B3- Part 1 .Capital Budgeting

Question 1

What is Capital Budgeting? How is it used?

Answer 1

Managerial Accounting technique used to evaluate different investment options

Helps management make decisions

Uses both accounting and non-accounting information

Internal focus

GAAP is not mandatory

Question 2

What values are used in Capital Budgeting?

Answer 2

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

Question 3

When is the Present Value of $1 table used?

Answer 3

For ONE payment- ONE time.

Question 4

When is the Present Value of an Annuity Due used?

Answer 4

Multiple payments made over time- where the payments are made at the START of the period.

Question 5

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

Answer 5

Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.

Question 6

What is the calculation for the Present Value of $1?

Answer 6

1 / (( 1+i )^n)i : interest rate - n : number of periods

Question 7

What is Net Present Value (NPV)?

Answer 7

A preferred method of capital investment valuation since it’s flexible to handle either uneven CF or inconsistent rate of return of the project.
NPV- One of two methods that use the Time Value of Money: PV of Future Cash Flows - Investment (cash outflows)
2nd method is IRR

Question 8

How is NPV used to calculate future benefit?

Answer 8

NPV : PV Future Cash Flows - Investment.
If NPV is Negative- Cost is greater than benefits (bad investment)
If NPV is Positive- Cost is less than benefit (good investment) since rate of return of the project is greater than hurdle rate.
If NPV : 0- Cost : Benefit (Management is indifferent)

Question 9

What is the rate of return on an investment called?

Answer 9

The Discount Rate.

Question 10

What does the Discount Rate represent?

Answer 10

The rate of return on an investment used.It represents the minimum rate of return required. It’s hurdle rate which compensate for all risk assumed.

Question 11

What are the strengths of the Net Present Value system?

Answer 11

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

Question 12

What are the weaknesses of the Net Present Value system?

Answer 12

Not as simple as the Accounting Rate of Return. It does not provide the true rate of return on investment. Simply mention if an investment will earn the hurdle rate used.

Question 13

How do Salvage Value and Depreciation affect Net Present Value?

Answer 13

NPV includes Salvage Value because it is a future cash inflow.
NPV does NOT include depreciation because it is non-cash.
Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.

Question 14

If multiple potential rates of return are available- which is used to calculate Net Present Value?

Answer 14

The minimum rate of return is used.

Question 15

What is the Internal Rate of Return (IRR)?

Answer 15

IRR is the expected rate of return of a project or rate is required for PV of future cash flows to EQUAL the investment. IRR method focuses on decision making.
Net incremental Investment / After Tax Annual Cash Inflow : PV Factor

Question 16

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

Answer 16

Cash flows are re-invested at the rate of return earned by the original investment.

Question 17

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

Answer 17

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

Question 18

What are the strengths and weaknesses of the Internal Rate of Return system?

Answer 18

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

Question 19

When is NPV on an Investment positive?

Answer 19

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

Question 20

When is NPV on an Investment Negative?

Answer 20

When Costs are greater than Benefits

IRR is less than the Discount Rate

Question 21

When is NPV Zero?

Answer 21

When benefits equal the Costs

IRR : Discount Rate

Question 22

What is the Payback Method? How is it calculated?

Answer 22

Is the time required for the Net After-tax cash inflows to recover the Initial Investment in a project. It ignored profitability factor.

• Payback period = Net initial investment (outflow) / Annual Net After-Tax CF
• Note: Depreciation x Tax= Cash Inflow savings
• Payback Method Compare to a targeted time frame; if payback is shorter than target- it’s a good investment. If payback is longer than target- it’s a bad investment.

Question 23

What are the strengths of the Payback Method?

Answer 23

Takes risk into consideration: 2 year payback is less risky than a 5 year payback. Emphasis on liquidity: the return of principal

Question 24

What are the weaknesses of the payback method?

Answer 24

Ignores the Time Value of Money, unless Discount CF is used; Ignores cash flow after the initial investment is paid back; reinvestment of CF is not considered.

Question 25

What is the Accounting Rate of Return?

Answer 25

An approximate rate of return on assets ARR : Net Income / Average Investment Compare to a targeted return rate; if ARR greater than target- good investment. If ARR less than target- bad investment.

Question 26

What are the strengths of the Accounting Rate of Return (ARR)?

Answer 26

Simple to use

People understand easily

Question 27

What are the weaknesses of the Accounting Rate of Return (ARR)?

Answer 27

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

Question 28

What is an Expected Return?

Answer 28

An approximate rate of return on assets.

Question 29

What is limitation of discounted CF?

Answer 29

use a simple constant growth assumption ( single interest rate): It’s unrealistic since actual interest rate and risk fluctuate.

Question 30

How to compute NPV by using discounted CF?

Answer 30

Step 1: Calculate After-tax CF
Step 2: Add Depreciation benefit ( depre x tax rate)
Step 3: Multiple Result by appro PV of annuity
Step 4: Subtract Initial CF
Step 5: NPV

Question 31

What is Profitable index?

Answer 31

ratio of PV of Net Future Cash Inflow / PV of net initial investment.
It ratio >1 = + NPV

Question 32

How to interprete IRR for investment decision?

between IRR and hurdle rate

Answer 32

If IRR> Hurdle rate –should accept the project

Question 33

Weakness of IRR method?

Answer 33

a. Ignore the size of project: Don’t know $ profit
b. Unrealistically by the reinvestment rate assumption
c. Inflexible CF assumption since the result will be different if there are several alternating periods when amt of CF differ significantly.

Question 34

What is degree of operating leverage (DOL)?

Answer 34

DOL = % change in EBIT / % change in sales
High DOL = The company produce sufficient sales to cover its high fixed costs. When FC are covered, additional sale go straight to operating income since VC are low.
DOL is often the result of industry rather than mgnt decision ( i.e: nursing home, CPA firm)

Question 35

What is degree of financial leverage (DFL)?

Answer 35

DFL= % change in EPS / % change in EBIT
When EBIT is Up, Interest exp N/C > EPS is up and vice versa.
When making financing decision, the firm can choose to issue debt or equity. When debt is issued, the firm generally must pay fixed interest costs. While equity issuance do not result in an increase in fixed cost since dividend payments are not required.
- DFL is decision made by mgnt. Dont want to take risk: add partner…

Question 36

What is a degree of combined leverage (DCL)?

Answer 36

DCL = % change in EPS / % change in sales = DOL x DFL

High DCL, greater sales go to earning – show it relates to shareholder, greater potential profit, greater profit