5. Captial Budgetting 1 Flashcards
What is NPV
Net Present Value is the difference between an investments market value and its cost (both in todays dollars)
Superior capital budgeting decisions will be made if the approach considers what three factors?
Identify’s the cash flows
Timing of cash flows
The risk associated with the cash flows
What is discounted cash flow valuation? (DCF)
The process of valuing an investment by discounting its future cash flows
What is the pay back period?
The amount of time required for an investment to generate cash flows that recover its initial cost
With the pay back rule, what are its shortcomings?
Ignores the time-value of money
Ignores cash flow beyond the cut-off date
Biased against long-term projects, such as R & D projects
What are some good qualities about the payback period rule?
It is simple, and is useful for small investments
The payback rule favours investments which free up cash quickly (good for small businesses)
Does not take into account the cash flow after a long time (which would be uncertain anyway)
What is the discounted payback period?
The length of time required for an investments discounted cash flows to equal its initial cost
When the discounted cash flow equals the initial investment is NPV zero?
True
What are the draw backs of discounted payback rule?
A cute off date has to be set and any cash flow after this period is ignored
Also just because one project has a shorter payback period doesn’t mean the NPV will be higher
What is the accounting rate of return? (ARR)
An investments average net income divided by its average book value
What are some of the issues with ARR?
It is not a rate of return of any meaningful economic sense, it is a ratio of 2 accounting numbers and not comparable to offers returned in the market.
The rate is specified for the benchmark has no economic meaning in the market world
It looks at net profit and book value, neither tells us what we make from the investment
What is internal rate of return? (IRR)
The discount rate that makes the NPV of an investment zero
What is the NPV profile?
A graphical representation of the relationship between an investment’s NPVs and various discount rates
Does IRR and NPV always lead to the same decision?
Yes if the 2 requirements are met
The projects cash flow must be conventional (year 0 is negative to pay for investment and the following are positive)
The project must be independent, the decision to accept or reject this project does not affect the decision on another project
What are some problems with IRR?
If there are non conventional cash flows (the multiple rates of return problem)
If there are mutually exclusive projects
