4. Capital Budgetting Flashcards
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What is capital budgeting in project finance?
Capital budgeting involves evaluating long-term investments to determine their viability and impact on financial growth. (Lesson 4, p.1)
Why is capital budgeting important?
- Determines company growth, 2. Influences risk management, 3. Enhances shareholders’ value. (Lesson 4, p.1)
What are the three classifications of investments in capital budgeting?
- Mutually Exclusive Investments, 2. Independent Investments, 3. Contingent/Complementary Investments. (Lesson 4, p.2)
What are the characteristics of a sound investment evaluation method?
- Maximizes shareholder wealth, 2. Considers all cash flows, 3. Provides project ranking, 4. Rational and applicable to various projects. (Lesson 4, p.2)
What are the two main types of capital budgeting evaluation methods?
- Non-Discounted Cash Flow Methods, 2. Discounted Cash Flow Methods. (Lesson 4, p.3)
What are the two traditional methods of project evaluation?
- Payback Period (PBP), 2. Accounting Rate of Return (ARR). (Lesson 4, p.3)
How is the Accounting Rate of Return (ARR) calculated?
ARR = (Average Annual Profits / Average Investment) × 100. (Lesson 4, p.3)
What are the advantages of ARR?
- Easy to compute, 2. Uses readily available financial data, 3. Simple to compare projects. (Lesson 4, p.3)
What are the limitations of ARR?
- Ignores time value of money, 2. No standardized formula, 3. Uses accounting profits instead of cash flows. (Lesson 4, p.3)
How is the Payback Period (PBP) calculated?
PBP is the number of years required to recover the initial investment from cash flows. (Lesson 4, p.4)
What are the advantages of the Payback Period method?
- Simple to calculate, 2. Helps in liquidity management, 3. Minimizes risk in uncertain projects. (Lesson 4, p.4)
What are the disadvantages of the Payback Period method?
- Ignores time value of money, 2. Excludes cash flows after the payback period, 3. No standardized payback threshold. (Lesson 4, p.4)
What are Discounted Cash Flow Methods?
Methods that consider the time value of money when evaluating investment projects. (Lesson 4, p.5)
What is Net Present Value (NPV)?
NPV is the difference between the present value of cash inflows and the present value of investment costs. (Lesson 4, p.5)
What is the decision rule for NPV?
- If NPV > 0, accept the project, 2. If NPV < 0, reject the project, 3. If NPV = 0, project is indifferent. (Lesson 4, p.5)
What are the advantages of NPV?
- Accounts for time value of money, 2. Evaluates all project cash flows, 3. Provides a clear ranking of projects. (Lesson 4, p.6)
What are the limitations of NPV?
- Difficult to compute, 2. Depends on an accurate discount rate, 3. Not ideal for comparing projects of different sizes. (Lesson 4, p.6)
What is the Internal Rate of Return (IRR)?
IRR is the discount rate at which the NPV of a project becomes zero. (Lesson 4, p.6)
What is the decision rule for IRR?
If IRR > Required Rate of Return, accept the project; otherwise, reject it. (Lesson 4, p.6)
What are the advantages of IRR?
- Considers time value of money, 2. Measures project yield, 3. Useful when cost of capital is unknown. (Lesson 4, p.7)
What are the limitations of IRR?
- Multiple or no IRR in some cases, 2. Unrealistic reinvestment assumptions, 3. No clear decision-making rule. (Lesson 4, p.7)
What is the Profitability Index (PI)?
PI is the ratio of present value of cash inflows to the initial investment cost. (Lesson 4, p.7)
What is the decision rule for PI?
If PI > 1, accept the project; if PI < 1, reject it. (Lesson 4, p.7)
What are the advantages of PI?
- Accounts for time value of money, 2. Consistent with shareholder value maximization, 3. Compares projects of different sizes. (Lesson 4, p.7)
