QUESTIONS

1. How is a project classification scheme (for example, replacement, expansion into new
markets, and so forth) used in the capital budgeting process?
Answer:
Project classification schemes can be used to indicate how much analysis is required
to evaluate a given project, the level of the executive who must approve the project,
and the cost of capital that should be used to calculate the project's NPV. Thus,
classification schemes can increase the efficiency of the capital budgeting process.
2. Explain why the NPV of a relatively long-term project, defined as one for which a high
percentage of its cash flows are expected in the distant future, is more sensitive to
changes in the cost of capital than is the NPV of a short-term project.
Answer:
The NPV is obtained by discounting future cash flows, and the discounting process
actually compounds the interest rate over time. Thus, an increase in the discount
rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year
1.
3. Are there conditions under which a firm might be better off if it were to choose a
machine with a rapid payback rather than one with a larger NPV?
Answer:
Yes, if the cash position of the firm is poor and if it has limited access to additional
outside financing it might be better off to choose a machine with a rapid payback.
But even here, the relationship between present value and cost would be a better
decision tool.
4. What does it mean for projects to be mutually exclusive? How should managers rank
mutually exclusive projects?
Answer:
Mutually exclusive projects are a set of projects in which only one of the projects
can be accepted. For example, the installation of a conveyor-belt system in a
warehouse and the purchase of a fleet of forklifts for the same warehouse would be
mutually exclusive projectsaccepting one implies rejection of the other. When
choosing between mutually exclusive projects, managers should rank the projects
based on the NPV decision rule. The mutually exclusive project with the highest

positive NPV should be chosen. The NPV decision rule properly ranks the projects
because it assumes the appropriate reinvestment rate is the cost of capital.
5. What are three alternative current asset financing policies? Is one best?
Answer:
There are alternative current asset investment policies which are mentioned below:

Maturity Matching, or Self-Liquidating, Approach

AGGRESSIVE APPROACH
CONSERVATIVE APPROACH

All three alternative current asset financing policies are best.

6. Identify and explain three alternative current asset investment policies?
Answer:
There are alternative current asset investment policies which are mentioned below:
Relaxed Current Asset Investment Policy
Moderate Current Asset Investment Policy
Restricted Current Asset Investment Policy

Relaxed Current Asset Investment Policy:

A policy under which relatively large amounts of cash, marketable securities, and
inventories are carried and under which sales are stimulated by a liberal credit
policy, resulting in a high level of receivables.

Moderate Current Asset Investment Policy:

A policy that is between the relaxed and restricted policies.

Restricted Current Asset Investment Policy:

A policy under which holdings of cash, securities, inventories, and receivables are
minimized.
7. What are the principal components of working capital?
Answer:
Working capital consists of four main components:
Cash
Marketable securities,
Inventory
Accounts receivable.
8. What is the fundamental trade-off that managers face when managing working capital?
Answer:

For each type of asset, firms face a fundamental trade-off: Current assets (that is,
working capital) are necessary to conduct business, and the greater the holdings of
current assets, the smaller the danger of running out, hence the lower the firms
operating risk. However, holding working capital is costlyif inventories are too
large, then the firm will have assets that earn a zero or even negative return if
storage and spoilage costs are high. And, of course, firms must acquire capital to
buy assets such as inventory, this capital has a cost, and this increases the
downward drag from excessive inventories (or receivables or even cash). So, there is
pressure to hold the amount of working capital to the minimum consistent with
running the business without interruption.