3.09 CAPITAL BUDGETING Flashcards
What are the four capital budgeting techniques?
- Payback period
- IRR
- ARR
- NPV
What does IRR stand for?
Internal rate of return
What does ARR stand for?
Accounting rate of return
What does NPV stand for?
Net present value
what is the formula for the payback period?
Initial investment / After tax annual net cash flows = number of years
What is the formula for IRR?
IRR: Investment / Annual cash flows = PV factor
What is the formula for ARR?
Accounting income (Cash - depreciation) / Avg. investment = ROI
What is the formula for NPV?
PV Cash inflows - PV Cash outflows = NPV
+ (positive) Good
- (negative) Bad
What are the advantages of payback period?
What are the disadvantages?
advantages of payback period: it’s easy to calculate
disadvantages: it doesn’t address total project profitability nor time value of money
What are the advantages of IRR?
What are the disadvantages?
advantages of iRR: it’s easy to calculate and easy to understand, it address time value of money, you can potentially address profitability through teh use of hurdle rates
disadvantages: different assumptions may yield different IRRs (inconsistent)
What are the advantages of ARR?
What are the disadvantages?
advantages of ARR: easy to compute and understand
disadvantages: doesn’t address time value of money, doesn’t address different risks across investments, using different depreciation methods will yield different ARRs (inconsistent)
