose the project with the highest NPV when estimates and decision conditions are comparable.
Why can NPV and IRR rank mutually exclusive projects differently?
NPV estimates the amount of value added, while IRR expresses a return as a percentage.
What does the profitability index measure?
The present-value benefit generated per dollar of initial investment; under the notes’ convention, it equals (NPV + initial investment) divided by initial investment.
What does the equal annuity approach do?
It converts a project’s NPV into an equivalent annual amount, then uses that amount to compare repeatable project values.
Why should managers revisit project valuations when conditions change?
New information may change forecast cash flows or other assumptions, making the original NPV estimate less relevant.

Quiz questions

  1. A project lasts three years and a competing project lasts six years. How does the replacement chain approach make their lives comparable?Answer: Compare the six-year project with two consecutive three-year projects.
  2. How does the equal annuity approach compare projects with different lives?Answer: Convert each NPV to an equivalent annual amount, then compare repeatable perpetuity values.
  3. Under the profitability-index convention in which PI equals (NPV plus initial investment) divided by initial investment, what does a PI above 1 indicate?Answer: The project has a positive NPV.
  4. When a company faces a binding investment budget, what should it aim to do?Answer: Choose a feasible project combination that maximizes total NPV within the budget.
  5. When a material change in market conditions alters a project’s cash-flow assumptions, what is a sound response?Answer: Reassess the forecasts and allocation decision using the updated information.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

More in Corporate finance

All Corporate finance lessons
Corporate financeCapital Structure: Debt, Equity, and Market-Value Weights5 flashcards · 5 quiz questions · 4 gamesPlay free →Corporate financeWACC Estimation: Capital Weights, Equity Costs, and Net Debt5 flashcards · 5 quiz questions · 4 gamesPlay free →