9: Financial Management, Capital Budgeting Flashcards
what is capital budgeting
the process of measuring, evaluating, and selecting long term investment opportunities for a firm
capital undertakings have elements of both risk and reward. define those
risk: the possibility of loss or other unfavorable results that derives from uncertainty implicit in future outcomes
reward: benefit expected or required from investment of resources in capital projects and other undertakings
the relationship is the greater the received risk, the greater expected reward. reward is perceived risk
what is risk free rate
it is to compensate lenders for determining use of funds by making an investment, does not change with perceived risk.
what is the payback period approach
determines the number of years needed to recover the initial cash investment in a project and compares that time with the preestablished maximum payback period
if payback period
what is the payback calculation
Payback = investment cost/annual cash savings
what are the advantages of payback period approach
easy to use, useful in evaluating project liquidity
what are the disadvantages of payback period approach
ignores time value of money, ignores cash flows after payback period, does not measure total project profitability
what is the discounted payback period approach
determines the number of years needed to recover the initial cash investment in a project using discounted cash flows and compares that time with a pre-established maximum payback period.
if payback period
what are the advantages of discounted payback period approach
easy to use, useful in evaluating project liquidity, uses time value of money concept
what are the disadvantages of discounted payback period approach
ignores cash flows after payback period, does not measure total project profitability
what is the accounting rate of return approach
determines the expected annual incremental accounting net income from a project as a percentage of the initial or average investment
ARR= (average annual incremental revenue-average annual incremental exp)/initial or average investment
if ARR > preestablished rate=accept
what are the advantages of ARR
easy to use, consistent with financial statement values, considers entire life and results of project
what are the disadvantages of ARR
ignores time value of money, uses accrual accounting values, not cashflows, assumes the incremental net income is the same each year
what is net present value approach
difference between present value of cash inflows and outflows. determined using a discounted rate called a hurdle rate based on cost of capital to the firm
what are the advantages of npv approach
recognizes time value of money, relates project rate of return to cost of capital, considers the entire life, provides for compounding of amounts over time.
what are the disadvantages of npv approach
requires the estimation of cashflows over the entire life of the project, assumes cashflows are immediately reinvested at the discount rate of return used
what is the IRR approach
determines what rate of return makes the npv of net cashflows equal to zero.
PV factor
PV factor=investment cost/future annual cash inflows
what are the advantages of IRR
recognizes time value of money, considers entire life of project
what are the disadvantages of IRR
difficult to compute, requires estimation of cash flows over entire life of project, assumes cash flows are immediately reinvested at internal rate of return
when is project economically feasible
what it has a positive net present value
what is the profitaility index
determines project rankings by taking into account both the npv and cost of each project
higher the percentage, the higher the rank
profitability index calculation
npv of project inflows/pv of project cost
