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Question 1

What is capital budgeting?

Answer 1

It is the process of making long-term investment decisions for projects that span multiple years, focusing on maximizing the capital value of a business.

Question 2

How is the Internal Rate of Return (IRR) calculated?

Answer 2

Investment=ExpectedCashInflow×PVAnnuityFactor
The IRR is the discount rate where NPV = 0.

Question 3

What is the payback period formula?

Answer 3

PaybackPeriod=
AnnualCashInflows /
NetInitialInvestment
​

Question 4

What does the Accounting Rate of Return (ARR) measure?

Answer 4

Definition: ARR measures the return on investment based on accounting income rather than cash flows.
Decision Rule: Accept the project if the ARR exceeds the company’s required rate of return.
(Accounting Income is the net income reported by a company on its financial statements. It’s calculated based on accrual accounting, which means it includes both cash and non-cash items like revenues earned (but not yet received) and expenses incurred (but not yet paid)).

Question 4

What is straight-line depreciation, and why is it used in capital budgeting?

Answer 4

Purpose: It spreads the cost of an asset evenly over its useful life, making it simple to calculate and easy to apply in financial statements.

Impact on ARR: Depreciation reduces operating income, which can lower ARR calculations.

Question 5

depreciation effect on cash flow

Answer 5

Depreciation reduces taxable income, resulting in lower tax payments, which increases the project’s cash flow.

Question 6

How do inflation and the nominal rate of return affect investment decisions?

Answer 6

Inflation reduces the purchasing power of future cash flows, making it important to use the nominal rate of return, which includes inflation, in NPV and IRR calculations.